FINANCIAL MANAGEMENT UNIT-I FOUNDATIONS OF FINANCE Lesson 1 Financial Management : An Overview INTRODUCTION 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". LEARNING OBJECTIVES 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


SECTION TITLE Meaning 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 profits. 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 finance. Definitions "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 ? Objective of Financial Management 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 organizations. Financial managers are interested in providing answers to the following questions: 1. Given 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.


2. Given 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 assets. 3. Given 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. PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION 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.


financial risks or any other risk that may work to the disadvantage of the firm before embarking on any particular course of action. A firm will have to assess risks involved in each source of funds. the average cost is minimum and the marginal cost and marginal revenue are equal. At this stage. While keeping the goal of maximization of the value of the firm. While issuing equity stock. the volume of sales or any other activities should be stepped up. The elements involved in the maximization of the wealth of a firm is as below: Increase in Profits: A firm should increase its revenues in order to maximize its value. 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. For this purpose. however. the management will have to consider the interest of pure or equity stockholders as the central focus of financial policies. 7 . employees and customers. it will have to accept fixed and recurring obligauons. a corporate manager will have to calculate business a common adage. should be sounded here. In theory. will have to be weighed properly. The advantages of leverage. 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. The sources of funds are not risk-free. Reduction in Cost: Capital and equity funds are factor inputs in production. in the world of business uncertainties. However. profits are maximized when a firm is in equilibrium. A firm has to make every effort to reduce cost of capital and launch economy drive in all its operations. While issuing debentures and preferred stock. "No risk. it will have to increase ownership funds into the corporation. A word of caution. management. no gain" . Minimum Risks: Different types of risks confront a firm. Sources of Funds: A firm has to make a judicious choice of funds so that they maximize its value. too.Wealth Maximization: The goals of financial management may be such that they should be beneficial to owners. These goals may be achieved only by maximizing the value of the firm.

employees and society at large.Long-run Value: The goal of financial management should be to maximize long run value of the firm. v Wealth maximization guide the management in framing consistent strong dividend policy.quick" methods. Here. v The concept of wealth maximization is universally accepted. adjustment is made to cover the risk that is associated with the investments. For permanent progress and sound reputation. the present value of cash flow is taken into consideration. The concept of increasing the wealth of the stockholders differs from one business entity to another. The net effect of investment and benefits can be measured clearly. or. or by pushing an inferior quality into the market. It also leads to confusion in. because. (Quantitatively) v It considers the concept of time value of money. Advantages of Wealth Maximization v Wealth maximization is a clear term. Such tactics. while calculating the Net Present Value at a particular discount rate. however. v The concept of wealth maximization considers the impact of risk factor. It may be worthwhile for a firm to maximize profits by pricing its products high. to be precise. The present values of cash inflows and outflows helps the management to achieve the overall objectives of a company. or by ignoring interests of employees. Criticisms of Wealth Maximization The concept of wealth maximization is being criticized on the following grounds: The objective of wealth maximization is not descriptive. it will have to adopt an approach which is consistent with the goals of financial management in the long-run. it takes care of interests of financial institution. by resorting to cheap and "get-rich. and 8 . to earn maximum returns to the equity holders. owners. are bound to affect the prospects of a firm rather adversely over a period of time.

In other words. Financial management should take into account the enterprise¶s legal obligations to its employees. Moreover. It should try to have a healthy concern which can maintain regular employment under favourable working conditions. Academicians and corporate officers alike have urged the advisability of more socially conscious business management. it should ensure an effective management of finance so that it may bear the desired fruits for the organization. the management must ensure administration. though not the only one. financial management will have to ensure that expectations raised by the corporation are fulfilled with a proper use of several tools at is disposal.misinterpretation of financial policy because different yardsticks may be used by different interests in a company. which will keep the business liquid and solvent.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. there are various other factors which may support or frustrate financial management by supportive or non. be described as a pre-requisite of a successful business. The operating objective for Financial Management is to maximize wealth or the net present worth of a firm. The objective finds its place in these segments of the 9 . Financial management should not only maintain the financial health of a business. it will positively ensure desired results. But it is a necessary condition for business success. a good financial management alone cannot guarantee that a business will succeed. Wealth maximization is as important objective as profit maximization.supportive policies. their influence has become more pervasive. Financial management will then have to rise equal to the acceptance of social responsibility of business. Wealth maximization is an objective which has to be achieved by those who supply loan capital. employees. If it is properly supported and nurtured by efficient activities at all stages. they have created an imbalance which is widely believed to have been instrumental in generating a movement to promote more socially conscious business behaviour. To the creditors. It may. society and management. However. In other words. As corporations have grown bigger and more powerful. however.

financing.corporate sector. The terms and conditions of the different financial sources may vary significantly at a given point of time. DIMENSIONS OF FINANCIAL MANAGEMENT The different dimensions of financial management are dealt below: Anticipating Financial Needs: The financial manager has to forecast expected events in business and note their financial implications. where and how to obtain the funds which a business needs. The financial manager should steer a prudent course between over-financing and under-financing. He should preserve a proper balance among the various assets. the aggregate value of the common stock will be maximized. He may adopt the famous marginal 10 . Profitability refers to the earning of profits and liquidity means closeness to money. The wealth of owners of a firm is maximized by raising the price of the common stock. the pro-forma income statement. If this is done. Financial needs can be anticipated by forecasting expected funds in a business and their financial implications. the pro-forma balance sheet. The financial manager should know how to tap the different sources of funds. dividends and current assets management. Assets are balanced by weighing their profitability against their liquidity. The financial image of a corporation has to be improved in appropriate financial circles which are primarily responsible for supplying finance. This is achieved when the management of a firm operates efficiently and makes optimal decisions in areas of capital investments. the statement of the sources and uses of funds. Much will also depend upon the size and strength of the borrowing firm. Financial Manager anticipates financial needs by consulting an array of documents such as the cash budget. Funds should be acquired well before the need for them is actually felt. Acquiring Financial Resources: This implies knowing when. Allocating Funds in Business: Allocating funds in a business means investing them in the best plans of assets. although the immediate objectives of Financial Management may be to maintain liquidity and improve profitability. etc. He may require short-term and long-term funds.

allocate funds according to their profitability. Accounting and Reporting to Management: Now. he will be able to compare the actuals with standards. Through the budgeting. it is very comfortable for the finance manager to take decisions. Asset management has assumed an important role in Financial Management. He is also responsible for maintaining upto date records of the peformance of financial decisions. He has to adopt close supervision and marking of flow of funds. He should. The cost of each financial decision and returns of each investment must be analysed. So. it may be pointed out that management of funds has both liquidity and profitability aspects. necessary steps or strategies are to be adopted to overcome such events. liquidity and leverage. Analysing the performance of finance: Once the funds are administered. 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. moreover. This will ensure continuous flow of funds as per the requirements of the organisation. while the primary financial responsibility from the owner¶s viewpoint may be to maximize value. Financial Management is concered with the many responsibilities which are the main thrust of a business enterprise. Administering the Allocation of Funds: 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 advise and supply information about the performance of finance to top management. The financial manager will have to keep the assets intact. Where ever the deviations are found. If need arises. 11 . In this connection.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 has to offer his suggestion to improve the overall functioning of the organisation. It is also necessary for the finance manager to ensure that sufficient funds are available for smooth conduct of the business. He not only acts as line executive but also as staff. which enable a firm to conduct its business. The returns on the investments must be continuous and consistent. The department of finance has gained substantial recognition. This helps the management to increase efficiency by reducing the cost of operations & earn fair amount of profits out of investments. This helps in achieving µLiquidity¶ of a business unit. the role of the finance manager is changing.

matching the inflows against cash outflows. The functions of financial management may be classified on the basis of liquidity. with a number of banks to ensure a high degree of liquidity with minimum external borrowing. The third approach is that it is an integral part of overall management rather than a staff specialty concerned with fundraising operations. (2) Profitability: While ascertaining profitability. that is. 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. profitability and management. and v To identify the need for funds and select sources from which they may be obtained.Scope and Functions of Financial Management A priori definition of the scope of financial management fall into three groups. keeping its accounts. (b) Raising funds. In this connection. At the other extreme is the relatively narrow definition that financial management is concerned with raising and administering of funds to an enterprise. 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. that is. that is. 12 . financial management will have to ascertain the sources from which funds may be raised and the time when these funds are needed. One view is that finance is concerned with cash. (1) Liquidity: Liquidity is ascertained on the basis of three important considerations: (a) Forecasting cash flows. (c) Managing the flow of internal funds.

It is also necessary for the financial manager to ensure that sufficient funds are available for smooth conduct of the business. Although a business failure may not always be the result of financial failures. These are the needs which may be described. keeping. (c) Forecasting Future Profits: Expected profits are determined and evaluated. Financial management is concerned with the many responsibilities which are thrust on it by a business enterprise. Profit levels have to be forecasted from time to time in order to strengthen the organization. The formulation of pricing policies should lead to profitability. and so on. and which involves land. v The management of short-term funds. as working capital needs. equipment. however. transport facilities. which is associated with plans for development and expansion. buildings. In this connection. (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. which is associated with the overall cycle of activities of an enterprise. Financial management may be divided into two broad areas of responsibilities. which are not by any means independent of each other. 13 . machinery. research project. financial failures do positively lead to business failures. Each. the image of the organization intact. may be regarded as a different kind of responsibility.(b) Pricing: Pricing is of great significance in the company¶s marketing effort. (3) Management: The financial manager will have to keep assets intact. Asset management has assumed an important role in financial management. it may be pointed out that management of funds has both liquidity and profitability aspects. image and sales level. for assets are resources which enable a firm to conduct its business. The responsibility of financial management is enhanced because of this peculiar situation. These two areas are: v The management of long-term funds. of course. and each necessitates very different considerations.

Once the investment proposals are evaluated and combined into a capital expenditure programme or planned capital budget. The dividend policy is thus instrumental for changes in market price of shares in the capital market. 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. A prudent financial management policy calls for an optimal mix of different decisions in line with organizational objectives. The investment decision involves current cash outlay in anticipation of benefits to be realised in the future. This task is already difficult in domestic companies. utilising and protecting the financial assets of internationally involved companies. Today. dividend distribution. different tax umbrellas and exchange. following diverse legal practices. in turn. heavy reliance on communication environments. problems of dealings between parents and subsidiaries speaking in multiple languages. For deciding the dividend policy. control system among others. financial management extends itself to the broad subject of international money management which refers to the problem of collecting. Financial management must offer a solution for decisions in areas of capital structure. 14 . and retention of surplus inter-alia. In other words. the financing decision involves the determination of the ideal financing mix or capital structure. the next decision involves finalisation of sources for a given capital outlay. depends upon the extent to which a firm is able to effect cash sales. It has become imperative to have reporting systems and optimal use of financial institutions attempting to forecast liquidity and foreign exchange risks of companies. But the task becomes more onerous on account of grated structural and environmental impediments confronting multi-national companies. The uncertain nature of future benefits necessitates evaluation of investment proposals in relation to their expected rate of return and risk.One of the functions of financial management is co-ordination of different activities of a business house. the percentage of earnings paid to shareholders becomes an important consideration. A business depends upon availability of funds which. 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. investment. It is obvious that the percentage of dividend policy paid affects the quantum of retained earnings.

The profit centre is a technique by which activities are decentralised for the development of strategic control points. Specifically the financial manager should anticipate financial needs. cheques and trade bills. exchange controls different currency units and multiple financial institutions. Funds held by individual subsidiaries in different countries cannot be considered fungible and there is little or no chance of international pooling of funds. If 15 . acceptances and letters of credit are termed as documentary credits. should. which is a lengthy process. Other international modes of payment include bank drafts. Planning involves heavy reliance on financial tools and analysis. International cash management involves longer distances. Direction is based. an informed and enlightened use of financial information is necessary for the purpose of coordinating the activities of an enterprise. acquire financial resources. on instruments of financial reporting. The determination of the nature and extent of staffing is aided by financial budget programme. Every business. He groups activities in such a way that areas of responsibility and accountability are cleared defined. irrespective of its size. A variety of instruments exist for effecting international transfer of funds. The international liquidity management is regulated by exchange control and other barriers which usually prohibit the flow of funds in desired directions. therefore. Sight and time drafts. This area is also affected by impediments in banking and mail systems. The standard method of transferring funds internationally is by mail payment order.International cash management deals with more mechanical areas of cash collection. and allocate funds to various departments of the business. Cable transfers reduce remittance time appreciably. have a financial manager who has to take key decisions on the allocation and use of money by various departments. Even intra-country liquidity management may be affected by weak capital markets which offer few investment media or banking systems which delay transfers. Role and Functions of the Financial Manager The financial manager performs important activities in connection with each of the general functions of the management. There may be payment instructions in written or documentary form incorporating some form of credit. holding and disbursement. to a considerable extent. Control requires the use of the techniques of financial ratios and standards. Briefly.

exempt itself from undertaking a study of the financial market. The logic here is very simple. which may be described as the co-ordination of a series of inter-dependent decisions over an extended period. on which depends the value of the firing. v Allocate these funds efficiently to various assets. Of the many environments in which the firm operates. A firm is a part of the entire business activity. therefore. he should so shape his decisions and recommendations as to contribute to the overall progress of the business. The financial market is sensitive to the reactions of firms to the supply of. financial management is nothing more or less than a continuing two-way interaction between a firm and its financial environment. its securities. decisions are the end product of the financial manager¶s task. The financial manager¶s concern is to: v Determine the total amount of funds to be employed by a firm. It has been explained earlier that financial management is related to the environment. 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 16 . This environment is the macro-economic environment. which is reflected in the financial market. and demand for. his firm is on the road to good financial health. That is his primary objective is to maximise the value of the firm to its stockholders. the one closest to the financial manager is the financial market. which is external to a firm. In a fundamental sense. A great deal of his time is spent on financial planning. Since the financial manager is an integral part of the top management. his day-to-day work consists of more than just decision-making.the financial manager handles each of these tasks well. Although. which includes the study of the financial market. v Obtain the best mix of financing in relation to the overall evaluation of the firm. which ultimately determines whether a firm¶s policies are a success or a failure. No firm can.

and select projects which are reasonably profitable and. 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. 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. a firm increases its liquidity at the cost of its profitability. Most financial managers are. if the investment is going to lock up funds for an unreasonable period. therefore. His central role requires that he understands the nature of problems so that he may take proper decisions. at the same time. sometimes one has to be sacrificed for the other. but not excessive amounts v Ensure that disbursements do not create shortage of funds v Analyse. Although both are desirable. He has to choose between profitability and liquidity. In several situations. sound from the liquidity point of view. The financial manager does something more than co-ordinate business activities in a mechanical way. receivables. tempted to compromise between profitability and liquidity. he is forced to sacrifice this option. Since cash earns no return. Macro-economics gives 17 . he faces a challenge: should he choose profitability or liquidity? Despite the knowledge that a particular investment is quite profitable. Financial Manage and Economics Knowledge of economics is necessary for the understanding of financial environment and the decision theories which underline contemporary financial management. A financial manager is often up against a dilemma.v Make sure that funds have been acquired in sufficient. the longer the period. the greater is the risk.

A considerable progress has been made in the development of theoretical structures for the solution of business problems. Accounting is a tool for handling only the financial aspects of business operations. a significant change has taken place in the study of financial management. aided by computer insight into the policies of the government and private institutions through which money flows. credit flows and general economic activity are controlled. evolved over the years as an autonomous branch of economics. in the most economic and suitable manner. production or any other discipline and other problems which have financial aspects Decisions for which accounting records and reports are widely used. legal and financial relationships of funds. credit policy. 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. cost accounting. fixed and working capital in general Financial structure. which is concerned mainly with the raising of funds. This includes: Decisions which affect external. A study of financial management is likely to be barren if it is divorced from the study of economics. statistics and other means. It is geared to the financial ends of a business only because these are measurable on the scale of money values. planning future operations and controlling current performance and future developments through financial accounting. payment of dividends. Effective planning and direction depends on adequate accounting information available to a management on the financial condition of an enterprise. Financial management has. decisions on methods of financing. 18 . budgeting. in fact. Financial Management and Accounting It is of greater managerial interest to think of financial management as something of which accounting is a part.economics and operations research. as it has in all other aspects of business and public administration. The link between economics and financial management is close. personnel. In recent years. using the funds as profitably as possible (for a given risk level). The model-building approach to financial management has been developed from two separate branches of study .

but the gap between the two is rapidly closing. that Ezra Solomon. consolidation. Evolution of Financial Management 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. however.The distinction between financial management and management accounting is a semantic one. The traditional treatment placed altogether too much emphasis on corporation finance and too little on the financing problems of non-corporate enterprises. however. Edward S. has the broader meaning of planning and control of all activities by financial means. It is clear. Thomas L. Financial management. Finally. while management accounting originally meant the internal management of finance in industry. Meade and Arthur Stone Dewing 19 . recapitalization and reorganization left too little room for problems of a normal growing company. The basic contents of the traditional approach may now be summarised. Financial management. 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 accountant devotes his attention to the collection and presentation of financial data. 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. develops additional data and arrives at decisions based on his analysis. as it was then more generally called. It is difficult to say at what stage the traditional approach was replaced by modern approach. incorporation. Matters like promotion. The financial officer evaluates the accountant¶s statements. emerged as a separate branch of economics. merger. it placed heavy emphasis on long-term financial instruments and problems and corresponding lack of emphasis on problems of working capital management. 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. Rein.

With the advent of industrial combination the financial manager of corporation was confronted with the complexities of budgeting and financial operations. aging of accounts receivable and monetary management assured considerable importance. etc. and it developed an interest in internal management procedures and control. securities. optimal capital structure. effects of capital structure upon cost of capital and market value of a firm were incorporated in the subject. floatations. reduce. and working capital management which constitute the crux of the financial problems of modern financial management. Ezra Solomon observes: If the scope of financial management is re-defined to cover decisions about both the use and the acquisition of funds. In this connection. In the circumstances. The concern for liquidity 20 . budget forecasting. Moreover. financial management was almost forced to improve its methodology. The major concern of financial management was survival. budgeting. They did not consider routine managerial problems relating to financing of a firm.among others were profoundly impressed by subjects like promotion. reorganization. consolidations. or increase its investments in all forms of assets that require company funds. Such things as cost of capital. The size and composition of the capital structure was of particular importance. The discipline of financial management was conditioned by changes in the socioeconomic and legal environment. With technological progress. cost. Their works laid emphasis on these topics. and showed a serious concern for the effects of multi-nationals upon price level movements. Its emphasis shifted from profitability analysis to cash flow generation. finance and cost control. 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. Financial problems are a vital and an integral part of overall management. Its attitude to long-term trade was hostile. The new or modern approach is an analytical way of looking at the financial problems of a firm. problems of profit planning and control. liquidation. It looked upon dividend as a residual payment. 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. financial management laid emphasis on international business and finance.

Modern Financial Management should hence forward concentrate on micro. were rejected by corporate decision-makers. to be precise. A Large number of empirical studies on the subject have already been conducted on different portfolios of Financial Management. while the traditional finance manager concerned him with such macroeconomic areas of finance as long-term financing. Fixed assets needs depend upon the nature of the business enterprise . the cost of different sources of funds. 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 others. A lot of literature on the subject of Financial Management seems to be devoted to these and similar matters. capital market (more particularly.whether It is a 21 . Determining Financial Needs: One of the most important functions of the financial manager is to ensure availability of adequate funds. Modern financial management. The functional areas of financial management is elaborated below. and so on. dividend policies. Money may be required for initial promotional expenses. some of which have been tested.economic areas with which a business enterprise has to deal during its day-to-day operations. For example. is basically concerned with optimal matching of uses and sources of corporate funds that lead to the maximisation of a firm¶s market value. retention of surpluses. which were not tested. the stock exchange). belong to corporation finance. however. capital structure and. liquidity. profit planning and control . study of financial institutions. depreciation policies.these are among the subjects which have captured the attention of different schools of thoughts from time to time. planning of corporations. Functional Areas of Financial Management It would indeed be an extremely difficult task to delineate functions of modern financial management. Financial needs have to be assessed for different purposes. These areas. Promotional expenditure includes expenditure incurred in the process of company formation. promotion. underwriting of securities.and profit margins was indeed tremendous throughout the several phases of financial management. short-term financing. more particularly. fixed capital and working capital needs.

Optimal Capital Structure: The financial manager has to establish an optimum capital structure and ensure the maximum rate of return on investment. Figure: 1 Functional areas of financial management Determining the Sources of Funds: The financial manager has to choose the various sources of funds. This is often a challenging task. and involves the comparison and interpretation of accounting data. A firm is committed to the lenders of finance and has to meet various terms and conditions on which they offer credit. the financial manager must definitely know what he is doing.manufacturing. he should exercise it with great care and caution. non-manufacturing or merchandising enterprise. He has to use a large number of ratios to analyse the financial status and activities of his firm. 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. The ratio between equity and other 22 . He is required to measure its liquidity. Financial Analysis: It is the evaluation and interpretation of a firm¶s financial position and operations. profitability and performance are to be measured. He may borrow from a number of financial institutions and the public. determine its profitability and assets and overall performance in financial terms. When a firm is new and small and little known in financial circles. He may issue different types of securities. Even when he has a choice in selecting sources of funds. To be precise. the financial manager faces a great challenge in raising funds. The financial manager has to interpret different statements. Current asset needs depend upon the size of the working capital required by an enterprise.

It is necessary to determine profits properly. if this is not accomplished. The operating leverage exists because of operating expenses. In the process. The finance manager has to ensure that the income for the firm will cover its variable costs. The second element in profit calculation is expenditure. Cost-Volume-Profit Analysis: This is popularly known as the µCVP relationship¶. a firm will have to generate an adequate income to cover its fixed costs as well. he has to consider the operating and financial leverages of his firm. for there is no point in being in business. Variable costs vary according to sales volume. investment income or income from other sources. Profit is the surplus which accrues to a firm after its total expenses are deducted from its total revenue. The first element in profit is revenue or income. The finance manager has to find out the break. variable costs and semi-variable costs have to be analysed. Economists have long before considered the importance of profit maximization in influencing business decisions. For this purpose. This expenditure may include manufacturing costs. 23 . Profit planning is an important responsibility of the finance manager. This revenue may be from sales or it may be operating revenue. fixed costs. Profit planning ensures attainment of stability and growth. Semi-variable costs are either fixed or variable in the short run. Moreover. the point at which total costs are matched by total sales or total revenue.e).even-point (i. 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. Fixed costs are more or less constant for varying sales volumes. The financial manager should have adequate knowledge of different empirical studies on the optimum capital structure and find out whether. selling costs. the profit test is constantly used to gauge success of a firm¶s activities. and to what extent. while financial leverage exists because of the amount of debt involved in a firm¶s capital structure. Profit Planning and Control: Profit planning and control have assumed great importance in the financial activities of modern business.liabilities carrying fixed charges has to be defined. he can apply their findings to the advantage of the firm. In view of the fact that earnings are the most important measure of corporate performance. general administrative costs and finance costs. for they measure the economic viability of a business. trading costs.

and retention of profits and surpluses of the company. 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. In actual practice. and revenues it has earned. the financial manager may lease them and use assets on a rental basis. Decisions are taken on the basis of feasibility and project reports. debentures. it is nevertheless important and needs careful assessment and recognition of its relationship to the company¶s progress. these assets are exposed to changes in their value. during a particular period. The acquisition of fixed assets involves capital expenditure decisions and long-term commitments of funds. furniture and also intangibles such as patents. commercial. should be taken with great care and caution. Profit planning and control are very important. technical. Often.Profit planning and control is a dual function which enables management to determine costs it has incurred. copyrights. appropriate depreciation on fixed assets has to be formulated. These fixed assets are justified to the extent of their utility and/or their productive capacity. and provides shareholders and potential investors with information about the earning strength of the corporation. Moreover. which determine dividends. building. goodwill. Because of this long-term commitment of funds. If they are ill-designed. When it is not worthwhile to purchase fixed assets. Fixed Assets Management: A firm¶s fixed assets include tangibles such as land. long-term borrowings and deposits from public. etc. and so on. To facilitate replacement of fixed assets. replacement. financial and organizational viabilities. Moreover. they may lead to over-capitalisation. It is because of these facts that management decisions on the acquisition of fixed assets are vital. and these changes may adversely affect the position of a firm. The break-even analysis and the CVP relationship are important tools of profit planning and control. machinery and equipment. Essentiality of a project is ensured by technical analysis. The economic and commercial analysis study demand 24 .. containing analysis of economic. The error of judgment in project planning and evaluation should be minimized. they lay the foundation for policies. these fixed assets are financed by issuing stock. Project Planning and Evaluation: A substantial portion of the initial capital is sunk in longterm assets of a firm. decisions governing their purchase. they are directly related to taxation. Profit planning and control are inescapable responsibilities of the management. in view of the fact that fixed assets are maintained over a long period of time.

therefore. The various proposal assets ranked on the basis of such criteria as urgency. The financial analyser should be thoroughly familiar with such financial techniques as pay back. Capital Budgeting: Capital budgeting decisions are most crucial. internal rate of return. It is the life-blood of a firm. It is a financial lubricant which keeps business operations going. The economy of size. The organizational and manpower analysis ensures that a firm will have the requisite manpower to run the project. Working Capital Management: Working capital is rightly an adjunct of fixed capital investment. He should match inventory trends with level of sales. There are several 25 . In this connection. It is. it should be remembered that a project is exposed to different types of uncertainties and risks. necessary for a firm to gauge the sensitivity of the project to the world of uncertainties and risks and its capacity to withstand them. choice of technology and availability of factors favouring a particular industrial site are all considerations which merit attention in technical analysis.position for the product. profitability and risk sensitivity. It results in capital expenditure investments. which is rotating in its nature. discounted cash flow and net present value among others because risk increases when investment is stretched over a long period of time. such as increase in volume of sales. Cash is the central reservoir of a firm that ensures liquidity. against limitations of costs and risks involved therein. liquidity. Capital budgeting forecasts returns on proposed long-term investments and compares profitability of different investments and their cost of capital. The uncertainties of inventory planning should be dealt within a rational manner. 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. accounts receivable and inventory are the important components of working capital. for they have long-term implications. Accounts receivables and inventory form the principal of production and sales. Cash. they also represent liquid funds in the ultimate analysis. It would be unjustifiable to accept even the most profitable project if it is likely to be the riskiest. They relate to judicious allocation of capital. The financial analyst should be able to blend risk with returns so as to get current evaluation of potential investments. Financial analysis is perhaps the most important and includes forecasting of cash inflows and total outlay which will keep down cost of capital and maximize the rate of return on investment. The financial manager should weigh the advantage of customer trade credit.

safety levels of stocks should be maintained. The former may hold up production. 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. Firms cannot avoid making investments in inventory because production and deliveries involve time lags and discontinuities. Thus. the most critical among them being profitability. Moreover. 26 . The financial manager should. the board of directors may be interested in maintaining its financial health by retaining the surplus to be used when contingencies arise. though these involve major problems of valuation and control. However. complex and prone to errors. The most difficult interest to value in a corporation is that of the equity stockholder because he is the residual owner. Dividend Policies: Dividend policies constitute a crucial area of minancial management. by acquiring other concerns or by entering into mergers. while the latter would result in an unjustified locking up of funds and increase the cost of capital. In the circumstances. go through the valuation process very carefully. the interests of a firm and its stockholders are complementary. While owners are interested in getting the highest dividend from a corporation. The risks are there when inventory is inadequate or in excess of requirements. Inventory management thus includes purchase management and material management as well as financial management. A firm may try to improve its internal financing so that it may avail itself of benefits of future expansion. the demand for sales may vary substantially. therefore. Mergers may be accomplished with a minimum cash outlay. Acquisitions and Mergers: Firms may expand externally through co-operative arrangements. Its close association with financial management primarily arises out of the fact that it is a simple cash asset. there are different dividend policy patters which a firm may choose to adopt. The process of valuing a firm and its securities is difficult.costs and risks which are related to inventory management. depending upon their suitability for the firm and its stockholders. The financial manager should determine the economic order quantities after considering the relationships of different cost elements involved in purchases. Inventory management entails decisions about the timing and size of purchases purely on a cost basis. and this is the ultimate goal of financial management. Acquisitions consist of either the purchase or lease of a smaller firm by a bigger organization. The dividend policy of a firm depends on a number of financial considerations.

The auditing approach should give place to a decision-making approach. It is. to fit these items into a coherent picture of the problem in relation to the firm¶s aims and financial resources. the modern executive. There is an absence of data on the marginal efficiency of capital. and completely avoids undertaking structure which is distinct from that which is applied to personal income. The financial controller is often behaviorally more concerned with expenditure than with profits. set performance standards. This is true for both private and public sectors. an all-encompassing function. who is buried in a maze of seemingly endless statistics and voluminous reports. and second.Corporate Taxation: Corporate taxation is an important function of the financial management. in actual practice. the management of finance should have the optimal use of funds as its focal point. The modern tools of management. cost control. Today¶s finance manager is engaged in such activities for the construction of models as to direct the search for new information. fails to cover the scope of modern financial management. have not yet become popular with the captains of our industry. The traditional notion that the finance function is simply a process of µmanaging cash and capital¶ or planning and controlling profits. is constantly struggling to gain real financial control. and establish operating control. Infact. However. 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. The final objective of financial management is to suggest alternative solutions to problems. including capital management. in brief. organizational development and R & D. performance budgeting. He tends to become a person who wants to keep his financial resources intact. input-output 27 . spends nothing. And this is a challenge which he has to face. for the former has a serious impact on the financial planning of a firm. 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. it is subject to an income. Since the corporation is a separate legal entity. rationalise operating rules. The management of capital in Indian industries is generally anchored to traditional legacies and practices. Its objective is first to select the items of financial information which are relevant to a particular problem. It is necessary to take a fresh look at finance management in most Indian industries.

As a consequence. which render current evaluation of issues somewhat difficult. which facilitate a business firm to achieve wealth maximisation. The present behaviour of financial management is a result of government policy. and physical productivity . Funds Requirement Decision: Financial requirement decision is one of the most important decisions of finance manager. etc. 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.these need a better re-orientation and gearing up of capital management practices. Financial decisions have been considered as the means to achieve long-term objective of the corporates. in an uncertain capital market.analysis. The total amount of capital and revenue expenditure of a company facilitates the financial manager in finding the total funds requirement. Moreover. growth potents. The preponderance of proprietary. This decision is considered with estimation of the total funds required by a business unit. even when the cost of these borrowing is relatively high. technical feasibility of financial planning and flow. Financial requirement. Financing and Dividend Decisions are the most important areas of financial management. Capital expenditure consists of acquiring fixed assets. partnership and private companies has made industrial units something like closed shops. social obligations. business houses are forced to look for their borrowings elsewhere as the only reliable method of finance. Financial Decisions Financial decisions are the decisions relating to financial matters of a corporate entity. The management of these sectors is rested in family complexes about which there is no adequate information. technical co-efficient. Revenue expenditure consists of maintaining the day-to-day 28 .. Investment.

Investment Decision: Investment decision is concerned with allocation of funds to both capital and current assets. State the role of the financial manager and explain his functions in an organization. Therefore. This decision will be made by considering the different factors. size of the organisation. creditors. 2. 4. The suppliers of materials. .activities of a business unit. shareholders and the government will measure and understand the soundness of the company through dividend decisions. financial institution and through the commercial banks. Hence the total of this expenditure helps the finance manager in determining the total funds requirement. viz. dividend decision has been considered as another important decision of the finance function. Capital budgeting. This decision has been considered as the barometer through which a business firm¶s performance is measured. Capital assets are financed through long-term funds and current assets are financed through short-term funds. Dividend Decisions: Regular and assured percentage of dividend and capital gains are the basic desires of equity shareholders. 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. The overall cost of that capital composition must be kept at minimum proper debt.Comment.. 29 . bankers. inflation. CVP analysis are the techniques generally used fir the process of investment decisions. Funds are available through primary market. Cost associated with each of the instrument or source is different. State the objectives of financial management. HAVE YOU UNDERSTOOD? 1. Indicate the possible areas of conflict between management and stockholders. government policies. etc. The overall objective of a corporation is to fulfill the desires of the shareholders and attain wealth maximization in the long run. 3. Discuss briefly the scope and functions of financial management. "Financial management is the appendage of the finance function". Equity ratio should be maintained to maximize the returns to the shareholders. 5. Financing Decisions: Financing decision is concerned with identification of various sources of funds.

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. Discuss briefly different functional areas of financial management. Describe the evolution of financial management. While this approach prima facia appears to be satisfactory. Lesson 2 Time Value of Money Introduction 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. b. 8. Distinguish between: a. Discuss briefly the problems of international financial management. 9. 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. 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 30 . 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. Learning Objectives On reading this lesson. 7. Financial management and economics. Financial management and accounting. the value of money remains the same. we will consider the project to the financially viable. We know intuitively that this assumption is incorrect because money has time value.6.

Capital can be employed productively to generate positive returns. 1.000 today and you deposit it with a financial institution. prefer current consumption to future consumption. SECTION TITLE Reasons for time value of money Many financial problems involve cash flows occurring at different points of time. discussing the methods for dealing with time value of money. in general.Present value of an annuity Money has time value. for a period of 3 years. which pays 10 per cent interest compounded annually. The deposit would grow as follows: Rs. For evaluating such cash flows an explicit consideration of time value of money is required. 31 . a rupee today represents a greater real purchasing power than a rupee a year hence. 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. This chapter. A rupee today is more valuable than a rupee a year hence. Why? There are several reasons: Individuals. is divided into four sections as follows: Future value of a single cash flow Future value of an annuity Present value of a single cash flow Present value of an annuity Future value of a single cash flow Suppose you have Rs.

The growth of future value is shown in the following Table:1 Table: 1 Future Value of a Single Cash Flow 32 .Formula 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.

2. 1. Naturally.1W12 = Rs.138) = Rs.10) 8 = Rs.000 (1. 1. 1. 1. We have plotted the growth curves for three interest rates: 0 per cent. so on and so forth.000 today in a bank which pays 10 per interest interest compounded annually.Equation (1) is a basic equation in compounding analysis.138 Graphic View It shows graphically how one rupee would grow over time for different interest rates. Table 2 shows some typical values of (I + k) n. 3. Table: 2 Value of FVIFk. published tables are available showing the value of (1 + k) n for various combinations of k and n. It is very tedious to calculate (1 + k)¶. if you deposit Rs.144 The future value. when the interest rate is 6 percent it takes about 12 years to double the amount. 6 per cent and 12 per cent. Doubling Period 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.000 (2.000 (1. Looking at the above table we find that when the interest rate is 12 percent it takes about 6 years to double the amount. will be: Rs. Is there a rule of thumb which dispenses with the use of the future value interest 33 . The factor (1 + k)n is referred to as the compounding factor or the future value interest factor (FVIFk. Growth curves can be readily plotted for other interest rates. the faster the growth rate.144) = Rs. how much will the deposit grow to after 8 years and 12 years? The future value.n for Various combinations of k and n For example.n).000 (3. To reduce the tedium. 12 years hence. 1. the higher the interest rate. 8 years hence will be: Rs.

we may employ the future value interest factor table. For example. 10 percent and 15 percent. if the interest rate is 8 percent. Though somewhat crude. What has been the compound rate of growth in the sales of Alpha for the period 1981-87.98. the doubling period is calculated for two interest rates.factor table? Yes. a sixyear period? This question may be answered in two steps: Step 1: Find the ratio of sales of 1987 to 1981. over a period of time. If you are inclined to do a slightly more involved calculation. it is a handy and useful rule of thumb. The process may be demonstrated with the help of the following sales data for Alpha Limited. This is simply: 99/50 = 1. a more accurate rule of thumb is the rule of 69. say the sales series or the profit series. According to this rule of thumb the doubling period is obtained by dividing 72 by the interest rate. there is one and it is called rule of 72. the doubling period is about 9 years (72/8). According to this rule of thumb. the doubling period is equal to: As an illustration of this rule of thumb. Likewise. 34 . Finding the Growth Rate To calculate the compound rate of growth of some series. if the interest rate is 4 percent the doubling period is about 18 years (72/4).

974 and the interest rate corresponding to is 12 per cent. the value closest to 1. Hence. till you find a value which is closest to 1.6 (between Rs. Your deposit (if interest is not withdrawn) grows as follows: Note that. we assumed that compounding is done annually. 1. the compound rate of growth is 12 per cent.000 (1. we consider the case where compounding is done more frequently. 3. Shorter Compounding Period So far. 1. you depoit Rs.120. 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) 35 .000 with a finance company which advertises that it pays 12 per cent interest semi-annually² this means that interest is paid every six months. 1. Now.123.60 under semi-annual compounding and Rs.12) = Rs.0 under annual compounding represents interest on interest for the second 6 months.98 is 1.Step 2: Consult the FVIFk.0. The difference of Rs.120. if compounding is done annually the principal at the end of one year would be Rs. Suppose.1. 1.98 and then read the interest rate corresponding to that value. In this case. n table and look at the row for 6 years.

000 grow to at the end of 6 years.000 grows to Rs. 10.0328 = Rs. if the nominal rate of interest is 12 per cent and the frequency is 4 times a year? The amount after 6 years will be: Rs.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. 5. 1.36 per cent per annum. 5.12) 4.6 = Rs. 5.000 (1. 5. 36 .03) 24 = Rs.000 grows at the rate of 12.000 (1 ÷0.123. Example: How much does a deposit of Rs. 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. 1. 1. This means that Rs.164 Effective versus Nominal Rate We have seen above that Rs.6 at the end of a year if the nominal rate of interest is 12 per cent and compounding is done semi-annually.36 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 12 per cent under semi-annual compounding.000 x 2. The figure of 12.

1. The premium payments of a life insurance policy.000 (1. 1.000 annually in a bank for 5 years and your deposits earn a compound interest rate of 10 per cent. to an annuity due. 1. Suppose you deposit Rs.000 (1.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. 37 . for example.000 (1. When the cash flows occur at the beginning of each period the annuity is called an annuity due.4641) + Rs. are an annuity.000 (1.000 (1.10) 3 + Rs. the future value of this annuity will be: Rs. 6. 1.000(1.000 = Rs.000(1. 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. 1.000= Rs.105 The time line for this annuity is shown in the following. 1.l0) + Rs. Future value of an annuity An annuity is a series of periodic cash flows (payments or receipts) of equal amounts.10) 2 + Rs. 1. 1. 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.10) + Rs. When the cash flows occur at the end of each period the annuity is called a regular annuity or a deferred annuity.2100) + Rs.10) + Rs.3310) + Rs. 1. 1.000 (1. with some modification. Our discussion here will focus on a regular annuity²the formulae of course can be applied. 1.

n). The value of this factor for several combinations of k and a is in following table. Table 6 Value of FVIVA k.Formula: In general terms the future value of an annuity is given by the following formula: FVAn = A (1+k)n + A (1+k)n-2 +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 for various Combinations of k and n 38 .

39 .000 are made into a deposit account that pays 8 per cent interest per year.000 (4. we get: In Eq..507)= Rs.014 Sinking Fund Factor Equation (4) shows the relationship between FI¶A A. Juggling it a bit. (5).Example: Four equal annual payments of Rs. 2. 2.000 (FVIFA8%. 4) = Rs. the inverse of FVIFA . Ic and a. 9. 2. What is the future value of this annuity at the end of 4 years? The future value of this annuity is: Rs. is called the sinking (1+ky-¶fund factor.

the interest rate (k) can be easily figured out if the values of the other three²FVn.000.6 2. and. k.000 at the end of 6 years to investors who deposit annually Rs.n Example: How much should you save annually to accumulate Rs. we find that 40 .000 for 6 years. What interest rate is implicit in this offer? The interest rate may be calculated in two steps: 1.k.000 = Rs. Example: A finance company advertises that it will pay a lumpsum of Rs. n. 1.k. Doing so. Look at the FVIFAk. 8. A. if the saving earns an interest of 12 per cent? Finding the Interest Rate Given the relationship between FVAn. and n. 1. 8.000 by the end of 10 years. Find the FVIFAA6 for this contract as follows: Rs.²are known.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.000 x FV1FA. A. 20.n table and read the mw corresponding to 6 years until you find a value close to 8.

we conclude that the interest rate is slightly below 12 per cent. someone promises to give you Rs. used for calculating the present value. to the present point of time. 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. 41 .6 is 8. Present value of a single cash flow Suppose. is simply the inverse of compounding. 1. 1. we get.000 three years hence. as follows: Formula The process of discounting.FVIFA12%. 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.000.115 So.

1.n for Various Combinations of k and n Graphic View of Discounting 42 .n for several combinations of k and n. is given in Appendix at the end of this book.6) is called the discounting factor or the present value interest factor (PV1F j.The factor in Eq. 1.000 x PVIF10%. 1.6 = Rs.000 (0.5 Example: 1 Find the present value of Rs. Example: Find the present value of Rs. A more detailed table of PVIF.000 receivable 6 years hence if the rate of discount is 10 per cent.5645) = Rs. 1. 564. Table 7 gives the value of PVIFk. Since Table 7 does not have the value of PVIF we obtain the answer as follows: Table 7 Value of PVIF k. The present value is: Rs.000 receivable 20 years hence if the discount rate is 8 per cent. (4.

the dividend stream associated with an equity share is usually uneven and perhaps growing.The following figure shows graphically. The present value interest factor declines as the interest rate rises and as the length of time increases. how the present value interest factor varies in response to changes in interest rate and time. the cash flow stream associated with a capital investment project is typically uneven. we often come across uneven cash flow streams. For example. Present Value of an Uneven Series In financial analysis. The present value of a cash flow stream--uneven or even--may be calculated with the help of the following formula: 43 . Likewise.

= 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. the shorter discounting period implies that (i) the number of periods in the analysis increases and (ii) the discount rate applicable per period decreases. quarterly monthly. cash flows may have to he discounted more frequently than once a year. or daily. using a Shorter Discounting Periods Sometimes. The general formula for calculating the present value in the case of shorter discounting period is: 44 . semiannually. As in the case of intra-year compounding.where PVn.

000 annually for 3 years.000 x PVJFk/m. 10. 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 annuity: The time line for this problem is shown in following figure 45 . you expect to receive Rs.000 to be received at the end of four years.000 x 0. 10.623 = Rs.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. 6.230 Present value of an annuity Suppose. The present value of this cash flow when the discount rate is 12 per cent (k = 12 per cent) and discounting is done quarterly (m = 4) and it is determined as follows: PV = Rs. 10. 1.000 x PVIF3%. 10. consider a cash flow of Rs. 16 = Rs. mxn = Rs.

Formula 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 46 .

000 will begin 7 years hence.000 discounted at 10 percent? The PVIFA10%. 10. 47 .n). 10.000 (3. 4 is 3. simply equal to the product of the future value interest factor for an annuity (PVIFAk.e. Table 9 shows the value of PVIFAL for several combinations of k and it A more detailed table of PVIFAk. n) and the present value interest factor (PVIFAk.170 Hence.000 (5.650) = Rs. i.170) = Rs.000 (PVJFA124 = Rs. as can be seen clearly. 31. 5. (The first occurs at the end of 7 years. 6 years from now. n values is found in Appendix A at the end of this book. This is equal to Rs.700 Example: A 10-payment annuity of Rs. 5. 28.) What is the value of this annuity now if the discount rate is 12 per cent? This problem may be solved in two steps. PVAn = Rs.It is referred to as the present value interest factor for an annuity (PVIFAk.250. It is. Step 1 Determine the value of this annuity a year before the first payment begins. Table 9 Value of PVIFA k. n for Different Combinations of k and n Example: What is the present value of a 4-year annuity of Rs.. 5. n).

Step 2 Compute the present value of the amount obtained in Step 1. Rs. 28,250 (PV1F1 6) = Rs. 28,250 (0.507) = Rs. 14,323. Capital Recovery Factor 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?

Finding the interest rate Suppose, someone offers you the following financial contract ie., if you deposit Rs. 10,000 with him he promises to pay Rs. 2,500 annually for 6 years. What interest rate do you earn on this deposit? The interest rate may be calculated in two steps: Step1. Find the P VIFA6 for this contract by dividing Rs. 10,000 by Rs. 2,500


Step 2. Look at the PVIFA table and read the row corresponding to 6 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. Present value of perpetuity 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. HAVE YOU UNDERSTOOD? 1. Why does money have time value? 2. State the general formula for the future value of a single cash flow. 3. What is the relationship between effective rate of interest and nominal rate of interest? 4. What is an annuity? 5. State the formula for the future value of an annuity. 6. What is a sinking fund factor? Illustrate it with an example. 7. State the general formula for calculating the present value of a single cash flow. 8. What is the general formula for calculating the present value of a cash flow series? Lesson 3 Risk and Return Introduction 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 Learning objectives 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 SECTION TITLE Risk and Return: Concepts 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 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:



= 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 2. 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. 2. 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.











Risks in a Portfolio Context 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 2 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. 12,000 per annum (because the mean return in the preceding five years was 12 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 12 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


is used. the formulae used for calculating the mean return and the standard deviation are as follows: 54 . rather than the probability distribution of return. In general. diversification results in risk reduction. if the rates of return of individual securities are not perfectly positively correlated.portfolio rate of return is much less than the variability of individual security rates of return. Table 2 Return and Risk: Individual Securities and Portfolio @When historical return data. Why? This happens because the rates of return on the two securities tend to move in opposite directions.

the portfolio risk decreases and approaches a limit. can be achieved by forming a portfolio of 10-15 securities . in the form of risk reduction.2 portfolio risk 55 . Figure 5. figure 3.2 represents graphically the effect of diversification on portfolio risk. Empirical studies have suggested that the bulk of the benefit from diversification.1 Diversifiable and Non-diversifiable Risk What happens when more and more securities are added to a portfolio? In general.figure 3.thereafter the gains from diversification are negligible or even nil.

Put differently such risk cannot be diversified away. 56 . diversified their portfolios may be. To illustrate. This is illustrated graphically in the above figure.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. it is expressed as a percentage of the beginning of period value of the investment.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. plant breakdown. and industrial policy. which have a bearing on the fortune of almost every firm. Hence.). risks arising from them can be diversified away by including several securities in a portfolio. It is evident that the return on the risky security (kr) is more volatile than the return on the market portfolio (km) whereas. Beta Rational investors hold diversified portfolios from which the diversifiable risk is more or less eliminated. 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). the return on the conservative security (kc) is less volatile than turn on the market portfolio (km). nonavailability of raw materials. a risky security (whose return is denoted by kr) and a conservation security (whose return is denoted by k. level of government spending. Return The return from an investment is the realisable cash flow earned by its owner during a given period of time. 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. however. investors cannot avoid the risk arising from them. Hence. Hence. etc. Events of this kind affect primarily a specific firm and not all firms in general. Different securities have differing sensitivities to variations in market returns. inflation. Typically. these factors affect returns on all firms. lawsuit. Do all securities have the same degree of non. It shows the returns on the market portfolio (km) over time along with the returns on two other securities. the relevant measure of risk of an investment is its no diversifiable risk (or systematic risk). Since. suppose you buy a share of the equity stock of Olympic Limited for Rs.

The expected return. However. one month. Probability When you buy an equity stock you are aware that the rate of return from it is likely to vary-and often vary widely. 90. For example. six months. is simply: In general. the rate of return is defined as: k = actual. 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. given this information. After a year you expect that (i) a dividend of Rs. or any other). it can be defined as any other interval.80 today. terms. one day. 2 per share will be received and (ii) the price per share will rise to Rs. 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 concerned: 57 . one week. expected.

For example. In more formal terms we say that the probability associated with outcome A is greater than the probability associated with the other outcomes. being more volatile. 10 per cent. Bharath Foods. 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. Oriental Shipping. based on the state of the economy as shown in Table 3. This implies that there is an 80 per cent chance that the price of the stock will increase and a 20 per cent chance that it will not increase during the next fortnight. Consider investment in two equity stocks. or 40 per cent with the same probabilities. may be more likely than the others. The first stock. 20 per cent. Table 3 Rates of Return and their Probabilities for Bharath Foods and Oriental Shipping 58 . The probability of an event represents the chance of its occurrence. The second stock. The first outcome. for example. 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.All the three outcomes may not be equally likely. or 25 per cent with certain probabilities associated with them based on the state of the economy as shown in Table 3. may provide a rate of return of 15 percent. may earn a rate of rate return of ²20 per cent.

it is common to calculate the expected rate of return. 59 . 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. a measure of central tendency.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. Expected Rate of Return When the rate of return can take several possible values because of the investment risk.

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.From Eq.0% = 13. 0.30) (25%) + (0.30) (40%) + (0.8 fluctuates lesser than the market portfolio. More precisely. the return on the security with a beta of 1.5.8 is expected to rise by 8 per cent (0. say. 1.5 x 10 per cent).. 60 . By definition.20) (15%) = 20. the expected rate of return for Oriental Shipping is: k0 = (0.50) (20%) + (0. A security which has a beta of say.5) (10%) + (0. (2) it is clear that k is the weighted arithmetic average of possible outcomes²each outcome is weighted by the probability associated with it. a security which has a beta of. the beta for the market portfolio is 1. Though not perfect.20) (-20%) = 13. On the other hand. 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 x 10 per cent). experiences greater fluctuation than the market portfolio.3 How is non-diversifiable risk measured? It is generally measured by beta.5% Similarly. The expected rate of return for Bharath Foods is: kb= (0. if the return on market portfolio is expected to increase by 10 per cent.5 is expected to increase by 15 per cent (1.0% Returns figure 3.

Calculation of Beta For calculating the beta of a security the following market model developed by William F. beta km = return on market portfolio ej = random error term Beta reflects the slope of the above regression relationship.80 and rarely. = Variance of return on the market portfolio 61 . Sharpe is employed: k1=+ where km++ej kj= return on security j = Intercept term alpha = Regression coefficient. km) = covariance between the return on security j and the return on market portfolio. It is equal to: Where Coy (kj. assume a negative value.60 to 1.Individual security betas generally fall in the range 0. if ever.

The intercept term for security j (a. 5.76 we infer that its return is less volatile than the return on the market portfolio.) is shown graphically in Fig.= Correlation coefficient between the return on jth security and the return on the market portfolio = 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. Table 5 Calculation of Beta 62 . The returns on security j and the market portfolio for a 10-year period are given below: Table 4 The beta for security j.6 percent (0. is calculated in Table 5.) is equal to 2. the return on security j would he expected to increase/decrease by 7.12 percent. If the return on the market portfolio rises/falls by 10 per cent.. It represents the expected return on security j when the return on the market portfolio is zero.. The graphic presentation is commonly referred to as the characteristic line. Given the values of (3 (0.76) and cx. 3.12 percent) the regression relationship between the return on security j (Ic) and the return on market portfolio (k. (2.76 x 10%). Since security j has a beta of 0.

if Rf is 8 per cent. is the product of the level of risk () and the compensation per unit of risk (km-Rf). the required rate of return is: 63 . is 1. Thus. it may be noted. The risk premium.4.Relationship between Risk and Return Capital Asset Pricing Model 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). for a risky security j. and kM is 14 per cent.

In this figure. and vice versa. the greater the required rate of return. the higher the beta. ceteris paribus. the required rate of return for three securities. B and C.5.It is evident that. which shows the relationship between beta and the required rate of return.4 Security market line 64 . Security A is a defensive security with a beta of 0. figure 3. The figure below shows the SML for the basic data given above. is shown. A. Security Market Line The graphical version of the CAPM is called the security market lines (SML).

The slope represents the price per unit of risk and is a function of the risk-aversion of investors.6 shows the change in the security market line when the risk-aversion of investors decreases 65 . Security C is an aggressive security with a beta of 1. Its required rate of return is equal to the rate of return on the market portfolio. the intercept of the security market line changes. For example.5 below shows the change in the security market line when the inflation rate increases and Figure 3. and if the beta of a security is more than 1 it is characterised as aggressive. if the beta of a security is equal to I it is characterised as neutral.) Changes in Security Market Line The two parameters defining the security market line are the intercept (R1) and the slope (kM R1). Security B is a neutral security with a beta of 1. If the real risk-free rate of return and/or the inflation rate change. Figure 3. If the risk-aversion of investors changes the slope of the security market line changes.Its required rate of return is 11 per cent.5. (In general. The intercept represents the nominal rate of return on the risk-free security. Its required rate return is 17 per cent. It is expected to be equal to: risk-free security real rate of return plus inflation rate. if the beta of a security is less than 1 it is characterised as defensive. if the risk-free real rate of return is 2 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.

figure 3. calculated as follows: 66 .5 change in the security market line caused by an increase in inflation Change In the Security Market Line caused by an Increase in Inflation Security Market Equilibrium Suppose the required return on stock A is 15 per cent.

in general. 22. 1.Change in the Security Market Line caused by a a decrese in Risk Aversion FIGURE 3. D0. after analyzing the prospects of stock A. 1. was Rs. The dividend per share expected a year hence is: D1= Rs. and price will continue to grow at the rate of 6 per cent annum.70. do? Investors would calculate the expected return from stock A as follows: 67 . 1.06) = Rs.80 The market price per share happens to be Rs.70 (1. conclude that its earnings. The previous dividend per share. What would investors. dividends.6 Change in the Security Market Line caused by a a decrese in Risk Aversion The investors.

its equilibrium price a year hence will be Rs. as there would be no demand for the stock at Rs. In this process.00. for P4. we find that the equilibrium price is Rs.. Suppose the values of underlying factors change as follows: Table: 6 68 .Finding that the expected return is less than the required rate.00. To illustrate. existing owners will have to lower the price to such a level that it fetches a return of 15 per cent. 20. 22 per share.20. investors. investors.00 If the market price initially had been lower than Rs. its equilibrium price. the price will be pushed up to Rs. 20. However. 20. finding its return to be greater than its required return. 20. That price. is in equilibrium and sells at a price of Rs. However. If the expectations with respect to this stock are fulfilled. would like to sell the stock. in general. its equilibrium price. is the value of P in the following equation: Solving Eq. Changes in Equilibrium Stock Prices Stock market prices tend to change in response to changes in the underlying factors. let us assume that stock A. 21.00 per share. seek to buy it. described above.6 per cent higher than the current price. several factors could change in the course of a year and alter its equilibrium price. its required return.

69 . Have you understood? 1. A and B. 36.The changes in the first three factors cause kAto change from 15 per cent to 13 cent. 4. causes the equilibrium price to increase from Rs: 20. What is a defensive security? Neutral security? Aggressive security? 7. What is the effect of change in risk aversion on the security market line? 8. Why is standard deviation regarded as the most important measure of risk in financial theory? 2. The change in expected growth rate. is the . Comment. "The increase in the risk-premium of all stocks. What is the relationship between the risk of a security measured by its beta and its required rate of return? 6. when risk-aversion increases". Distinguish between non-diversifiable risk and diversifiable risk. What happens to risk when we add more and more securities to a portfolio? 3. How is the systematic risk of a security measured? 5. irrespective of their beta.same. 9. along with the change in the required rate return.00 to Rs. The following information is available about two securities.80.

Therefore.(i) Which of the two securities is more risky? Why? 10. Valuation of equity under dividend capitalization approach. Learning objectives On learning this lesson. an estimate of current normal earning power and dividend pay-out. What is the empirical evidence on CAPM? Lesson 4 Valuation of Securities Introduction The goal of investors and investment managers is to maximize their rate of return. 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. 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. 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. you will be conversant with: Valuation concept Valuation of bonds The concept and calculation of YTM. or in other words. and 70 . market value of their investments. Thus.

is divided into four sections as follows: Valuation concept Bond valuation Equity valuation: dividend capitalization approach Equity valuation: ratio approach SECTION TITLE Valuation Concept From a financial point of view. the value of an asset is equal to the present value of the benefits associated with it. 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. presenting such a framework. the value of the asset can be calculated as follows: 71 . 1.000 per year for the next 10 years and the appropriate discount rate is 16 per cent. if an investor expects an investment to provide an annual cash inflow of Rs.Valuation of equity under Ratio approach This chapter. Symbolically.

Bond Valuation a) Terminology A bond or debenture (hereafter referred to as only bond). Hence.5 per cent). Coupon Rate and Interest A bond carries a specific interest rate which is called the coupon rate.5 (Rs. 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. is payable to the bondholder. akin to a promissory note. we need familiarity with certain bond-related terms. the value of a bond is: 72 . For example. perhaps a nominal premium. 100 x 13. Usually. 100. At the time of maturity the par (face) value plus. In order to understand the valuation of bonds. the annual interest payable on a bond which has a par value of Rs. 100 and a coupon rate of 13.000. par value of the bond x coupon rate. Par Value: This is the value stated on the face of the bond.5 percent is Rs. 13. is an instrument of debt issued by a business or governmental unit. b) Basic Bond Valuation Model As noted above. Sometimes it is Rs 1. whereas government bonds have maturity periods extending up to 20-25 years. It represents the amount the firm borrows and promises to repay at the time of maturity. Maturity Period: Typically corporate bonds have a maturity period of 7 to 10 years. The interest payable to the bondholder is simply. the par or face value of bonds issued by business Finns is Rs.

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. 73 . 100 at the end of 8 years. What is the value of this bond? Since. will mature after 8 years. They state the effect of the following factors on bond values: 1. bearing a coupon rate of 12 per cent. the value of the bond will be: c) Bond Value Theorems Based on the bond valuation model. What is the value of this bond? Since. 1. several bond value theorems have been derived. the annual interest payment will be Rs.000 at the end of 5 years. Example: A Rs. The required rate of return on this bond is 14 per cent. bearing a coupon rate of 14 per cent. The required rate of return on this bond is 13 per cent. will mature after 5 years. the value of the bond will be: Example: A Rs. Number of years to maturity. the annual interest payment will be Rs. 100 par value bond. 2. Relationship between the required rate of return and the coupon rate. 140 for 5 years and the principal repayment will be Rs. 12 for 8 years and the principal repayment will be Rs.000 par value bond. 1.

the value of a bond is less than its par value. which has the following features: What happens to the value of Magnum¶s bond when the required rate of return is 14 per cent? 16 per cent? 12 per cent? If the required rate of return is 14 per cent (which is the same as the coupon rate). the bond value is: If the required rate of return is 16 per cent (which is higher than the coupon rate). the bond value is: 74 . the value of a bond is more than its par value. Ic When the required rate of return is less than the coupon rate.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. To illustrate the above theorems let us consider a bond of Magnum Limited.

when the matuirty period will be 7 years. IIa When the required rate of return is greater than the coupon rate. the greater its price change in response to a given change in the required rate of return. 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. IIc The longer the maturity of a bond. To illustrate the above theorems. IIb When the required rate of return is less than the coupon rate. the bond value is: The following theorems express the effect of the number of years to maturity on bond values. it will have a value of: One year from now. the discount on the bond declines as maturity approaches. the premium on the bond declines as maturity approaches.If the required rate of return is 12 per cent (which is lower than the coupon rate). the bond will have a value of: 75 .

as follows: The lower curve in the following figure represents how the bond value will behave as a function of years to maturity. until it matures. the bond will increase in value with the passage of time.Given the required rate of return of 15 per cent.1 Bond Value as a Function of Years to Maturity If the required rate of return on the bond of Bharath Limited is 11 percent it will have a value of: 76 . figure 4.

To further illustrate the theorem . 916. which are alike in all respects except their period of maturity. given a maturity period of 7 years. 1.8 to Rs. the bond value will decrease with the passage of time.4 to Rs. as follows: The upper curve in Fig 4. 967.1 When the required return decreases from 15 per cent to 11 per cent. if the same change in the required rate of return occurs with only 2 years to maturity. the bond will have a value of: Given the required rate of return of II percent.One year from now.1 above represents how the bond value will behave as a function of years to maturity. 4. the greater is its price change in response to a given change in the required rate of return. To show that the longer the maturity of a bond. the bond value would rise from Rs. the value of the bond increases from Rs. when the maturity period will be 7 years.0 per cent. we may refer to Fig.034.6.7²an increase of only 7.094. However. 1. 77 . an increase of 19A percent. until it matures. consider two bonds A and B.

called the yield to maturity (YTM hereafter). d) Yield to Maturity (YTM) Suppose the market price of a Rs. we have to try a higher value for led. we may have to try several values of led till we µhit¶ on the right value. carrying a coupon rate of 9 percent and maturing after 8 years.What happens if the required rate of return on these two bonds rises to 14 per cent. 800. Let us try led = 14 percent. is the value of led in the following equation: To find the value of led which satisfies the above equation. with a discount rate of 12 percent. is Rs. 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. 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. 1. this value is greater than Rs. 800.000 par value bond. Putting a value of 12 percent for led we find that the right-hand side of the above expression becomes equal to: Since. or falls to 10 percent? The prices of these bonds will behave as follows: From the above data. Let us begin. This makes the right-hand side equal to: 78 .

we find that Ic is equal to 13. 800. and a maturity period of 6 years. In approximation if you are not inclined to follow the trial-and-error approach described above. This makes the right-hand side equal to: Thus. Let us kd = 13 percent. Using a linear interpolation in the range 13 percent to 14 percent. What is he yield to maturity? Using the approximate formula the yield to maturity on the bond of Zion works out to: 79 . we try a lower value for k.Since. you can employ the following formula to find the approximate YTM n a bond: Example: The price per bond of Zion Limited is Rs. d lies between 13 percent and 14 percent. this value is less than Rs. a coupon rate of 14 per cent.2 per cent. 100. 90. The bond has a par value of Rs.

i.9 or 0. This means that the bond valuation equation has to be modified along the following lines: The annual interest payment. The number of years to maturity must be multiplied by two to get the number of half-yearly periods. we have to work with a unit period of six months.1). To value such bonds. which in this case is Rs..9 (Rs. 39.e) Bond Values with Semi-annual Interest Most of the bonds pay interest semi-annually. and not one year. (b) Find the difference between the present value corresponding to the lower rate (Rs. must be divided by two to obtain the semi-annual interest payment. 808²Rs. 1. 800). (c) Divide the outcome of (b) with the outcome of (a). 768. 808 at 13 per cent) and the target value (Rs. Add this fraction to the lower rate.2 percent. 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.2.0139.0. 13 percent. which in this case is Rs. With the above modifications. which is 8. The discount rate has to be divided by two to get the discount rate applicable to half-yearly periods. This gives the YTM of 13. Where V = value of the bond 1/2 = semi-annual interest payment 80 . 8.e.

and (ii) the first dividend is received one year after the equity share is bought. Applying Eq. Interest is payable semi-annually. Single-Period Valuation Model Let us begin with the case where the investor expects to hold the equity share for one year. For applying the dividend capitalisation approach to equity stock valuation.4). Compute the value of the bond if the required rate of return is 14 per cent. 100 par value bond carries a coupon rate of 12 per cent and a maturity period of 8 years. 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. The price of the equity share will be: Where P0 = current price of the equity share 81 . we will make the following assumptions: (i) dividends are paid annually²this seems to be a common practice for business firms in India. the value of the bond is: Equity Valuation: Divided Capitalization approach According to the dividend capitalization approach.kd/2 = discount rate applicable to a half-year period F = par value of the bond repayable at maturity 2n = maturity period expressed in terms of half-yearly periods. (6. a conceptually very sound approach. Example: A Rs.

too.D1= dividend expected a year hence P1 = price of the share expected a year hence ks= rate of return required on the equity share.00 a year hence. 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. 18. is expected to grow at the same rate. the market price of the equity share of Road king Limited.00. We get. Example: The expected dividend per share on the equity share of Road king Limited is Rs. This growth rate will continue in future. 2. we get: Simplifying Eq. Further. What price would it sell for now if investors¶ required rate of return is 12 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. becomes P0 (1+g) a year hence. Example: Prestige¶s equity share is expected to provide a dividend of Rs. F0.00 and fetch a price of Rs. 2. The dividend per share of Road king Limited has grown over the past five years at the rate of 5 percent per year. we get the following estimate: 82 .

and also the most complex. the expected rate of return is: Multi-Period Valuation Model Having learnt the basics of equity share valuation in a single-period frame-work. equity shares have no maturity period. Now. and (ii) the required rate of return. The dividend is expected to grow at the rate of 6 percent per year. discuss the more realistic. given information about (i) the forecast values of dividend and share price. Since. what is the expected rate of return? Applying Eq.00.00. the value of an equity share may be put as: µThe steps in simplification are: 83 . 5. 50. we now. case of multiperiod valuation.Expected Rate of Return In the preceding discussion we calculated the intrinsic value of an equity share. we look at a different question: What rate of return can the investor expect. If the price per share now is Rs. they may be expected to bring a dividend stream of infinite duration. 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. Hence.

Is it applicable to a finite horizon? Yes. The value of the equity share to him is: Now. To demonstrate this consider how an equity share would be valued by an investor who plans to hold it for n years. Applying the dividend capitalization principle. the value of F. and sell it thereafter for a price of P.P0 = where Po = price of the equity share today D1= dividend expected a year hence D2= dividend expected two years hence Doo = dividend expected at the end of infinity. evaluated as at the end of the nth year. would be the present value of the dividend stream beyond the nth period. This means: 84 . Equation above represents the valuation model for an infinite horizon. what is the value of Pn. in Eq.

Valuation with Constant Dividends If we assume that the dividend per share remains constant year after year at a value of 1). the Eq. (ii) constant growth of dividends. and (iii) changing growth rates of dividends. becomes Valuation with Constant Growth of Dividends 85 . (6.Substituting this value of P in Eq.10) we get: We discuss below three cases: (i) Constant dividends. becomes: Equation on simplification.

00. The dividend expected on Ramesh¶s equity share a year hence is Rs. If we assume that dividends grow at a constant compound rate. This is a reasonable hypothesis because business firms typically grow over time.Most stock valuation models are based on the assumption that dividends tend to increase over time. what will be the dividend 5 years hence? It will be: When the dividend increases 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. the share valuation equation becomes: Eq.00.2. 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: Changing Growth rates of Dividends 86 . If the constant compound growth rate is 6 percent. simplifies to: Example: Ramesh Engineering Limited is expected to grow at the rate of 6 percent per annum.

this can be represented as: Step 2. gn = normal growth rate of dividends. P0.18). the following procedure may be employed. this discounted value is: Step 3. 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. as given below: 87 . Assuming that the dividends move in line with the growth rate. and discount this value to the present. Calculate the value of the share at the end of the initial growth period. In terms of our symbols. (6. (As per the constant growth model). To compute the value of P0 in Eq. Find the present value of this dividend stream. Add the above two present-value components to find the value of the share. Step 1.Many firms enjoy a period of super normal growth which is followed by a normal rate of growth. Using the symbols presented earlier. Specify the dividend stream expected during the initial period of supernormal growth.

2.00 n = duration of the period of super-normal growth = 4 years = growth rate during the period of super-normal growth = 20 per cent ga= normal growth rate after the super-normal growth period is over = 5 per cent gn = equity investors required rate of return = 12 per cent Step 1. The dividend stream during the supernormal growth period will be: Step 2. will be: 88 . applying the constant growth model at that point of time.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. The price of the share at the end of 4 years.

Assuming a constant total required return. dividend yields. and P/E Ratio The expected growth rates of companies differ widely.54 + Rs.07 The following figure presents a graphic view. Returns. Some companies are expected to remain virtually stagnant. of the above procedure. The sum of the above components is: P0 = Rs. still others are expected to achieve super-normal growth rate. capital gains yields.2 Time line diagram Impact of Growth on Price. To illustrate. 9. 49.53 = Rs. in terms of a time line diagram. figure 4. consider three cases: 89 . 39.Step 3. and price-earnings ratios. differing expected growth rates mean differing stock prices. other companies are expected to show normal growth.

The expected earnings per share and dividend per share of each of the three firms are Rs. Table 1 Price.00 respectively. other things being equal. Given the above information. the priceearnings ratio increases. 2. As the expected growth in dividend increases. and price-earnings ratio for the three cases as shown in Table 1. the expected return¶ depends more on the capital gains yield and less on the dividend yield. 4. capital gains yield. As the expected growth rate in dividend increases. Low dividend yield and high price-earnings ratio imply considerable growth prospects. we may calculate the stock price. 2. Investors¶ required total return from equity investments is 15 per cent. 3. dividend yield. High dividend yield and low price-earnings ratio imply limited growth prospects. Dividend yield. and Price-earnings ratio under Differing growth assumptions for 15 percent return The results in Table 1 suggest the following points: 1. Equity Valuation: Ratio Approach 90 .00 and Rs. Capital gains yield. other things being equal. 3.

the book value per share works out to Rs. 18. 37 mitlion divided by 2 million). its proponents argue that it represents. 37 million and the number of outstanding equity shares of Zenith is 2 million. Practitioners seem to prefer the ratio approach. The kinds of ratios employed in the context of valuation are discussed below. largely because of its simplicity. 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.50 Qts. A closer examination. 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. if the net worth of Zenith Limited is Rs. 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. 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. Liquidation Value The liquidation value per share is equal to 91 . An allied. 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. however. Book Value 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. it is often not as widely practised as it should be. and a more powerful. Due to this.While conceptually the dividend capitalization approach is unassailable.

it is very difficult to estimate what amounts would be realised from the liquidation of various assets. Given these problems. If the number of outstanding equity shares of Pioneer is 1. the liquidation value does not reflect earnings capacity. need to be examined: sales. gross profit margin.5 million. financial analysts have employed price-earnings ratio models more than dividend capitalization models. the expected profit after tax is rather difficult to estimate. the liquidation value per share works out to: While the liquidation value appears more realistic than the book value. First. there are two serious problems in applying it. Price/Earnings Ratio Traditionally. 92 . 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. To get a reasonable handle over it the following factors. 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. According to the price-earnings ratio approach. Second. 45 million from the liquidation of its assets and pay Rs.To illustrate. inter alia. 18 million to its creditors and preference shareholders in full settlement of their claims. assume that Pioneer Industries would realise Rs.

consider the price-earnings ratio for the market as a whole and also for the industrial grouping to which the share belongs. 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. the higher the price-earning ratio. one may. While these advantages make the price-earnings approach attractive to the practitioner. it becomes identical to the dividend capitalization approach. the higher the price-earnings ratio. to begin with. Size of the company 4. Dividend payout ratio While it is difficult to quantify the impact of these factors on the price-earnings ratio. it must be emphasised that this approach. the greater the stability of earnings. 93 . Should an attempt be made to develop a sound conceptual basis for this approach. the higher the price. it provides a convenient measure for comparing the prices of shares which have different levels of earnings per share. Quality of management 5. The next step would be to judge the price-earnings ratio applicable to the particular share under consideration. the larger the size of the company.depreciation. Stability of earnings 3. Some financial analysts. interest burden. Growth rate 2.earnings ratio. and tax rate. the higher the dividend payout ratio. the following qualitative observations may be made: the higher the growth rate. does not have a sound conceptual basis ² the estimate of the priceearnings ratio does not have a firm theoretical underpinning. (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. as it is practised. In forming this judgment the following factors may be taken into account: 1. 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. To establish the appropriate price-earnings ratio for a given share. the higher the priceearnings ratio.

What 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. capital gains yield. 7." Illustrate this with a numerical example.Have you understood? 1. Discuss the impact of growth on price. What are the advantages and limitation of the price-earnings ratio approach? 94 . State the formula for valuing a bond which pays interest semi-annually and which is redeemable. dividend yield. and priceearnings ratio. 2. Discuss the basic bond valuation model. How relevant and useful is the book value per share as a measure of investment value? 11. What are the limitations of the liquidation value approach? 12. the value of a bond is equal to/less than/more than its par value. 4. When the required rate of return is equal to/greater than/less than the coupon rate. 9. 6. Explain and illustrate the concept of yield to maturity. What is the expected rate of return on an equity share when dividends are expected to grow at a constant annual rate? 8. the greater its price change in response to a given change in the required rate of return. Discuss the valuation of an equity share with variable growth in dividends.¶ Illustrate this with a numerical example. "When the required rate of return is greater than/less than the coupon rate the discount/premium on the bond declines as maturity approaches. 10. "The longer the maturity of a bond." Illustrate this with a numerical example. 5. 3.

An enterprise may put up a new subsidiary. Preparation of cash flow projections for projects 5. expansion of existing ones. as opposed to financial assets like shares. Criteria for preliminary screening 4. R&D activities. The exercise involves ascertaining and estimating cash inflows and outflows. 95 . These require investments with a longer time horizon. Capital projects may be new ones. The benefits from the projects last for few to many years. you will be conversant with: 1. increase stake in existing subsidiary or acquire a running firm. matching the cash inflows with outflows appropriately and evaluation of the desirability of the project. Scanning and identification of investment opportunities 3. or captive service projects. Assessing the financial viability of projects using the various appraisal criteria. All these are considered as capital projects. bonds or funds. diversification of existing ones. These capital projects involve investment in physical assets. The initial investment is heavy in fixed assets and investment in permanent working capital is also heavy. Capital projects necessarily involve processing. The nature of investment decisions 2. renovation or rehabilitation of projects. under consideration. Learning Objectives: after reading this lesson.UNIT ± II INVESTMENT DECISIONS INTRODUCTION Capital budgeting is budgeting for capital projects. manufacturing or service works. SECTION TITLE Capital Projects Businesses investments in capital projects are of different nature.

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 needed. Significance of Capital Budgeting 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 made.


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 of Capital 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. Requisites for Appraisal of Capital Projects 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.20 lakhs. You have estimated the following for the next 4 years. Table 1

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. 20,00,000/4 = 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 = (200-100) (30000) - 12,00,000 - 5,00,000 = 30,00,000 - 47,00,000 = 13,00,000. Table gives the working and results. Table 2

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 Table 3


Cash flow from business is equal to PAT plus depreciation. Table 3 gives cash flow from business. TABLE 4

Methods used for Projects Appraisal A. Payback Period (PBP) Method 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. 20,00,000 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.,


20,00,000 - 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 cutoff 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. Merits of payback period 1. It is cash flow based which is a definite concept 2. Liquidity aspect is taken care of well 3. Risky projects are avoided by going for low gestation period projects 4. It is simple and common sense oriented Demerits of payback period 1. Time value of money is not considered as earnings of all years are simply added together 2. Explicit consideration for risk is not involved 3. Post-payback period profitability is ignored totally. B. Accounting Rate of Return (ARR) Method


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 = 46,00,000/4 = Rs.11, 50,000 ARR = AAPBT / Investment = 11,50,000/20,00,000 = 0.574 = 57.4% The denominator can be an average investment, i.e., (original value plus terminal value)/2.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 / 20,00,00 = 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%. Merits of ARR 1. It is simple and common sense oriented. 2. Profits of all years are taken into account. Demerits of ARR


i. ii. iii.

Time value of money is not considered. Risk involved in the project is not considered. Annual average profits might be the same for different projects but accrual of profits might differ having significant implications on risk and liquidity.


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. C. Net Present Value (NPV) Method 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. Given these, NPV is calculated as follows

I = Original or initial investment CFt = annual cash flows K = 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 + CF2 /(1+k) 2 + CF3 I (1+k) 3 + CF4 (l+k) 4 = -20,00,000 + 14, l0, 000/l.l + 19,70000 / 1.12 + l 1,60,000 / 1.13+


5,60,000 / 1.14 = -20,00,000 + 14,10,000 x 0 .909 + 19,70,000 x 0.826 + 11,60,000 x 0.751 + 5,60,000 x 0.683 = - 20,00,000 + 12,81,818 + 16,28,099 + 8,71,525 + 3,79,042 = - 20,00,000 + 41,60,484 = Rs. 21,60,484 If it is required that k= 10%, 11%, 12% 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 + CF2 / (l+k2) 2 + CF3 /(1+k3) 3 + CF4/(1+k4) 4 In the above example, NPV = -20,00,000+14,10,000/1.1+19,70,000/1.112+1 1,60,000/1. 123+ 5,60,000/1.134 =-20,00,000 +14,10,000 x 0.909+19,70,000 x 0.817 + 11,60,000 x 0.712 + 5,60,00 x 0.635 = - 20,00,000 + 40,49,482 = Rs. 20,49,482 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. D. Internal Rate of Return (IRR) Method


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. Decision Tree Approach 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 2 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 inception. 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. 1,60,000, Rs. 2,20,000 and Rs. 3,00,000. The level of penetration during the 2nd year is influenced by the level of penetration in the first year. The probability values of different penetration levels in the 2nd year, given the level of penetration in the 1st year and respective cash flows are estimated as follows: TABLE 5


000 and high penetration in 2" year with probability of 0.2.000 are possible.3.6 and cash flow of Rs.If low penetration resulted in 1st year. low penetration in 2nd year with probability of 0. 9 outcomes are possible. you can follow for other cases. 000. 00.80. Similarly.2 and cash flow of Rs. These are: TABLE 6 106 . 00.2 and cash flow of Rs. Combining 1st and 2nd year penetration levels together. moderate penetration in 2 year with probability of 0.

1/1. the NPV relevant to each stream (i. 744 with 107 .1 receivable at 1st year end is Rs. These values...At this stage. Then the present value of Rs.4.16085. And this is done below.e.e.826 (i. if low penetration in 1st year and moderate penetration in 2nd year have prevailed and the probability of this happening is 18%. For this. we may go for present value evaluation of these sets of outcomes.. the present values of the 9 cash flow streams can be worked out.0. joint probability (i. joint probability times NPV of each stream) are given below in table 7.909 (i.06. the aggregate of the present value of the two cash flows of each stream minus investment of Rs. we require a discounting rate.48.000).e.e.00. Outcome 8 shows that NPV of Rs. The expected NPV of the project is negative at Rs.0.12269.1) and at 2nd 1 year end it Rs. 1/1. product of probabilities of the two cash flows of each stream) and expected value of NPV (i.e.12). Let us take a 10% discount rate. if low penetration prevailed both in the 1st and 2nd years and this has a probability of 6 out of 100 or . Now. The expected NPV is negative at Rs..

gives a risk-return relationship for the portfolio of various projects. Then. the project may be taken up.return on market portfolio Bi. The expected NPV of the project is the aggregate of the expected NPV of the different streams = Rs. Simulation Analysis 108 . Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM) is one of the premier methods of evaluation of capital investment proposals. According to CAPM. like investment in any government securities.risk free rate of return Rm. accept the project. The formula is: Required rate of return = Rf + (Rm -Rf) Bi. CAPM gives a mechanism by which the required rate of return for a diversified portfolio of projects can be calculated given the risk. The risk-free return is the rate of return obtainable on risk free investments.probability of 24% is possible when high penetration in 1st year and moderate penetration in the 2nd year result. get the estimated return for the project. the required rate of return comprises of two parts: first. Otherwise.47395. CAM technique for evaluating capital projects We have to calculate the required rate of return for the capital project given its beta coefficient.Beta or risk coefficient of the evaluated portfolio given market portfolio beta = 1 CAPM. reject the project. therefore. where R1. If the estimated return for the project is greater than or equal to the required rate of return. a risk-free rate of return and second a risk premium for the amount of systematic risk of the portfolio. risk free return and market return. Since. it is positive.

P. we construct cumulative probability and assign number ranges.000 . In such cases. in a project.18. We start with 00 and end with 99. Suppose.Annual depreciation and N Number of years of the project¶s life). Then rural profit before tax = [(P-V) Q] . V. T is not predictable.15.000/p. Q.a. K.Tax rate. the K and T will be dealt through simulation while others are take at given values. V. V = Rs.a.Discount rate or cost of capital. separately for T and K.300/unit. Q. Let the probability distribution for µT¶ and µK¶ be as follows: Next. D . F.00.000 = Rs. Q = 2O. Suppose.Quantity of output. we use simulation here.000. I . taking the other variables at their best estimates. N = 3 years and I = Rs.When uncertainty haunts the estimation of variables in a capital budgeting exercise.Original investment.a. Simulation process gives a probability distribution to each of the truant playing variables. thus using 100 numbers. The profit after tax and hence cash flow cannot be computed as tax rate. that P = Rs. 150/unit. P.F D = [(300-I 50)*200001 . D and N are the important variables. Two digit random n ranges are used. N and I arc fairly predictable but k and µT¶ are playing truant.00. So.00. Further. F = l5. T. 109 . as µk¶ is also redictable. simulation technique may be used with respect to a few of the variables.000/p. V -. Variable cost per unit of output. I. T . F .Fixed cost of operation. Q . present value cannot be computed as well.00. (P -Price per unit of output. K . F.000/p. 9.

15. For the first value of the unpredictable variable. we assign random numbers 00 to 19.000 Rs.00.85. Then µT¶ is 35% and the random number 48 falls in the random number range 20-69 corresponding to 35% and µK¶ is 12% as the random number 80 fails in the random number range 80-99 corresponding to 12%. To this.85. Now taking the T = 35% and K = 12%. the NPV of the project can be worked out. So. Similarly.000 p. for variable T.000 (i.00.For the different values of the variable in question. Thus. 110 .9.000 / 3 years) to get the cash flow.000= Rs. 20% of random numbers aggregated for its first 30% and 50% of random number for its next value 35% and 40%.000 . So.00.a. for the variable µK¶ also random numbers are assigned as given in table 6.18.6. we have to add depreciation of Rs.000 p/a for 3 years.000 pa. random number pairs (one for µT¶ and another for µK¶). For the second value we assign random numbers 20²69 and for the third value random numbers 70 . Simulation process now involves reading from random number table.000 ± Tax @ 35% = Rs.00. as many random numbers as are equal to the probability values of respective values are used.99 are assigned.000 + 6. 11.85.e.9. the cash flow= 5. We know that the project gives a PAT of Rs. the PAT = 9.3.5. The values of µT¶ and µK¶ corresponding to the random numbers read are taken from the above table.00. Suppose the random numbers read are: 48 and 80. Rs.00.

3.85.l0.000 = 28.= (11. This process must be repeated at least 20 times.000 /1. 8.462) ±Rs.28.122 + 1/1. 5. 9. for changes in a key influencing factor. The cash flow = Rs 5. keeping the influence of all other influencing factors at constant level. 18.12 + 1/1.10.000 x 2.00. Similarly.6 1. =(Rs.000 ± Rs.85.798 .11.85.000 = Rs.85.113). 123) -18.122 + 11.12 + 11. Suppose the next pair of random numbers are 28 and 49: Corresponding µT¶ = 35% and µK¶ = 11%. 56. 67.112+Rs.6. 95.000 = Rs.Rs.000 = (Rs. 00. Sensitivity Analysis Sensitivity analysis attempts to study the level of sensitivity of the project say the NPV. NPVs may be averaged if the same is positive.798 We have just taken one pair of random numbers from the table and calculated the NPV as Rs.000/1.00.4018 .10.000 [1/1.11+Rs.T = Rs.000 = Rs.85.000. reading 20 pairs of random numbers and getting the NPV for values of T and K corresponding to each pair of random numbers read. 95.18.000 = 11.56.798. the NPV for other simulations can be obtained. 85.11. 85.000 =Rs.00.12] .773 +Rs.11.598 +Rs. 85. 111 . 85.00.000/1. + Rs. 00.803 ±Rs.85.000 / 1.000/1. Then the PAT = PBT .000 = 1l.000 = Rs. 18. 00.

We know. Accordingly. 1. Most Likely rate is 35% Suppose.70) +Rs. namely.000 = [Rs. 35%. N = 3 years. we want to study the sensitivity of NW with respect to µT¶. The annual cash flow is: = [(P-V) Q .000. µT¶ shall take different values within its range.000.000.300-Rs. that NPV of a project is influenced by P. D = Rs. 37.000] (0.00. D and K be constant at Rs.5%. N. Q. Most Likely quantity is 20. the range of their values and most likely values are given. NPV will be worked out and sensitivity of NW be analysed.Sensitivity analysis presumes uncertainty of the values of all or some of the influencing factors. The NPV will be worked out and sensitivity of the NPV to that factor also be analysed. Q and T and let the uncertain variables. say 30%. T and K.6. 150 and 20.000 units. 00.D] (J-T) + D = [(Rs. Most Likely value is Rs.15.000 ±Rs. The variable T¶ will be taking different values within the range of its values for each such values of T. V and Q at their most likely values are Rs.000.000 112 . V.5% and 40%.000±Rs. For such factors.15. First let T be 30%. 00.30.150 Q: 15000-22000. N. 00.150) 20000units-Rs. V and Q will be assigned their most likely values. the variables taking constant values will take their fixed values.300. 00.6. 1. 00.6.200-Rs. Let their range of values and most likely values be as follows: P: Rs. 3 years.000 and 15% respectively P. V. P. Most Likely value is Rs. 00. then other uncertain variables. Rs. k = 15%. Let F.300 V Rs.18.000](1-30%) + Rs. 00. Rs. Other factors are taken at constant values. Rs.00.100-Rs. F = Rs.000 T: 30%-40%. For each of these 5 values of T. 21. Needless to say. 18. 00.15. 00. 32. for our purpose: I = Rs. F.F .350.00.

5%) + Rs. 12.00.30. 07.000/1.56.500 p.369 -Rs. 00.00.a NPV = (Rs. 85. 15.30.F .07.00. 6.000 = Rs.300-Rs. 6.00.15)- 113 . 6.27. 12.000] (0.12.F .85. 10. 00.70) +Rs.18.000 = [30.000 pa NPV = (Rs.00.000 -Rs.000/1.000] (0. 21.000 ² 21.000 = Rs.000 = Rs.00.675) +Rs.65) ÷ 6.00.000 = Rs.00.15 +Rs. 00.08. 11.000(0.000/1.000] (1-35%) + 6.00.369 Let T be 32.9.000 / l.a NPV = (Rs.675) +Rs. ±Rs.11.150) 20000 units-Rs.08.000] (1- = [Rs. ± Rs.6.500/1.07.= Rs.000 = Rs.000 = Rs.00.15 + Rs.5%.000 = 9.65) + 6.00.D] (I-D) +D = [(Rs.00.00.500/1.500/1. The annual cash flow is: = [(P-V) Q .15+Rs.000= Rs.152+Rs.000 ² 6.30.07. 56.000 ±Rs.00. 00.000(0.D] (I-D) +D = [(300-150) 20000² 15. 28. 18. 85.30.000/1. 9.000(0.152 +Rs.000 p.994 Let T be 35% the annual cash flow is: = [(P-V) Q .30.12.6. 85.994 ± Rs.000 / 1.152 + Rs.000 = Rs.

l5)-Rs.152 + Rs.000 ² 21.500/1.000 = Rs. 27.300-Rs. 07.000 = 9.369 ±Rs.150) 20000 units-Rs.18.994«««. The annual cash flow is: = [(P-V) Q .6. 30. + 6.000 = Rs.18.00.12. 00.00 + Rs.500/ = Rs.000] (1-35%) + 6.150) 20000 units-Rs. 6.000 = Rs.00] (1.000 114 .00.15.000 = [30.08.Rs.000= Rs. 07.F .D] (I-D) +D = [(Rs. 00.000] (1.l2.500 p.00.500/1.000 = Rs.000 = Rs.07.994 ± Rs.000 ±Rs. 6.00. 18.21. 00. 30.12.000 ±Rs.15) .00.00.08. 12. 12.12.Rs.675) + Rs.000/1.000 NPV = (Rs. 00.000 = [Rs.07.12+Rs. 00.27.00.D] (I-D) +D = [(300-150) 20000² 15.15+Rs.] (0. 00.00. 00.65) ÷ 6.000] (0. 10.6.622 Let T be 37.a NPV = (Rs.000 ² 6.5%.F .00. 28.D] (I-D) +D = [(Rs.05. 00.F . The annual cash flow is: = [(P-V) Q . 9.000 ±Rs. 56. 9.12.622 ± Rs.369 Let T be 32%.37.00.000/l. 30. Let T be 35% the annual cash flow is: = [(P-V)Q .000(0. 6.5%) +Rs.5%) +Rs.

000 p.62.D] (I-D) +D = [(300-150) 20000 ² 15.000 .000 p.500/1.e. 8.000(0.249 18.00.000/1.00.F .00.60) + 6.500/1.153)-18.369.000²21.00.9.O0¶¶] (1-37.000 = Rs.62.00.152 + 11.54.00. 0.15 + 11.00.000 = Rs.5%.000 = Rs.000 (0.3) NPV falls to Rs.500/1.000/1.622 Let T be 37.000 = Rs. (0.876 You might have noted that as T rises. 11.000] (0.00.56. 02. When T rises to 32.85.11. 11.40.15)² 18.000/l.15+Rs11.18.85.000 = 27. npv falls.152 + 1² 18. 9.249 = [30.625) + 6.000 = 9.000/1.000/1. The annual cash flow is: = [(P-V)Q .00.60) + 6.000 = Rs. Rate of change in NPV for a given change in T.000 = Rs.= 9.05.000/1.85.40. 40. 40.5%) + 6.5% (i.00.15 + 11.994 from Rs.00.00.000 = [30.26.152+Rs.622 .500 p. ² 6.a NPV = (11.000] (0.325) from 30% (i.05.10.65) + 6. = Rs. ± Rs.a NPV = (11.00.e.000 = 26.a NPV = (Rs. 115 .00.

5% from 35% NPV falls to Rs.02. 56.3.249 from Rs.622 Rate of change = When T rises to 40% from 37.35) from 32.02.994. 8.5% NPV falls to Rs.249 Rate of change = 116 .Rate of change = When T rises to 35% (i.816 falls to Rs.9.54. (0. 8. Rate of change = When T rises to 37.622 from Rs.e.8.5% (i.05.9.e.816 from Rs. 05. 0. 9.325) NPV falls to Rs.54.

other variables at their fixed values and changing the value of P within its given range of values. say µP. 117 .¶ keeping V. other variables at their fixed values and changing the value of V within its given range of values. Tax rate and capital gain tax is 10% on inflation un-adjusted capital gain. 00. We can do the sensitivity analysis of NPV with respect to another uncertain variable. we can do the sensitivity analysis of NPV with respect to V. The profits before tax and depreciation are as follows for the two machines: The firm adopts fixed installment method of depreciation.000. 00.00. the utility of sensitivity analysis. Q and T at their most likely values.000. 00. also we can replicate the sensitivity with respect to µQ¶. Now. Hence. namely.2. We can study the sensitivity of NPV to µT¶ in the form of a graph. NPV is highly negatively sensitive with tax rate. So. Knowledge of the same will help in monitoring the project with respect to those variables very ably. Similarly.000. V. Q and T at their most likely values.28. Increase in working capital is Rs. It is considering replacing the machine with a new one which will cost Rs. Illustration A firm is currently using a machine purchased two years ago for Rs.The rate of MI in NT¶V is rising with the rise in tax rate. taking NPV on the Y axis and µT¶ on the X-axis also.l4. keeping P. of the 4 uncertain variables. can be seen. Q and T.4. P. Hence.000 Cost of installation is Rs. with respect to which variable the NPV is most sensitive. It has further 5 years of life.

we have to calculate the size of investment needed.Rs.000 x 40% = Rs. cost = Rs.4.000 + life 7 years] It is sold for This gain has two components.2. at beginning as follows: 118 . reduced by net sale proceeds (after capital gain tax) of old machine. This includes.14.14.000 = Rs.000 = Rs. Revenue gain Total gain-capital gain= Rs.Rs. capital gain and revenue Capital gain = Rs.000 .000 Depreciation for the past 2 years Rs.1.Rs. after adjustment. 16. cost of installation and working capital addition needed. Therefore. Sale value . Solution First..000 .00.2. ARR.000.2.Is it desirable to replace the current machine by the new one.000 at present and using.00. Now.000 .00. taking the resale value of old machine at Rs.4. NPV and IRR? (For NPV method take 10% as discount rate.00.60. Tax on revenue gain = Rs.00. PBP.000 = Rs. Tax on capital gain = 200000 x 10% = 20.20.e.00.1. purchase cost of new machine. 00. i.5 years). we can compute net investment at time zero. The old machine¶s original cost =Rs. for ARR shod cutoff rate is 15% and for PBP method cutoff period is 14.000 .00.000 [14.Rs. net sales proceeds of old machine = Rs.6.

Illustration 119 . 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. we have to calculate the change or increment in cash flow because of the firm going for replacement of old machine by new one. The difference of former over the latter is the change in cash flow. For this purpose.Now.

A company bought a machine 2 years earlier at a cost of Rs. The new machine can produce 15 units more per hour. The annual operating hours are 1000 both for new and old machines. The management considers replacing this machine with a new one with life of 10 years and price at a Rs. The new machine will involve add.3.000 p.1000 and repairs of Rs.6. using NPV method.000 and labour by RS.00. 1.25. Material cost by Rs.10000 introduced now.60. Its current market price is Rs.6. 000. cost of capital as 10% and SLM of depreciation. The corporate tax rate is 40%. Advice on the replacement assuming additional working capital of Rs.000.a.l000 p. ii) Cash Flow Computation 120 .a. But savings in cost of consumable stores of Rs. Selling price per unit is Rs. can be redeemed at 10 years later. will result. 000 and estimated its useful life as 12 years in all.

75000 = (Rs. 70195 The replacement is advised.Rs.386)-75000 = Rs. Illustration 121 .I = Rs.759) + (Rs.1 + 1 / 1.23000 [l / 1.33000 x 0.110 .19] + 33000 x 1 / 1.12 + «««1 / 1. the NPV formulate can be slightly modified as: NPV = [ACF S 1 / (I+k) t +CF10 X 1 (1+k) 10] . uniform cash flow is found throughout l to 9th years.145195 ± Rs.75000 = Rs.23000 x 5.Since.

4. Find which projects are to be taken. Solution Projects 1 & 3 will be chosen as NPV is higher Risk Analysis in the Case of Single Project Project risk refers to fluctuation in its payback period. higher is the risk and vice versa.2 lakhs. and NPV or so higher the fluctuation. ARR. If all the 3 projects are combined.4 lakhs. Let us take NPV based risk. 122 .A company has 3 investment proposals. combined PV of cash flow will be Rs. economies result in investment and combined investment will be Rs. there will be no economies or diseconomies. If 2 and 3 are combined. IRR.6. The expected PV of cash flows and the amount of investment needed are as below: If projects 1 and 2 are jointly taken. all the above economies will result but diseconomy in the form of additional investment of Rs.25 lakhs will be needed. 1. If projects 1 and 3 are undertaken.

C.78 and 2&3: -0. sj = standard deviation of iin and jth projects.6000 and Rs.4000. That is the correlation coefficient between NPVs of pairs of projects. the risk of all projects put together in the form of combined standard deviation is given by the formula: Where.V = Rs. i. sp = combined portfolio standard deviation Pij = correlation between NPVs of pairs of projects (i and j) si. So. When two projects are considered together.V is given by sm. 1&3 0.000 / Rs 18.e. what is the overall risk of all projects put together? Is it the aggregate average of standard deviation of NPV of all projects? No. The correlation coefficients are l&2 0.6.6 lakhs. the expected NPV of a project is Rs.33.10000. This can be measured through standard deviation of the NPV figures. Then what? Now another variable has to be brought in to the scene. What is the overall standard deviation of the portfolio of projects? sp = [SPij si sj ] ½ = [s12+s22+s32+2P12s1s2+2P23s2s3+2P13s1s3] ½ 123 . Risk Return Analysis for Multi Projects When multiple projects are considered together.18 lakhs. it is not. the variation in the combined NPV is influenced by the extent of correlation between NPVs of the projects in question.. 00.000=0.If NPV from year to year fluctuates. A high correlation results in high risk and vice versa.6. any pair of projects taken at a time. Illustration Three projects have their standard deviations as follows: Rs. and standard deviation of Rs. Suppose. there is risk.00. the coefficient of variation C. Rs.5. Deviation divided by NPV.

78x6000xl0000 + 2x(-0.310 What is the return from these multiple projects? This is simple.2x14% + 0.6x4000x6000 -i. 00. This results essentially when there is low degree of correlation among the projects.44. The combined NPV = 16000 + 20000 + 44000 = Rs. 000. 00. 10% and 10%. More so. Find the portfolio return and risk.= [40002 + 60002 + 100002 + 2x0.15340/Rs. The standard deviation of returns are 5%.000. unadjusted figures of combined standard deviations and combined NPVs. Rs.5 for the three projects respectively) and Ri . 15. Portfolio return = (wi Ri) = 0. This is given by: Swi Ri where wi . The estimated return from the projects are 14%.2. 16% and 20%. Rs.2.2.6 and 1&3: 0. 000. It is the aggregate NPVs.000 respectively.000 and Rs.80000.5. 000 and Rs.3 and 0. if there is higher negative correlation among the projects.5x20% 124 . the respective project return.19 = 19% If we take the correlation factor. The combined coefficient of variation = combined standard deviation I and combined NPV = Rs. 00.25 = 25%.4. The correlation factor has resulted in reducing overall portfolio risk from 25% to 19%.3x16% + 0.80000 = 0.2x0. the three projects have NPVs of Rs. Solution The portfolio or combined return is simply the weighted return of the projects. 5) x 10000x4000] ½ = [16000000+36000000+ 100000000+28800000+93600000-400000000] ½ = [234400000] ½ = the weight (0. The correlation coefficients are 1&2: 0. the coefficient of variation would have been: 20000/80000 = 0. Illustration Three projects involve an outlay of Rs.20.3. 2&3: 0. Suppose.16.

which is otherwise impossible. The leverage of a firm is 125 . while the latter increases it.= 2. 2. The term leverage refers to an increased means of accomplishing some purpose. In business. = [0. With leverage. it is possible to lift objects. 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.8% + 4.8% -µ-10% = 176% p = Portfolio risk = [(wi wj pij (i (j]112 = [wlwl(l (1 + w2w2(2(2 + w3w3(3(3 + 2w1w2(12 (1(2 + 2w2w3(23 (2(3 + 2w1w3(13 (1(3]1/2 Putting the given values.2+0. bring out the meaning and significance of capital projects. NPV (at k=10%) and given IRR.5+2A+18+2] ½ = [26] ½ = 5. It may be favourable or unfavourable. The former reduces profit. It is the principle that permits the magnification of force when a lever is applied to a fulcrum. UNIT ± III FINANCING AND DIVIDEND DECISION Lesson 1 Financial an Operating Leverages INTRODUCTION Leverage has been defined as µthe action of a lever. sp.099% Have you understood? 1. The term refers generally to circumstances which bring about an increase in income volatility.9+2. we get that. leverage is the means of increasing profits. ARR. Calculate payback period.

It is an important tool of financial planning because it is related to profits. 126 . which may be a return on investment or on earnings before taxes. It is also known as gearing. it is a double-edged weapon. However. The meaning and types of leverages 2. you will be conversant with.essentially related to a measure. Managerial analysis of leverages SECTION TITLE Leverage Calculation Christy and Rodent define leverage as the tendency for profits to change at a faster rate than sales. The term capital gearing is used to describe the ratio between the ordinary share capital and the fixed interest bearing securities of a company. and creates fixed interest and dividend charges. Advantages and limitations of financial leverage 4. LEARNING OBJECTIVES On reading this lesson. 1. and emphasises the effects of deterioration as well as of improvement. Capital gearing reveals the suitability or otherwise of a company¶s capitalization. It is a relationship between equity share capital and debt securities. Steps involved in simulation procedure 3. 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.


A small rise in sales may enhance profits considerably. Naturally. Asset Leverage The asset turnover aspect of the ROI leverage is often referred to as asset leverage. while a small decline in sales may reduce and even wipe out the EBIT. Operating Leverage The operating leverage takes place when a change in revenue produces a greater change in EBIT.The return on investment is a very important indicator of a firm¶s performance. it is a relative term which is used to compare inter. The profit margin may be increased with a careful cost control . It should be remembered that the return on investment is the result of asset turnover and profit margin. It is always safe for a firm to operate sufficiently above the break-even point to avoid dangerous fluctuations in sales and profits. There is nothing like an absolute high or low asset leverage. A firm with a high operating leverage has a relatively greater effect on EBIT for small changes in sales. In other words. distribution expenses and administrative reducing production costs. It indicates the impact of changes in sales on operating income. no firm likes to operate under conditions of a high operating leverage because that creates a high-risk situation. The operating leverage is the highest near the 128 . while the profit margin is the ratio of EBIT to sales. It is interesting to note that beyond the break-even point. A firm with relatively high fixed costs uses much of its marginal contribution to cover fixed costs. Asset turnover is the ratio of sales to total assets. It is an index of operational efficiency. A firm with a relatively high turnover is said to have a high degree of asset leverage. the marginal contribution is converted into EBIT.firm performance. The operating leverage is related to fixed costs. selling expenses. This may be expressed as follows: Return on Investment Leverage = Asset Turnover x Profit Margin This leverage is popularly known as µROI leverage.

The extent of the operating leverage depends on the employment 129 . increasing profits at a rapid rate when sales are expanding and reducing them or causing losses when operations decline. This leverage operates both positively and negatively. Illustration The operating leverage decreases with an increase in sales above the break. the greater the leverage and the more frequent the changes in the rate of profit (or loss) with alternations in the volume of activity.even point.break-even point. 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. The reason is that fixed costs become relatively smaller than the revenues and the variable costs once the break-even point is reached. 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. even a small increase in sales results in a big increase in EBIT. the rate of profit would show fewer changes at different operating levels. The higher the fixed costs. then. The operating leverage. After a firm reaches this point. If all the costs were variable.

business risk can be determined objectively. Business risk associated with the nature of a company¶s operations. Leverage is thus the utilisation of fixed costs to effect disproportionate changes in income. The determination of this limit. A highly geared capital structure. It. and that they demand a higher return for the greater risk involved in an investment. It may be defined as the employment of an asset or 130 . which is known as the corporate debt capacity. Frank H. which may occur due to Dividend policies and the building up of reserves and Capital structure management.of fixed assets in the production process. distorts the profit earning capacity. subject to given risk constraints. therefore. the greater is its operating leverage. Investors risk preference 2. While the investors¶ risk preference is difficult to assess because it varies from individual to individual. The proportion of debt in the capital structure of a company is limited by two factors: 1. A firm¶s capital structure is the relation between debt and equity securities. or what is known as high leverage. shows the effects of borrowing on equity stockholders. The higher the fixed costs a firm employs in the production process. This operating leverage is measured with the help of following formula: Capital Gearing Affects It is a company¶s capacity to maintain an even distribution policy in the face of difficult trading periods. is an important aspect of the financial policy of a company to get the maximum benefit from debt financing. Financial Leverage It is generally accepted that investors seek to maximize their return on investments. Jones rightly says that the profit earning capacity of ordinary shares in a wellfinanced company is not always fully appreciated.

It also means that. The reason is that. 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. On the other hand. At a high debt-equity ratio. when the ROI is less than the interest rate. or the firm is said to be trading on equity. therefore. 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. there is no financial leverage in this situation. 131 . It refers to typical situation in which a firm has fixed charges. In other words. Traditionally. In fact. How can creditors have confidence in the company which has only creditors and no equity stockholders? The company will. borrowings place it in an embarrassing position. when there is a favourable financial leverage. there is no use making any borrowings. the firm loses money by its borrowings. In other words. It exits in both these conditions. the financial leverage is favourable. If the ROT (return on investment exceeds the rate of interest. 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. equity financing by way of a public sale of stock offers real value of a firm. if a firm earns exactly as much as it pays for the use of its capital.funds for which a firm pays a fixed cost or fixed return. it has served as a spearhead for expansion of resources and productive capacity involving risk. such as preferred stock and debentures. the advantage is passed on to equity stockholders. have to strive hard to regain a reasonable debt-equity ratio so that the expectations of the market may be satisfied. the financial leverage is favourable when it is worthwhile for a firm to borrow. when the ROl exceeds interest rate. However. In other words. financial leverage is absent. If these conditions are not present. and its return on investment must not be equal to fixed charges. 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. securities. Charles Ellis observes that there seems to exist a general management preference for equity and retained earnings rather than for debt and preferred capital.

either by force of circumstances or as the result of the doctrine of gearing or leverage. trading on equity is profitable. It is. Companies have tended to borrow at different times in circumstances which often bear little relationship to their present size and financial position. But in times of poor business. includes all forms of business with funds (or properties) obtained on contracts calling for limited payments to those who supply funds. In recent years. trading on equity is unprofitable. When a corporation earns more on its borrowed capital than the interest it has to pay on bonds. it is possible to lever the return on investment through a tighter management. a term full of an academic flavour. non-participating preferred stock. and/or limited rental leases. On the µstreet¶. The capital obtained from debt securities is used in a project which produces a rate of return which is higher than its cost. when the interest on bonds amounts to more than the company makes from the use of these funds. however. a synonym for this academic phraseology is financial leverage. This allows the difference to be distributed to holders of equity securities. Extent of Financial Leverage Financial leverage depends upon the ratio of debt and preferred stock together to common stock equity. Thus. however. In other words. trading on equity may be based upon bonds. 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. There are three ratios which the degree of financial leverage implies. borrowings have increased as a percentage of net tangible assets. which. and textbooks use it in discussions of the financial structures. it is said that trading on equity magnifies profits and losses. 132 . Most companies benefit from an objective review of their borrowings.Merwin Waterman states that the term trading on equity is seldom heard among the practitioners of business finance. The expectation is that these funds will produce a larger revenue than the limited payments call for. For these reasons. Doing business partly on borrowed capital is known as trading on equity.

the shareholders received a 6 percent after .000. return. In spite of the firm Q issuing a debt of Rs. it had no leverage. for the ROI (10 per cent) was equal to the 133 .The effect of financial leverage in a firm¶s capital structure may be analysed from the following information given below llustration When the firm P issued no debt.

If it earns higher rate than it pays for its borrowings. It may cause dividends to disappear altogether and. Companies enjoying a fairly regular income can employ borrowed funds more safely than those with widely fluctuating incomes. The advantages and attractiveness of trading on equity for the owners of equity capital are all too apparent. when ROl is high. 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. Beyond a certain point. for its ROI (7 per cent) was less than its interest rate (8 per cent). Some of these have already been explained while discussing the requirements for trading on equity. Similarly. It is logical for a firm to borrow reasonable amounts. if it has been financed by stock alone. 2. A growing company which is progressively increasing its net 134 . may offset all the advantages of trading on equity. the firm S suffered from an adverse or unfavourable leverage. 2. However. The bigger the amount of funds borrowed. The principle of capital structure management is then simple.interest (10 per cent). if carried far off. 4. may be responsible for the insolvency and even bankruptcy of a corporation. The firm issued a similar debt and enjoyed a favourable leverage. 3. Such increase in interest rates. But such a general principle does not inevitably follow. for its ROI (9 per cent) was higher than its interest (7 per cent). Limitations of Financial Leverage 1. 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 employment. Advantages of Financial Leverage 1. the firms with a favourable financial leverage are bound to enjoy high earnings. the higher the interest rate the corporation may be forced to pay in order to market its successive issues of bonds. indeed.

Moreover. money rates may fall.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. 20. its fixed charges leverage at a sales volume of 20. 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 Fixed Charges Leverage It takes place when a firm has such sources of funds as preferred stock and debentures which carry fixed charges. At any given level of a firm¶s operations. This leverage indicates the extent to which changes in operating income affect the EBT. It may be calculated by the following formula: Illustration It is evident that if a firm has fixed interest charges amounting to Rs.000 units would be: 135 . Total Leverage Operating and financial leverages are inter-dependent.000.

The reason is that each additional unit of sales produces a 136 .29 times increase in EBT. Combined leverage isolates both fixed costs and interest and compares changes in revenues with changes in EBT. The fixed charges leverage isolates interest and compares changes in EBIT with changes in EBT.000. Marginal Analysis It is clear from the above discussion that the operating leverage. fixed charges leverage is also referred to as financial leverage. The new level of fixed charges leverage would then be: In other words. The fixed charges leverage isolates costs and compares changes in revenues with changes in EBIT. In Financial Management.In other words. 2. the fixed charges leverage and the combined leverage are techniques of marginal analysis.000 (2.70. the fixed charges leverage also decreases with an increase in EBIT. 2. If the EBIT gets trebled. it means that any increase in EBIT would be accompanied by a 1. as different leverage concepts are associated with the term financial leverage.20.50.000 . It has already been stated that operating and combined leverage uses the marginal contribution of sales. like the operating leverage. it would be better to refer to fixed charges leverage separately as the ratio of EBIT to EBT. the EBT would be Rs. However.000).70. say Rs. This would probably make it distinct from financial leverage which is more popularly associated with trading on equity.

1. the leverage works only when sales decrease or increase. 30. for example. If.000 Earnings before interest and taxes = Rs. From the following Information. the same will be reduced to Rs. you are required to compute the return on investment leverage.000 units at Rs. 3. the operating leverage is a drop of 50 percent in sales may wipe off the EBIT.20 per unit. Moreover. Illustration 1. It is clear that the EBIT has been wiped off.unit of marginal contribution.00. Total Assets = Rs. Sales 1. Illustration Now. if sales drops by 50 percent.00. 2.50.000 Solution 137 .000.

20 per unit. you are required to find out the asset of a firm.Financial Analysis Through Leverages 1.00. 1. 1. 2.000 Total Assets Rs. 3. compute operating leverage of a firm. From the following information. From the following information. 138 .000 units @ Ps.80. Sales Rs.000 Solution (Note: It should be remembered that the asset leverage is a part of the ROI Leverage).50. Sales 1.

000 EBIT (1989) Rs.000 Solution 3. EBIT (1988) Rs. 100 each.00. The tax rate is 50% and the current equity capital structure amounts to 1. 35.000 units Sales (1989) 1. The earnings before interest and taxes are Rs. 36.000 shares of Rs. A company is thinking of expansion and financing it by issuing equity stock of Rs.000. 50. you are required to find out the extent of operating leuerage in the year 1989.000 units Solution 4. From the following Information.000 shares of Rs. You are required to explain the financial leverage underlying the second proposition.000 Sales (1988) 1.80. 30.50.Varilable Cost 40 paise per unit Fixed Cost Rs. 100 per share or by Issuing 12% debentures of the same amount. 50. 139 .00.

1.Solution To find out the financial leverage. 500 II when fixed costs are Rs. 50. The actual exploited capacity Is 500 units. Calculate the operating leverage in each of the following situations: I when fixed costs are Rs.500 Solution Statement showing the details of costs under different situations: 140 .67 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. 16. 5. 10 and Variable cost Is Rs. 1.100 III when fixed costs are Rs. Selling price per unit is Rs.000 instead of equity stock. the earnings per share has arisen from Rs.00. 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. 6 per unit. The installed capacity of a factory is 700 units.22.

Operating Leverage: Have you understood? 1. there is no interest component. EBIT Itself will be treated as EBT. Explain the following terms (a) ROI Leverage (b) Asset Leverage (c) Operating Leverage (d) Financial Leverage (e) Total Leverage (f) Fixed Charges Leverage 141 .Since.

As a financial analyst how would you analyze each leverage from the point of view of financial decisions? Lesson 2 Cost of Capital Introduction Now that. Learning objective 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. Unless the company earns this minimum rate. or on the returns they are getting risk from shares of other companies they have invested in. we are familiar with the different sources of long-term finance. leave alone participate in any further capital investment in that company. let us find out what it costs the company to raise these various types of finance.(g) Combined Leverage (h) Marginal Leverage 2. SECTION TITLE Costs of Different Sources of Finance 142 . 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. on the company¶s past performance. debentures of term loans. For example. equity investors expect a minimum return as dividend based on their perception of the risk they are undertaking. the investors will be tempted to pull out of the company.

If Ajax Limited realises Rs. The interest is payable annually and the debenture is redeemable at a premium of 5 per cent after 10 years.100 and carries a rate of interest of 14 per cent.5. The cost per debenture (kd) will be: 143 . what is the cost of the debenture to the company? Solution Given I = Rs. The terms of the issue are as follows: each debenture has a face value of Rs. F Ps. P = Rs.14. The following example illustrates the application of this formula. t = 0.Cost of Debentures The cost of a debenture is defined as: 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.97 and n = 10 years.97 per debenture and the corporate tax rate is 50 per cent.105.400 lakhs. Example Ajax Limited has recently made an issue of non-convertible debentures for Rs. period The interest payment (I) is multiplied by the factor (t-t) because interest on debt is a taxdeductible expense and only post-tax costs are considered.

100 and carries a rate of dividend of 14 per cent payable 144 . The interest rate to be used here will be the interest rate applicable to the new term rate). Cost of Preference Capital 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 Example The terms of the preference share issue made by Colour-Dye-Chem are as follows: Each preference share has a face value of Rs. The interest is multiplied by I (1 .7 percent Cost of Term Loans The cost of the term loans will be simply equal to the interest rate multiplied by ( rate) as interest on term loans is also tax deductible.= 7.

P = 95 and n = 12 = 0. and the bond yield plus risk premium approach.148 or 14. we shall consider only the dividend forecast approach. Several approaches are adopted for estimating this rate of return like the dividend forecast approach.annually. 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. F = 100. capital asset pricing approach. The share is redeemable after 12 years at par. 145 . For our purposes.95. realised yield approach. earnings-price ratio approach.8 per cent 2 Cost of Equity Capital 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). 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 the net amount realised per share is Rs. what is the cost of the preference capital? Solution Given that D = 14.

What is the cost of the equity capital to the company? Solution The cost of equity capital (ke) will be: 146 . In practice. Therefore to apply this model in practice. Assuming a constant growth rate in dividends. we can determine the rate of return required by the equity shareholders (k8) from equation (1). 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. dividend per share expected a year hence is Rs. 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. which is nothing but the cOSI of equity capital. the equation (1) can be simplified as follows: If the current market price of the share is given (Pe). rewritten as The following example illustrates the application of this formula: Example The market price per share of Mobile Glycois Limited is Rs.125.If we know the current market price (Pe) and can forecast the future stream of dividends. and the values of D1 and g are known.12 per share and the DPS is expected to grow at a constant rate of 8 per cent per annum. then the equation (2) can be.

100 lakhs of retained earnings and Rs.95% Weighted Average Cost of Capital 147 .05 = 18. Gamma Asbestos Limited has got Rs. For example. legal charges.). The cost of issuing external equity is 5%.100 lakhs of external equity through a issue. The cost of retained earnings and the cost of external equity can be determined as follows: Cost of retained earnings kr = ke i. in its capital structure. The formula for ke in this will be as follows: Where f = floatation costs..e. fees to managers of issue. 18% Cost of external equity raised by the company Now k0 = 1 . the company has certain floatation costs (costs incurred during public issue.0. underwriting commission. like brokerage. kr (representing cost of retained earnings) = ke But when for raising external equity.. i. The equity investors expect a rate of return of 18%. advertisement and printing expenses etc.Cost of Retained Earnings and Cost of External Equity The cost of retained earnings or internal accruals is generally taken to be the same as the cost of equity.e.

To illustrate the calculation of the weighted average cost of capital. The tax rate applicable to the firm is 50 per cent. debentures. Step 1: Determine the costs of the various sources of finance. let us consider the following example: Example The market price per equity share is Rs. kp. 148 .2.. retained earnings. preference capital. The next expected dividend per share (DPS) is Rs. We shall define the symbols ke.75 per share in the stock exchange.25. Calculate the weighted average cost of capital. The debentures are redeemable after 6 years at par and their current market quotation is Rs. Solution We will adopt a three-step procedure to solve this problem. kd and ki to denote the costs of equity.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.90 per share. And term loans respectively. kr.

Determine the weights associated with the various sources of finance. Wd and Wi to denote the weight of the various sources of finance. 149 . We shall define the symbols We. Wr.Step 2. Wp.

recommend the use of market value weights provided the values are available and reliable. 150 .1780) + (0.25 x 0. however.175 x 0. 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.0912) +(0. we. WAC = Wake + Wrkr ÷ Wkp + Wdkd + Wiki = (0.25 x 0.16) + (0. There are pros and cons associated with each of these systems of weighting. 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).16) + (0.1259 or 12. On the balance.07) = 0.Step 3.59 per cent. Therefore.025 x 0. System of Weighting 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.30 x 0.

The total funds employed in a business are obtained from various sources. the permanent or long-term funds often occupy a large portion of total funds and involve long-term policy decision. The latter affects the building up of retained earnings which is an important component of long-term owned funds. What is cost of capital? What is the significance in capital structure planning? 2.Have you understood? 1. As such the proportion of various sources for short-term funds cannot perhaps be rigidly laid down. The entire composition of these funds constitute the overall financial structure of the firm. What is weighted average cost of capital? How do you calculate WACC? Lesson 3 Capital Structure INTRODUCTION Finance is an important input for any type of business and is needed for working capital and for permanent investment. such as share capital and reserves (owned funds). some others are held for a long period such as longterm borrowings or debentures. More significant aspects of the policy are the debt equity ratio and the dividend decision. the term financial structure is often used to mean the capital structure of the firm. How do you calculate cost of debenture capital? 3. Since. 151 . A more definite policy is often laid down for the composition of long-term funds. The firm has to follow a flexible approach. While some of the funds are permanently held in business. Explain the method of calculating the cost of preference capital and equity capital. and still some other funds are in the nature of short-term borrowings. How do you calculate cost of retained earnings? 5. 4. A part of the funds are brought in by the owners and the rest is borrowed from others² individuals and institutions. known as capital structure.

However. debentures. The unplanned capital structure does not permit an economical use of funds for the company. term loans from financial institutions. cost of capital and related aspects. 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 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. sooner or later they face considerable difficulties. All these sources together are the main constituents of the capital of the business. It includes funds raised through ordinary and preference shares. The portion of profits retained in the business is a reinvestment of owners¶ funds. LEARNING OBJECTIVES: After reading this chapter you would be able to understand capital structure and its features. its capital structure. SECTION TITLE What is Capital Structure? The term µcapital structure¶ represents the total long-term investment in a business firm. These companies may do well in the short-run. Hence. Any earned revenue and capital surpluses are included: Capital Structure Planning Decision regarding what type of capital structure a company should have is of critical importance because of its potential impact on profitability and solvency. that is. Small companies often do not plan their capital structure. bonds. it is also a source of long-term funds. The profits earned from operations are owners¶ funds²which may be retained in the business or distributed to the owners (shareholders) as dividend. etc.There are certain sources of long-term funds which are generally available to the corporate enterprises. a company 152 . determinants of capital structure. The main sources are: share capital (owners¶ funds) and long-term debt including debentures (creditors¶ funds).

In practice. a company may be in an industry that has an average debt to total capital ratio of 60 percent. a company should plan an optimum capital structure in such a way that the market value of its shares is maximized. Two similar companies can have different capital structures if the decision makers differ in their judgement about the significance of various factors. That is why. for most companies within an industry. The judgement of the person or group of persons making the capital structure decision plays a crucial role. While developing an appropriate capital structure for his company. the appropriate capital structure for the company ranges between 45 percent to 75 percent debt to total capital ratio. Features of An Appropriate Capital Structure Capital structure is usually planned keeping in view the interests of the ordinary shareholders.may just either follow what other comparable companies do regarding capital structure or may consult some institutional leader and follow its practice. The value will be maximized when the marginal real cost of each source of fund is the same. 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. A capital structure in this context can be determined empirically. complex and qualitative and do not always follow the accepted theory. The ordinary shareholders are the ultimate owners of the company and have the right to elect the directors. Capital markets are not perfect and the decision has to be taken with imperfect knowledge and consequent risk. For example. the discussion on the issue of optimum capital structure is highly theoretical. These factors are highly psychological. The management of the company should try to seek the capital structure near the top of this range in order to make 153 . there will be a range of an appropriate capital structures within which there are no great differences in the market values of shares. a finance manager should aim at maximizing the long-term market price of equity shares. In general. perhaps. Theoretically. 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. The determination of an optimum capital structure in practice is a formidable task. Thus.

For example. the relative importance of these requirements may change with changing conditions. we need to approach capital structuring with due conservatism. A sound or appropriate capital structure should have the following features: Profitability: The capital structure of the company should be most advantageous. subject to other requirements such as flexibility. Solvency: The use of excessive debt threatens the solvency of the company. Furthermore. It should have enough cash to pay periodic fixed charges to creditors and the principal sum on maturity. Determinants of Capital Structure Capital structure has to be determined at the time a company is promoted. from the solvency point of view. solvency. Debt should be used judiciously. while another company may be more concerned about solvency than about any other requirement. It should be possible for a company to adapt its capital structure with minimum cost and delay if warranted by a changed situation. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve 154 . The initial capital structure should be designed very carefully. The particular characteristics of a company may reflect some additional specific features. etc. maximum use of leverage at a minimum cost should be made. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. Within the constraints. In other words. Flexibility: The capital structure should be flexible to meet the changing conditions. the emphasis given to each of these features may differ from company to company. Further.maximum use of favourable leverage. The debt capacity of the company which depends on its ability to generate future cash flows should not be exceeded. a company may give more importance to flexibility than to retaining the control which could be another desired feature. The above are the general features of an appropriate capital structure.

(iv) Control.the target capital structure. 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. 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. (vii) Marketability. Similarly. Generally. such as debt and preference share capital. the earnings per share will also increase if preference share capital is used to acquire assets. 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. Because of its effect on the earnings per share. the factors to be considered whenever a capital structure decision is taken are: (i) Leverage or Trading on equity. Let us briefly explain these factors. the Finance Manager then has to deal with the existing capital structure. Leverage or Trading on Equity The use of sources of finance with a fixed cost. 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. (iii) Cash flow. financial leverage is one of the important considerations in planning the capital structure of a company. the earnings per share will increase without an increase in the owners¶ investment. The EBIT-EPS analysis is one important tool in the hands of the Finance Manager to get an insight into the firm¶s capital 155 . (v) Flexibility. Once a company has been formed and it has been in existence for some years. Every time the funds have to be procured. 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 company may need funds to finance its activities continuously. the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finances. (ii) Cost of capital. (vi) Size of the 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. and (viii) Floatation costs.

You will note that the proportion of fixed return securities under plans B and C 156 .00. 30% preference shares (12%). 4. 200/c equity shares Plan C 80% debt (10%).structure management. The effect of financial leverage (trading on equity) is presented in Table1. The total amount of capital required to be raised is Rs. Illustration Plan A No debt. 10. The company estimates its earnings before interest and taxes (EBIT) at Rs. 2. The rates in parentheses indicate the fixed return on debt and preference shares. from shareholders¶ point of view as the EPS of Rs. 200/c equity shares The face value of equity shares is Rs.25 is the highest under this plan. all equity shares Plan B 50% debt (10%). 50.000 annually.000. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financing plans. The lowest EPs are when the company does not use any debt or fixed return securities. It will be seen that Plan C is the most attractive.

whether it makes profits or not. But when no debt is employed in the capital structure. it can also increase financial risk to the shareholders. other things remaining the same. In the case of debt-holders. Therefore. However. the rate of interest is fixed and the company is legally bound to pay interest. the shareholders would be benefited to the maximum if plan C is adopted. Cost of Capital Measuring the costs of various sources of funds is a complex subject and needs a separate treatment. The secret of the advantage in financial leverage lies in the fact that whereas the overall return (before tax) on capital employed is 25% the return on preference share and debt is only 12% and 10% respectively. Needless to say that it is desirable to minimize the cost of capital. The cost of a source of finance is the minimum return expected by its suppliers. The savings resulting from this difference enable the management to enhance the return on equity shares. The shares of the company will command a high premium in the market and would be greatly in demand. A high degree of risk is assumed by equity shareholders than debt-holders. a firm should employ debt to the extent the financial risk perceived by the shareholders does not exceed the benefit of increased BPS. The managements of companies sometimes intentionally want to make their equity shares very attractive and prized possessions. cheaper sources should be preferred. Assuming that the estimates about EBIT turn out to be correct. Hence. Although leverage increases BPS under favourable the same (80%). This they can achieve by the practice of trading on equity. the shareholders will be deprived of the benefit of increases in BPS arising from financial leverage. 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. 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. A firm can avoid financial risk altogether if it does not employ any debt in its capital structure. The expected return depends on the degree of risk assumed by investors. For equity shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation 157 .

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. it appears reasonable that a firm should employ a large amount of debt provided its earnings do not fluctuate very widely. the latter is cheap. up to a point the overall cost of capital decreases with debt. debt can be used to the point where the average cost of capital is minimum. retained earnings are preferable. the risk to creditors also increases. in order to minimise the overall cost of capital. and also because. unlike new issues. This has the -effect of increasing the cost of equity. Furthermore. a company should employ a large amount of debt. no floatation costs are incurred if the earnings are retained. 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. The cost of equity includes the cast of new issue of shares and the cost of retained earnings. Thus. between these two sources. Thus. The cost of debt is cheaper than the cost of both these sources of equity funds. other factors should also be evaluated to determine the appropriate capital structure for a 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. When the degree of leverage increases. 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. Between the cost of new issue and retained earnings. However. the excessive amount of debt makes the shareholders¶ position very risky. In fact. but is not as cheap as debt is. but beyond that point the cost of capital would start increasing and. Thus. These two factors taken together set the maximum limit to the use of debt. 158 . The preference share capital is cheaper than equity capital. there is a combination of debt and equity which minimizes that firm¶s average cost of capital and maximizes the market value per share. it would not be advantageous to employ debt further. The tax deductibility of interest charges further reduces the cost of debt. However. This leads one to conclude that debt is a cheaper source of funds than equity. when we consider the leverage and the cost of capital factors. As a result. So. therefore.

Let us understand this concept by taking an illustration. Ko which is equal to Kipl+Kep2 Where Ki = Cost of debt P1 = Relative proportion of debt in the total capital of the firm Ke = Cost of equity P2 = Relative proportion of equity in the total capital of the firm Before we arrive at any conclusion..e. it would be desirable to prepare a table showing all necessary information and calculations. 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 capital: For determining the optimal debt equity mix. Illustration A company is considering a most desirable capital structure.Theoretically. 159 . we have to calculate the composite cost of capital i. a company should have such a mix of debt and equity that its overall cost of capital is minimum.

It can therefore be concluded that a mix of 20% debt and 80% equity will make the capital structure optimal. The fixed charges of a company include payment of interest. it should analyze its expected future cash flows to meet the fixed charges. Any other mix of debt and equity gives a higher overall cost of capital. It is obligatory to pay interest and return the principal amount of debt. Cash Flow One of the features of a sound capital structure is conservatism.4%. Whenever. it may have to face financial insolvency. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital. The companies which expect large and stable cash inflows can employ a large amount of debt in their capital structure. 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. It is somewhat risky to employ sources of capital with fixed charges for companies whose cash inflows are unstable or unpredictable. 160 .Cost of Capital Calculations The optimal debt equity mix for the company is at a point where the composite cost of capital is minimum. The closest to the minimum cost of capital is a mix of 40% debt and 60% equity where Ko is 14. From the table. it is evident that a mix of 20% debt and 80% equity gives the minimum composite cost of capital of 14%. Conservatism does not mean employing no debt or a small amount of debt. If a company is not able to generate enough cash to meet its fixed obligations. preference dividend and principal. Conservatism is related to the assessment of the liability for fixed charges. a company thinks of raising additional debt.

The shares of such a company are widely scattered. holders of debt do not have voting right. when a company uses large amounts of debt. A shareholder or a group of shareholders could purchase all or most of the new shares and thus control the company. The risk of loss of control can almost be avoided by distributing shares widely and in small lots. The capital structure of a firm is flexible if it has no difficulty in changing its capitalization or sources of funds. They are simply interested in dividends and appreciation in the price of shares. Most of the shareholders are not interested in taking active part in the company¶s management. Fear of having to share control and thus being interfered by others often delays the decision of the closely held companies to go public.Control In designing the capital structure. Since. Flexibility Flexibility means the firm¶s ability to adapt its capital structure to the needs of the changing conditions. the company should be able to raise funds without undue delay and cost to finance the profitable investments. Whenever needed. If the company issues new shares. This is not a very important consideration in case of a widely held company. there is a risk of loss of control. which means a complete loss of control. could be a significant question in the case of a closely held company. However. To avoid the risk of loss of control the companies may issue preference shares or raise debt capital. it is often suggested that a company should use debt to avoid the loss of control. An excessive amount of debt may also cause bankruptcy. sometimes the existing management is governed by its desire to continue control over the company. lot of restrictions are imposed on it by the debt-holders to protect their interests. 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. They do not have the time and urge to attend the meetings. Maintaining control however. The company should also be 161 . The ordinary shareholders have the legal right to elect the directors of the company. These restrictions curtail the freedom of the management to run the business.

preference shares and debentures to the a position to redeem its preference capital or debt whenever warranted by future conditions. the market favours debenture issues and at another time. It can obtain loans at easy terms and can also issue ordinary shares. it should keep its debt capacity unutilised and issue ordinary shares to raise finances. the company should not issue ordinary shares but issue debt and wait to issue ordinary shares till the share market revives. Small companies. The management thus cannot run business freely. the company has to decide whether to raise funds through common shares or debt. 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. it may not be possible for the company to issue debentures successfully. It should keep itself in a position to substitute one form of financing for another to economies on the use of funds. Therefore. A company should make the best use of its size in planning the capital structure. 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. If the share market is depressed. it may readily accept ordinary share issues. therefore. If somehow it manages to obtain a long-term loan. Due to the changing market sentiments. A small company may often find it difficult to raise long-term loans. 162 . Size of the Company The size of a company greatly influences the availability of funds from different sources. Marketability 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 financial plan of the company should be flexible enough to change the composition of the capital structure. During boom period in the share market.

The decision regarding distribution of disposable earnings to the shareholders is a significant one. the cost of floating a debt is less than the cost of floating an equity issue. lower income or no income at all to the shareholders. What are the factors effecting capital structure of the company? 2. no floatation costs are incurred. The utilisation of profits earned is a significant financial decision.Floatation Costs Floatation costs are incurred when the funds are raised. namely the board of directors. As in any other type of organization. Explain the features of an optimal capital structure? Lesson 4 Dividend Policy INTRODUCTION A business organization always aims at earning profits. HAVE YOU UNDERSTOOD? 1. or both. Generally. This may encourage a company to use debt rather than issue ordinary shares.e. The decisionmaking is somewhat complex in the case of joint stock companies. dividend may also 163 . In case of a partnership the agreement often provides for the basis of distribution of profits among partners. The decision may mean a higher income. Since a company is an artificial person. Besides affecting the mood of the present shareholders. Floatation cost generally is not a very important factor influencing the capital structure of a company except in the case of small companies. the disposal of net earnings of a company involves either their retention in the business or their distribution to the owners (i. shareholders) in the form of dividend.. the decision regarding utilisation of profits rests with a group of people. This decision does not involve any problem is so far as the sole proprietory business is concerned. If the owner¶s capital is increased by retaining the earnings. The main issue here is whether the profits should be used by the owner(s) or be retained and reinvested in the business itself.

employees. Hence. in unusual circumstances. Stock dividends. In case the company does not have a comfortable cash position it 164 . These are briefly described below: Scrip Dividends Dividends can be paid only out of profits earned in the particular year or in the past reflected in the company¶s accumulated reserves. Even among the shareholders there may be conflicts as they may belong to different income groups.influence the mood. others may be interested in capital appreciation and capital gains. behavior and responses of prospective investors. Learning Objectives The objectives of this unit are: To acquaint with the meaning. debenture holders. 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. Mostly dividends are paid in cash. etc. shareholders. Disposal of profits in the form of dividends can become a controversial issue because of conflicting interests of various parties like the directors. which influence the determination of dividend policy. SECTION TITLE Forms of Dividend Dividend ordinarily is a distribution of profits earned by a joint stock company among its shareholders. 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. types and purpose of dividend To highlight the various factors. lending institutions. Debenture dividends. Property dividends. It needs careful consideration of various factors. and. formulation of dividend policy is a complex decision. While some may be interested in regular income. but there are also other forms of dividends such as Scrip dividends. Profits do not necessarily mean adequate cash to enable payment of cash dividends.

bonus shares are not issued in lieu of dividends. Debenture Dividends Companies may also issue debentures in lieu of dividends to their shareholders. A company sometimes may hold shares of other companies. These debentures bare interest and are payable after a prescribed period.. While maximizing the market value of shares. Property Dividends This form of dividend is unusual. Dividend Policy The objective of corporate management usually is the maximization of the market value of the enterprise i. The market value of common stock of a company is influenced by its policy regarding allocation of net earnings into µplough back¶ and µpayout¶. eg. Such a practice is not common. the shareholders acquire the right and this way their marketable equity increases. If these shares are transferred to its shareholders. In case the company sells these shares it may have to pay capital gains which may be subject to taxation. It is just like creating a longterm debt. its subsidiaries which it may like to distribute among its own shareholders.e. as laid down by the government. It may also issue convertible dividend warrants redeemable in a few years. while the funds continue to remain with the company. Certain guidelines. Such dividend may be in the form of inventory or securities in lieu of cash payment. Ordinarily.. are applicable for issue of bonus shares in India. They can either retain their bonus shares and thus be entitled to increase total dividend or can sell their bonus shares and realise cash. there is no tax liability. the latter may be capitalized by issue of bonus shares to the shareholders. its wealth. Bonus Shares or Stock Dividends Instead of paying dividends out of accumulated reserves. Thus.may issue promissory notes payable in a few months. instead of paying dividend in cash. the dividend policy should be so oriented as to satisfy the interests of 165 . They are periodically issued by prosperous companies in addition to usual dividends.

However. 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.. stable dividends. property dividend or bonus dividend. shareholders opportunity loss. As such no two companies may follow exactly similar dividend policies. i. i. i. the following aspects have general applicability: Dividend policy should be analysed in terms of its effect on the value of the company. regular dividends. investment and financing decisions are interdependent and a trade off. It is not merely concerned with dividends to be paid in one year. Policy Options Dividend policy options refer to the policy options that the management formulates in regard to earnings for distribution as dividend among shareholders. such as: Whether dividend should be paid right from the initial year of operation i. 166 . Dividend. The dividend policy has to be tailored to the particular circumstances of the company. 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.e.. Thus. but is concerned with the continuous course of action to be followed over a period of several years. Dividend Policy Goals There are several factors which influence the determination of the dividend policy.. Irrespective of the quantum of earnings as in case of preference shares. a fixed payout ratio.e.e. Dividend decision involves dealing with several questions..the existing shareholders as well as to attract the potential investors.e. Whether equal amount or a fixed percentage of dividend be paid every year. Investment by the company in new profitable opportunities creates value and when a company foregoes an attractive investment. the aim should be to maximize the present value of future dividends and the appreciation in the market price of shares.

The Finance Manager plays an important role in advising the management i.Dividend decision should not be treated. Reduction in the rate of dividend is a painful thing for the shareholders to bear. The retention of profits in business helps the company in mobilizing funds for expansion.e. In case the company has more favorable reinvestment opportunities within it as compared to those offered outside. The shareholders can later be compensated by issue of bonus shares.. Economists. all of them may decide to reinvest the distributed earnings in the same company is another thing. the general principles guiding the dividend policy should. Erratic and frequent changes in dividends should be avoided. A workable compromise is to treat dividends as a long-term residual to avoid undesirable variations in payout. The relevant figures would then appears as follows: 167 . Role of the Finance Manager The disposal of the earnings. it would be more profitable for the company to retain earnings than to pay them out as dividends. believe that the entire earnings of a business should be paid to its owners who should then decide where to reinvest them. That. 1 lakh and is totally distributed as dividend to shareholders. as far as possible. This needs financial planning over a tawny long time horizon. as a short run residual decision because variability of annual earnings may cause even a zero dividend in a particular year. is an issue of fundamental importance in financial management. Board of Directors regarding the decision. retention in business or distribution among shareholders. Whatever dividend policy is adopted by the company. Let us illustrate this point by taking an example. however. The management will find it hard to convince the shareholders of the desirability of a lower dividend for the sake of preserving their future interests. 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. be communicated clearly to investors who may then take their decisions in terms of their own preferences and needs. It is the latter whose privilege it is to take the decision. Suppose the net profit after taxes of a company is Rs.

its decision cannot be challenged and there is no way to force a dividend by direct legal action. besides the rationale behind the investment programme of the company. Role of the Board of Directors The Board of Directors has the power to determine whether and at what rate dividend shall be paid to the shareholders. assuming that the stockholders are willing to reinvest their entire dividend income. So long as the Board acts in good faith. there are some restrictions. The dividend policy. acts on the basis of a reasonable policy. 54. on the discretion of the Board of Directors which are as follows: 168 . as they might perceive it to their detriment. it is likely that not more than Rs. Even a majority of shareholders have no right to interfere with the authority of the Board. particularly the timing of the declaration of dividend. As such they would be interested in receiving larger dividends.It is clear from the above example that if dividends are not paid. Rs. The Finance Manager. 1 lakh of income is available to the company for reinvestment in business. should be well-informed about the capital market trends and the tax policies of the government. influences the market value of a company¶s shares. and it does not flagrantly abuse its fiduciary responsibility. depending upon the environment prevalent in the capital market. lf better outside investment opportunities are available to the shareholders. However.000would be available for reinvestment (in the same or any other business). they may not appreciate the recommendation (or action) of the Board of Directors for retention of larger amounts in the business. dictated by law or prudence. therefore. The payment of dividend is not obligatory. In case dividends are paid.

The corporate management is an elective management. depletion. should be made prior to dividend declaration. The rights of creditors should be taken care of while taking a decision on dividend. if it feels this course is necessary.Dividends may be declared out of any inappropriate surplus. in order to enable the company to stand on a firm ground. A due provision for depreciation. if they have declared any unlawful dividends or have grossly neglected their interests. Dividend declarations which impair the capital strength of a corporation must be discouraged. Factors Affecting Dividend Decision It is possible to group the factors affecting dividend policy into two broad categories: 169 . the corporate management must satisfy the shareholders by offering them a fair return on their investment by way of dividends. It is not easy to lay down an optimum dividend policy which would maximize the long-run wealth of the shareholders. Second. therefore. should be taken into consideration while deciding a policy in this respect. and the date and mode of dividend payment. First.. If there is a loss. The Board is expected to act judiciously in taking a decision on dividends. the interest of the shareholders may come into conflict with those of the company. by not declaring dividends). Dividend declarations which might lead to insolvency should be discouraged. etc. At times.e. The power of recommending a dividend is delegated by the shareholders to the Board of Directors. it should be absorbed first before dividends can be declared. There are certain factors that impinge upon the dividend decision and. The decision has two dimensions. 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. The dividend decision thus is a difficult one because of conflicting objectives and also because of lack of specific decision-making techniques. the management has a commitment to ensure the financial stability of the corporation by withholding dividends (i. Directors can be used by shareholders.

the influence of stockholders¶ interests on dividend decision becomes uncertain because: (a) the status or preferences of stockholders relating to their position. ownership is decentralized on a wide spectrum the identification of their interests becomes difficult. various groups of shareholders may have different desires¶ and objectives. 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. Inspite of these difficulties. Ownership Considerations: Where ownership is concentrated in few people. there are no problems in identifying ownership interests. capital gains. (b) a conflict in shareholders¶ interests may arise. which include the following: Contractual and legal restrictions Liquidity. Since companies generally do not have a singular group of shareholders. however. investors gravitate to those companies. Further. etc. understandably. 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 170 . Since. current income. cannot be precisely ascertained. the objective of the maximization of the market value of shares requires that the dividend policy be geared to investors in general. Where. Firm-oriented Considerations Ownership interests alone may not determine the dividend policy. A firm¶s needs are also an important consideration. which combine the mix of growth and desired dividends.Ownership considerations Firm-oriented considerations.

pay dividends with greater regularity than the capital goods industries. But once they get established. The following factors affect the shaping of a dividend policy. Thus. If earnings fluctuate and losses are caused during depression. they might afford to make liberal dividend payments. with long gestation period and multiplicity of hazards. a healthy company with an eye on future follows a somewhat cautious policy and builds up reserves. oil or mines²which get depleted over time. Such a company may offer dividends. in part. may well pursue a policy of gradually returning capital to its owners because its resources are going to be exhausted. on the other hand. Generally speaking. Industries with stable income are in a position to formulate consistent dividend policies. public utilities may be able to establish a relatively fixed dividend rate. Excessive dividends may be paid only by µmushroom¶ companies. the continued payment of dividends may become a risky proposition. A company which believes in publicity gimmicks may follow a more liberal dividend policy to its future detriment. therefore. A company with µwasting¶ assets²such as timber. Attitude and Objectives of Management 171 . Companies with unstable earnings adopt dividend policies which are different from those which have steady earnings. Mining companies. 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. which include. a return of the owner¶s investment.Business cycles Post dividend policies and stockholder relationships. Nature of Business This is an important determinant of the dividend policy of a company. large and mature companies pay a reasonably good but not an excessive rate of dividend. Consumer goods industries usually suffer less from uncertainties of income and. may not be able to declare dividends for years.

While some organizations may be niggardly in dividend payments. Though such an approach may easily meet their future needs for funds. The stockholders who control the management of the company may be interested in µempirebuilding¶ 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. on the other hand. a company which is closely held by a few shareholders in the high income-tax brackets. Thus. a number of corporations adopt several venations.¶ some others may be liberal. when the stock is widely held. Niggardly organizations prefer to conserve cash. and do not attach much importance to tax considerations. The directors of a closely held company may take into consideration the effect of dividends upon the tax position of their important shareholders. The attitude of the management affects the dividend policies of a corporation in another way. feel that stockholders are entitled to an established rate of dividend as long as their financial condition is reasonably sound. Widely held companies have scattered shareholders. the personal objectives of the directors and of a majority of shareholders may govern the decision. it deprives the stockholders of a legitimate return on their investment. Such companies may take the dividend decision with a greater sense of responsibility by adopting a more formal and scientific approach. Composition of Shareholding There may be marked variations in dividend policies on account of the variations in the composition of the shareholding. The tax burden on business corporations is a determining factor in formulation of their dividend policies. In the case of a closely held company. A large number of firms may be found within these two extremes. 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 172 . 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. is likely to payout a relatively low dividend. Within these two extremes. However. stockholders are enthusiastic about collecting their dividends regularly. Liberal organizations.

they may adopt a policy for retaining larger portion of earnings. Companies sometimes prune dividends when their liquidity declines. and working capital needs. Regularity 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. They may use past profits to pay dividends regularly. Similarly. The past record of a company in payment of dividends regularly builds up the 173 . repayment of long-term debt. 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. irrespective of whether they have enough current profits or not. the shareholders of a large and widely held company may be interested in high dividend payout. Desire for Financial Solvency and Liquidity 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. In the context of opportunities for expansion and growth. even though large variations in earnings and consequently in dividends may be observed from year to year. Investment Opportunities Many companies retain the earnings to facilitate planned expansion. 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. On the other hand. it may adopt a conservative dividend policy. consider it necessary to conserve their cash resources to face future emergencies. therefore. Other companies may consider regularity in payment of dividends as more important than anything else. influence the dividend decision. if a company has lucrative opportunities for investing its funds and can earn a rate which is higher than its cost of capital. capital expenditure commitments.subject to higher personal income taxes. They may. So. Cash credit limits. etc.

financial institutions which grant. Consequently. funds generated from depreciation may not be adequate to replace worn out equipment¶. undergo great oscillations during the different stages of a business cycle. dividend policies may fluctuate from time to time. The demand for capital expenditure. 174 . As a result. Regularity in dividends cultivates an investment attitude rather than a speculative one towards the shares of the company. Inflation Inflation is also a factor which may affect a firm¶s dividend decision. A higher payout ratio based on overstated profits may eventually lead to the liquidation of the company. long-term loans to corporations put a clause restricting dividend payment till the loan or a substantial part of it is repaid. 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 firm has to depend upon retained earnings as a source of funds to make up for the shortfall. Inflation has another dimension. This is of particular relevance if the assets have to be replaced in near future. In an inflationary situation. Restrictions by Financial Institutions Sometimes. the dividend payout ratio will tend to be low. They would thus expect a higher payout ratio. Other Factors Age of the company has some effect on the dividend decision. etc.morale of the stockholders who may adopt a helpful attitude towards it in periods of emergency or financial crisis. In the period of inflation. money supply. On account of inflation often the profits of most of the companies are inflated. Under these circumstances. current income becomes more important and shareholders in general attach more value to current yield than to distant capital appreciation.

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. What factors a company would in general consider before it takes a decision on dividends? 175 . "While formulating a dividend policy the management has to reconcile its own needs for funds with the expectations of shareholders".Have you Understood? 1. Explain the statement. What policy goals might be considered by management in taking a decision on dividends? 3. Explain the statement. "Dividend can be paid only out of profits". What is dividend and why is dividend decision important? 2. Will a company be justified in paying dividends when it has unwritten-of accumulated losses of the past? 5.

and research and development. Funds are thus blocked in different types of inventory. raw material. semi-finished (manufacturing-in-process) goods and finished marketable goods. It can also be regarded as that portion of the firm¶s total capital which is employed in short-term operations. The management of working capital is no less important than the management of long-term financial investment. that is. of proper management of investment of funds in business. some of it may be sold on credit. work-in-process and finished goods. among other things. Learning Objectives 176 . In simple words. renovation or modernization of plant and machinery. Funds can be invested for permanent or long-term purposes such as acquisition of fixed assets. diversification and expansion of business. Working Capital refers to a firm¶s investment in short-term assets: viz. It refers to all aspects of current assets and current liabilities. Hence. if you are managing a manufacturing unit you will have to arrange for procurement of raw material. The credit sales also involve blocking of funds with debtors till cash is received or the bills are cleared. the whole of the stock of finished goods may not be sold against ready cash. short-term securities. All the goods which are manufactured in a given time period may not be sold in that period. we can say that working capital is the investment needed for carrying out dayto-day operations of the business smoothly.. some goods remain in stock..UNIT ± IV WORKING CAPITAL MANAGEMENT Lesson 1 Working Capital INTRODUCTION Effective Financial Management is the outcome. For example. for current operations of the business. amount receivables (debtors) and inventories of raw materials. Again. payment of wages to your workmen and for meeting routine expenses. eg. Funds are also needed for short-tem purposes. cash.

177 . The channels of the investment are called current assets. a commercial enterprise is virtually good for nothing without merchandise to sell. the larger will be the turnover of funds invested for various purposes. (c) the capacity to wait for the market for its finished products. is the life-blood of a business. eg. (b) cash to meet the wage bill. A perusal of the operating¶ cycle would reveal that the funds invested in operations are re-cycled back into cash. Even a fully equipped manufacturing firm is sure to collapse without (a) an adequate supply of raw materials to process. The longer the period of this conversion the longer is the operating cycle. The cycle. Obviously.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 SECTION TITLE Significance of Working Capital One will hardly find an operating business firm which does not require some amount of working capital.. Operating Cycle 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. whether profit-oriented or otherwise. As a matter of fact. A standard operating cycle may be for any time period but does not generally exceed a financial year. The successive events which are typically involved in an operating cycle are depicted in Figure I. thus. Sometimes the available funds may be in excess of the needs for investment in these assets. will not be able to carry on day-to-day activities without adequate working capital. any organization. takes some time to complete. receivables and minimum essential cash balance. of course. and (d) the ability to grant credit to its customers. Working capital. Similarly. the shorter the operating cycle. inventory. Any surplus may be invested in government securities rather than being retained as idle cash balance.

and are expected to yield earnings over and above the 178 . To a certain degree. working capital refers to the firm¶s investment in current assets. similarity can be observed in fixed and current assets so far as both are partly financed by borrowed funds. Gross Working Capital According to this concept. The amount of current liabilities is not deducted from the total of current assets. The proponents of the gross working capital concept advocate this for the following reasons: 1. Profits are earned with the help of assets which are partly fixed and partly current.Concepts of Working Capital There are two types of working capital. 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¶. namely Gross and Net working capital.

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. This needs some explanation.interest costs. A negative net working capital occurs when current liabilities are in excess of current assets. prompt and timely action should be taken by management to improve and correct the imbalance in the liquidity position of the firm. 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. current assets and current liabilities with a general understanding that working capital is the difference between the two". An increase in the overall investment in the enterprise also brings about an increase in the working capital. bills payable. Every firm has a minimum amount of net working capital which is permanent. Net Working Capital The net working capital refers to the difference between current assets and current liabilities. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe. A positive net working capital will arise when current assets exceed current liabilities. Excessive liquidity is also bad. "Whenever working capital is mentioned it brings to mind. Therefore. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors¶ dues. Therefore. Net working capital can be positive or negative. 3. The net working capital concept also covers the question of a judicious mix of long-term and short-term funds for financing current assets. It may be due to mismanagement of current assets. bank overdraft and outstanding expenses. 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 portion of the working capital should be financed 179 . 2. Logic then demands that the aggregate of current assets should be taken to mean the working capital.

It helps to ascertain the correct comparative financial position of companies having the same amount of current assets. In support of their stand. Management must decide the extent to which current assets should be financed with equity capital and/or borrowed capital.with permanent sources of funds such as owners¶ capital. Seasonal. there is always a certain minimum level of current assets which is essential for the firm to carry on its business 180 . the gross concept underscores the quantitative. Several economists uphold the net working capital concept. Temporary or Special Working Capital. Regular or Permanent Working Capital. 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. the need for current assets is felt constantly. Kinds of Working Capital Ordinarily. It is this concept which helps creditors and investors to judge the financial soundness of the enterprise. working capital is classified into two categories: Fixed. they state that: In the long run what matters is the surplus of current assets over current liabilities. debentures. The magnitude of investment in current assets however may not always be the same. preference capital and retained earnings. As such. Fluctuating. It may be stated that gross and net concepts of working capital are two important facets of working capital management. While the net concept of working capital emphasizes the qualitative aspect. and Variable. Fixed Working Capital The need for current assets is associated with the operating cycle is a continuous process. The need for investment in current assets may increase or decrease over a period of time according to the level of production. Both the concepts have operational significance for the management and therefore neither can be ignored. long-term debt. Nevertheless.

The need for working capital may also vary on account of seasonal changes or abnormal or unanticipated conditions. Additional doses of working capital may be required to face cutthroat competition in the market or other contingencies like strikes and lockouts. the need for working capital. 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. Any special advertising campaigns organized for increasing sales or other promotional activities may have to be financed by additional working capital. For example. over and above the permanent working capital.irrespective of the level of operations. Figures II and III give an idea about fixed and fluctuating working capital. temporary or special) working capital. Fluctuating Working Capital Depending upon the changes in production and sales. will fluctuate. seasonal. It is permanent in the same way as investment in the firm¶s fixed assets is. The extra working capital needed to support the changing business activities is called as fluctuating (variable. 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. This is the irreducible minimum amount necessary for maintaining the circulation of the current assets. 181 .

while variable Working capital is fluctuating²sometimes increasing and sometimes decreasing. The permanent working capital line. may not always be horizontal. however. The typical items are: Cash to meet expenses as and when they occur. For a growing firm. permanent working capital may also keep on increasing over time as has been shown in Figure III.figure II. Both these kinds of working capital²permanent and temporary²are required to facilitate production and sales through the operating cycle. Components of Working Capital It is already noted that working capital has two components: Current assets and Current liabilities. Current assets comprise several items. 182 . fixed working capital remaining constant over time It is shown in Figure II that fixed working capital is stable overtime. but temporary working capital is arranged by the firm to meet liquidity requirements that are expected to be temporary.

Typical items of current liabilities are: Goods purchased on credit Expenses incurred in the course of the business of the organization (eg. and deferment. work-in-process. the need for funds to finance the current assets may be met from supply of goods on credit. Apart from these. rent. of payment for expenses.) which are not yet paid for. 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 183 . wages or salaries. We must not lose sight of the fact that management of working capital is an integral part of the overall Financial Management and. or as short-term deposits. and finished goods. Temporary investment of surplus funds which could be converted into cash whenever needed.Accounts receivables or sundry trade debtors. Temporary or short-term borrowings from banks. ultimately. on account of custom. financial institutions or other parties. These items arc collectively called current liabilities. The remaining part of the need for working capital may be met from short-term borrowing from financiers like banks. which are recoverable. Importance of Working Capital Management Because of its close relationship with day-to-day operations of a business. usage or arrangement. stores. interest etc. It is being increasingly realised that inadequacy or mismanagement of working capital is the leading cause of business failures. a study of working capital and its management is of major importance to internal. Inventory of raw materials. Advances received from parties against goods to be sold or delivered. Other current liabilities such as tax and dividends payable. 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. Advance payments towards expenses or purchases. and other short-term advances. as well as external analysts. electricity bills. supplies and spares..

It may provide an undue incentive for adopting too liberal a credit policy and slackening of collection of receivables. On the other hand. 8. Fixed assets may not be efficiently utilised due to lack of working funds. 12. and theft. The firm loses its reputation when it is not in a position to honour its short-term obligations. leading eventually to managerial inefficiency. Inefficient working capital management may cause either inadequate or excessive working capital which is dangerous. 7. the firm is likely to face tight credit terms. waste. managers need to develop a long-term perspective for managing working capital. As a result. Attractive credit opportunities may have to be lost due to paucity of working capital. 5. Excessive working capital may make management complacent. Excess of working capital may result in unnecessary accumulation of inventories. It may encourage the tendency to accumulate inventories for making speculative profits. 6. increasing the chances of inventory mishandling.Central Bank. It may become difficult for the firm to undertake profitable projects due to non-availability of funds. 13. excessive working capital may pose the following dangers: 10. A firm may have to face the following adverse consequences from inadequate working capital: 4. causing a higher incidence of bad debts. causing a liberal dividend policy which becomes difficult to maintain when the firm is unable to make speculative profits. 11. Growth may be stunted. 9. thus lowering the rate of return on investments in the process. Implementation of operating plans may become difficult and consequently the firm¶s profit goals may not be achieved. Operating inefficiencies may creep in due to difficulties in meeting even day-to-day commitments. This has an adverse effect on profits. 184 .

Thus. The corporate management has to consider a number of factors to determine the level of working capital. Manufacturing Cycle 185 . 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. Their working capital requirements are nominal because they have cash sales only and they supply services. Some manufacturing businesses like tobacco. but require a large investment in working capital. Trading and financial firms generally have a low investment in fixed assets. Financial and statistical techniques can be helpful in predicting the quantum of working capital needed at different points of time. should maintain the right amount of working capital on a continuous basis. public utilities have a limited need for working capital and have to invest abundantly in fixed assets. The working capital needs of most of the manufacturing concerns fall between the two extreme requirements of trading firms and public utilities. Among the various factors the following are important ones. and construction firms also have to invest substantially in working capital but only a nominal amount in fixed assets. Nature and Size of Business The working capital needs of a firm are basically influenced by the nature of its business. monetary and general business environment. In contrast. the amount of funds tied up with debtors or in stocks is either nil or very small. Determinants of Working Capital Needs There are no set rules or formulas to determine the working capital requirements of a firm. Retail stores. not products. must carry large stocks of a variety of merchandise to satisfy the varied demand of their customers. 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. for example. therefore. The size of business also has an important impact on its working capital needs. A firm with larger scale of operations will need more working capital than a small firm.An enlightened management. Size may be measured in terms of the scale of operations.

inventory will accumulate during off-season periods and there will be higher inventory costs and risks. especially temporary working capital requirements of the firm. You may have observed that firms making heavy machinery or other such products. If the costs and risks of maintaining a constant production schedule are high. A firm may follow a policy of steady production in all seasons to utilise its resources to the fullest extent. Firms whose physical facilities can be utilised for manufacturing a variety of products can have the advantage of diversified activities. The financial plan should be flexible enough to take care of any seasonal fluctuations. This will mean accumulation of inventories in off-season and their quick disposal in peak season.The manufacturing cycle starts with the purchase of raw materials and is completed with the production of finished goods. a decline in the economy may register a fall in sales and. because an extended manufacturing time span means a larger tieup of funds in inventories. Seasonal fluctuations may also create production problems. involving long manufacturing cycle. resulting in an increase in the firm¶s investment in inventory and receivables or book debts. a fall in the levels of stocks and book debts. the firm may adopt the policy of varying its production schedule in accordance with the changes in demand. On the other hand. Production Policy If a firm follows steady production policy. financial arrangements for seasonal working capital requirement should be made in advance. If the manufacturing cycle involves a longer period the need for working capital will be more. Therefore. even when the demand is seasonal. Such firms manufacture their main products during the season 186 . Any delay at any stage of manufacturing process will result in accumulation of work-in-process and will enhance the requirement of working capital. An upward swing in the economy leads to increased sales. Increase in production level may be expensive during peak periods. consequently. attempt to minimise their investment in inventories (and thereby in working capital) by seeking advance or periodic payments from customers. Business Fluctuations Seasonal and cyclical fluctuations in demand for a product affect the working capital requirement considerably.

A firm enjoying liberal credit terms will need less working capital. Thus. yet it may endeavour to shape its credit policy within such constrains. Growing industries require more working capital than those that are static. Slave collection procedures may even increase the chances of bad debts. Growth and Expansion Activities As a company grows. 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. Turnover of Circulating Capital 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.and other products during off-season. production policies may differ from firm to firm. (Refer to Figure 1 on operating cycle). Accordingly. the need for working capital will also vary. Credit Terms The credit policy of the firm affects the size of working capital by influencing the level of book debts. The fact to be recognised is that the need for increased working capital funds may precede the growth in business activities. larger amount of working capital will be needed. A long collection period will generally mean tying of larger funds in book debts. The working capital requirements of a firm are also affected by credit terms granted by its creditors. 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. rather than following it. Operating Efficiency 187 . depending upon the circumstances. The shift in composition of working capital in a company may be observed with changes in economic circumstances and corporate practices. logically.

The effects of increasing price level may. Payment of dividend consumes cash resourse and reduces the firm¶s working capital to that extent. etc.Operating efficiency means optimum utilisation of resources. however. be felt differently by different firms. Increasing prices for the same levels of current assets need enhanced investment. firms which can immediately revise prices of their products upwards may not face a severe working capital problem in periods of rising price levels. It is possible that some companies may not be affected by the rising prices. that is. The net profit is a source of working capital to the extent it has been earned. whereas others may be badly hit by it. Outstanding expenses. However. The firm¶s appropriation policy. Approaches to Managing Working Capital Two approaches are generally followed for the management of working carpet (i) the conventional approach and (ii) the operating cycle approach. rising price level requires a higher investment in working capital. The cash inflow can be calculated by adjusting non-cash items such as depreciation. A high net profit margin contributes towards the working capital. the firm¶s working capital position will be strengthened. The firm can minimise its need for working capital by efficiently controlling its operating costs. The Conventional Approach 188 . from the net profit. losses written off. Other Factors There are some other factors which affect the determination of the need for working capital. With increased operating efficiency application use of working capital is improved Price Level Changes Generally. the policy to retain or distribute profit has a bearing on working capital. If the profits are retained in the business.

payables. On the other hand. The banks .This approach implies managing the individual components of working capital (ii) the inventory. In India. commencing with acquisition of raw materials to the realisation of proceeds from debtors. most of the organizations used to follow the conventional approach earlier. etc. Measuring of Working Capital Measurement of working capital is dealt in the following illustration. 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 Operating Cycle Approach This approach views working capital as a function of the volume of operating expenses. more emphasis is given to the management of debtors because they generally constitute the largest share of the investment in working capital. In India.usually apply this approach while granting credit facilities to their clients. The optimum level of working capital will be the requirement of operating expenses for an operating cycle. The credit period allowed by creditors will have to be set off in the process. 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. The duration of the operating cycle is the number of days involved in the various stages. Illustration Determine the magnitude of working capital (with the help of the following particulars) for Gujarat Tricycles Limited. calculated on the basis of operating expenses required for a year. but now the practice is shifting in favour of the operating cycle approach. receivables. inventory control has not yet been practiced on a wide scale perhaps due to scarcity of goods (or commodities) and ever rising prices. 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: 189 .

Hence. c) Raw material. parts and components are expected to remain in the stores for an average period of one month before issue to production.000 tricycles. parts and components is one month.Materials. i) Selling price will be Rs 200 per tricycle j) Assume that sales and production follow a consistent pattern. 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. g) Credit period allowed by suppliers of raw material.000 tricycles. monthly production will be 500 tricycles. h) The lag of payment to labor is one month. k) Allow 20% to computed figure for buffer cash and contingencies. d) Finished goods are likely to stay in the warehouse for two months on an average before being sold and delivered to customers. Before attempting to calculate the working capital.50% of the overhead consists of salaries of nonproduction staff. 190 . parts and components 40% Labour 30% Overhead 10% b) Production in 19x 8 is estimated to be 6. it will be helpful to work out the following basic data a) The yearly production is 6. The debtors will be allowed two months credit from the date of sale.

cost of production is Rs.. (200x). 191 .e.. labour and overheads) comprise 80% (40%+30%+ 10%) of the selling price. The various elements of cost (i. parts and components.b) The selling price per tricycle is Rs. Hence. raw material. 200. 160 i.e.

if any. the following measures may be applied. Such a control acquires even more significance in times of inflation. the cost involved must 192 . with financial assistance provided by the Government and the corporate sector. Greater disciplines in all segments of the production front may be attempted as under: 14. 15. Attempts must be made to increase the productivity of the work force by proper motivational strategies.Working Capital Management Under Inflation It is desirable to check the increasing demand for capital for maintaining the existing level of activity. Before going in for any incentive scheme. The possibility of using substitute raw materials without affecting quality must be explored in all seriousness. Research activities in this regard may be undertaken. In order to control working capital needs in periods of inflation.

managerial salaries and payments. to some extent. the maximum possible use of facilities already created must be ensured. Further. Only when there is a pressure on working capital does the management become conscious of the existence of slow-moving and obsolete stock. Such costs include office decorating weighed against the benefit to be derived. Efficiency Criteria 193 . 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. they have tended to become partly fixed in nature due to the influence of various legislative measures adopted by the Central or State Governments in recent times. The management tends to adopt ad hoc measures which are grossly inadequate. If they do not. The managed costs should be properly scrutinised in terms of their costs and benefits. there should be an efficient management information system reflecting the stock position from various standpoints. Though wages in accounting are considered a variable cost. Increased productivity results in an increase in value added and this has the effect of reducing labour cost per unit. In addition to this. . etc. Therefore. be neutralised if the span of the operating cycle can be i-educed. advertising. Greater turnover with shorter intervals and quicker realisation of debtors will go a long way in easing the situation. The increasing pressure to augment working capital will. Managed costs are more or less fixed costs and once committed they are difficult to retreat. either some payments have to be postponed or purchase of some avoidable items has to be deferred. Projections of cash flows should be made to see that cash inflows and outflows match with each other. the management should be vigilant in sanctioning any new expenditure belonging to this cost area. In order to minimise the cost impact of such items. a clear-cut policy regarding the disposal of slowmoving and obsolete stocks must be formulated and adhered to.

Whether there is enough assurance for the creditors about the ability of the company to meet its short-term commitments on time. The following indices can be used for measuring the efficiency in managing working capital: Current Ratio (CR) CR =Current Assets/Current Liabilities It indicates the ability of a company to manage the current affairs of business. Whether maximum possible inventory turnover is achieved. a reliable index is whether a company can settle the bills on due dates.. to a great extent. t. s. Both depend upon a company¶s strength as a seller and as a buyer. Whether there are adequate safeguards to ensure that neither overtrading nor undertrading takes place. It is useful to study the trend of working capital over a period of time. A single criterion would not be sufficient to judge or evaluate the efficiency in a dynamic area like working capital. Some of the parameters for judging the efficiency in managing working capital are: p. The finance department has to plan in advance to maintain sufficient liquidity to meet maturing liabilities. r.e. negative trade credit. q. 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. It depends upon the company¶s position in relation to its suppliers and the nature of supply market i. whether there is a single supplier or an oligarchy or a large number of suppliers. Whether reasonable credit is extended to customers. Hence. The other side of the same coin is receiving credit. 194 . This powerful instrument to promote sales should not be misused. depends on its efficiency in managing working capital. The adverse effect of ineffective inventory management may not be offset even by the most efficient management of other components of working capital. Whether adequate credit is obtained from suppliers.Improved profitability of firm.e. At times the supplier imposes the credit terms as 100% advance i.

Quick Ratio (QR) QR=Liquid Assets/Current Liabilities Liquid assets mean current assets minus those which are not quickly realisable. Cash should be turned over as many times as possible. 195 . the proportion should usually be kept low. in order to achieve maximum sales with minimum cash on hand. like current ratio. It is not only the quantum of current ratio that is important but also its quality. Inventory and sticky debts are generally treated as non-quick assets. i. as cash by itself does not earn any profit. this may have to be modified depending on the peculiar conditions prevailing in a particular trade or industry. The relationship of 1:1 between quick assets and current liabilities is considered ideal.e. extent to which assets and liabilities are really current. Average Collection Period (Debtors/Credit Sales) X 365 This ratio explains how many days of credit a company is allowing to its customers to settle their bills. depending on the peculiar conditions of a particular industry. Sales to Cash Ratio Sales to Cash Ratio=Sales/Average cash balance during the period. it also varies from industry to industry. Cash to Current Assets If cash alone is a major item of current assets then it may be a good indicator of the profitability of the organization.Though the current ratio of 2:1 is considered ideal. but..

avoid both over-trading and undertrading. or b) Undertrading when the conditions of market are not good. Its symptoms being (I) High Inventory Turnover Ratio (ii) Low Current Ratio.Average Payment Period Average payment period=(Creditors/Credit purchases) x 365 It indicates how many days of credit is being enjoyed by the company from its suppliers. this ratio helps management in maintaining working capital which is adequate for the planned growth in sales. it signifies that for any amount of sales a relative amount of working capital is needed. Therefore. If any increase in sales is contemplated it has to be seen that working capital is adequate. Inventory should be maintained at a level which balances production facilities and sales needs. therefore. it may lead to: a) Over trading when the conditions are in the upswing. When this ratio is not carefully watched. Working Capital to Sales Usually expressed in terms of percentage. Inventory Turnover Ratio (ITR) ITR=Sales/Average Inventory It shows how many times inventory has turned over to achieve the sales. Its major symptoms are: i) Low Inventory Turnover Ratio ii) High Current Ratio. 196 . Working Capital to Net Worth This ratio shows the relationship between working capital and the funds belonging to the owners. Efficient working capital management should.

It is an important source. accrual accounts. The invoice is the basic document. advances from customers. that is advance retirement or extension of credit period can be negotiated. Either open account credit or acceptance credit may be adopted. The buyer is not giving any debt instrument as such. Hypothecation advance is granted on the hypothecation of stock or other asset. It is a secured loan. Commercial banking system in the country is broad based and fairly developed. overdrafts and bill purchase and discounting are the principal forms of working capital finance provided by commercial banks. Trade credit is an informal and readily available credit facility. finance companies. indigenous bankers. Pledge loans are made against physical deposit of security in the bank¶s custody. Trade credit might be costlier as the supplier may inflate the price to account for the loss of interest for delayed payment. Straight loans. In the credit system a bill of exchange is drawn on the buyer who accepts and returns the same. The borrower can deal with the goods. Commercial banks are the next important source of working capital finance. A onetime lump-sum payment is made. There are both external or internal sources. It is unsecured. In the former as per business custom credit is extended to the buyer. loans and advances from directors are external short-term sources. the limit being subjected to examination and revision year after year. Straight loans are given with or without security. Companies can also issue debentures and invite public deposits for working capital which are external long-term sources. though a commitment charge for utilization may be charged. commercial banks. cash credits. Cash credit is an arrangement by which the customers (business concerns) are given borrowing facility upto a certain limit. public deposits. hypothecation loans.Sources of Working Capital Sources of working capital are many. Equity funds may also be used for working capital. It is flexible too. Trade credit. The external sources are both short-term and long-term. while repayments may be periodical or one time. pledge loans. It is a common source. Trade credit Trade credit is a short-term credit facility extended by suppliers of raw materials and other suppliers. The bill of exchange evidences the debt. Here the borrower cannot deal with the goods 197 . Interest is charged on actual borrowings.

constitute another source of working capital. 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. Quantity restriction is placed at 25% of paid up capital + free services for deposits solicited from public is prescribed for non-banking manufacturing concerns. In certain cases. They provide services almost similar to banks.until the loan is settled. Cash rich companies lend to liquidity companies under liquidity crunch. They provide need-based loans and sometimes arrange loans from others for customers. Loans from directors. Indigenous bankers also provide financial assistance to small business and trades. This is a popular form. Accrual accounts are simply outstanding suppliers of overhead service requirements. Here. Overdraft facility is given to current account holding customers to overdraw the account upto certain limit. The RBI is regulating deposit taking by these companies in order to protect the depositors. to ensure performance of contract an advance may be insisted. Finance companies in the country About 50000 companies exist at present. Public deposits 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. Since 1990 CPs came into existence. advances from customers may be insisted. Where sellers market prevails. Interest rate is higher. loans from group companies etc. There are restrictive conditions as to the issue of commercial 198 . They charge exorbitant rates of interest by very much understanding. It is a very common form of extending working capital assistance. The rate of interest ceiling is also fixed. But timely assistance may be obtained. Advances from customers are normally demanded by producers of costly goods at the time of accepting orders for supply of goods. This form of working capital financing is resorted to by well-established companies. Contractors might also demand advance from customers. Commercial papers are usance promissory notes negotiable by endorsement and delivery. Bill financing by purchasing or discounting bills of exchange is another common form of financing.

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. Debentures and equity fund can be issued to finance working capital so that the permanent working capital can be matchingly financed through long term funds. Tandon Committee Recommendations 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: 21. To 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 advances. 22. To 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. 23. To 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. 24. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowing. 25. To make recommendations regarding resources for financing the minimum working capital requirements. 26. To 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: 27. It 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. 28. Bank credit, instead of being taken as a supplementary to other sources of finance, is treated as the first source of finance.


29. Bank credit is extended on the account of security available and not according to the level of operations of the borrower, 30. There 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. Commitee Recommendations: 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. Fixation of norms. An important feature of the Tandon Committee¶s recommendations relate to fixation of norms for bank lending to industry. Working Capital Gap 31. In 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. 32. Inventory and Receivables norms: The committee has suggested norms for 15 major industries. The norms proposed represent the maximum level for holding ventures and receivables. They pertain to the following: gg. Raw materials including stores and other items used in the process of manufacture hh. Stock in process


ii. Finished goods jj. 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. iii) Lending norms: 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 25% 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,25% of current assets should be financed through long-term funds. 25% of current assets are greater than 25% of working capital gap. Hence 2nd method meant more non-bank finance for working capital. The third method provided for long-term fund financing of whole permanent current assets and 25% 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.


Chore Committee Recommendations 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. To review the working of cash credit system 38. To study the gap between sanctioned and utilized cash credit levels 39. To suggest measures to ensure better credit discipline 40. To suggest measures to enable banks to relate credit limits with output levels. The recommendations of the committee were: 41. To continue the present system of working capital financing, viz., credit, bill finance and loan 42. If possible supplement cash credit system by bill and loan financing 43. To periodically review cash credit levels 44. No need to bifurcate cash credit accounts into demand loan and cash credit components. 45. To fix peak level and non-peak level limits of bank assistance wherever, seasonal factors significantly affect level of business activity. 46. Borrowers to indicate before commencement requirement of bank credit within peak and sanctioned. A variation of 10% is to be tolerated. 47. Excess or under utilization beyond 10% tolerance level is to be considered as irregularity and corrective actions are to be taken up. 48. Quarterly statements of budget and performance be submitted by all borrowers having Rs.50 lakh working capital limit from the whole of banking system. 49. To discourage borrowers depending on adhoc assistances over and above sanctioned levels. 50. The second method of financing of working capital as suggested by the Tandon committee be uniformly adopted by banks. 51. To 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.


Marathe Committee Recommendations Later Marathe Committee was appointed to suggest meaningful credit management function of the RBI. The recommendations of the committee include: 52. The second method of financing Tandon committee should be followed. 53. Fast-track system of advance releasing upto 50% of additional credit required by borrowers pending RBI¶s approval of such enhanced credit authorization. 54. The 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. The 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 12 months from the date of previous balance sheet. 56. A minimum of 1.33 current ratio should be maintained. That is, 25% current assets should be financed from long-term funds. 57. A 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 adopted. 58. A quarterly performance reporting system giving data on performance within 6 weeks following the end of the quarter to which the data is related and adopted. 59. A half yearly operating and fund flow statement to be submitted with in 2 months from the close of the half-year 60. The banker should review the borrower¶s accounts at least once a year HAVE YOU UNDERSTOOD? 61. Discuss the concept of working capital. Are the gross and net concepts of working capital exclusive? Explain. 62. Distinguish between fixed and fluctuating working capitals. What is the significance of such distinction in financing working needs of an enterprise?


Define working capital and describe its components 70. 65. 77. How would you judge the efficiency of the management of working capital in a business enterprise? Explain with the help of hypothetical data. What is an operating cycle and how a close study of the operating cycle is helpful? 67. Do you think this pattern of financing would be in the interest of the firm? Support your answer with a cogent argument. What factors a Finance Manager would ordinarily take into consideration while estimating working capital needs of his firm? 66.63. What shall be the repercussions if a firm has (a) shortage of working capital and (b) excess working capital? 64. How 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 across. Discuss the terms of reference and recommendations of the Tandon Committee. Explain the different sources of working capital finance. 69. Lesson 2 Accounts Receivables Management 205 . What is operating cycle? Explain its significance in the context of estimation of working capital and ensuring efficient management of working capital. 75. 76. A firm desires to finance its current assets entirely with short-term loans. How would you plan the working capital requirements of a manufacturing undertaking. Discuss the significance of working capital management in a business enterprise. 74. 73. Give the impact on financing of working capital. What do you mean by working capital management? What approaches would you adopt to ensure effectiveness? 72. What are the recommendations of Chore Committee? Explain them. 68. Bring out the kinds and concepts of working capital and the nature and significance of each type of working capital 71. Discuss clearly the factors affecting the size and composition of working capital.

in the books of the buyer. This is what happens in the books of the seller. it may be very pertinent to mention here that generally speaking.Introduction When the finished goods are sold on credit. Learning objectives After reading this lesson. 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 Management. with a view to fully understand and appreciate the high need for effective monitoring and follow-up of sundry debtors. 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 206 . after the company¶s investment in plant and machinery. Accounts Payables (APs) and Bills Payable (BPs). while the cash sales get represented in terms of cash in hand or in bank or some assets purchased on cash basis. the sundry debtors constitute the third largest and most important item of assets of the company. the credit sales are reflected in the value of sundry debtors (SDs) (as referred to in India). the entire sales (both on cash and credit bases) are recorded as sales in the profit and loss account. and stocks of inventory (mostly in that order). But. Bills Receivable (BRs) on the assets side of the balance sheet. etc. Accounts Receivable (ARs). Therefore. the purchases made on credit basis are accounted for as sundry creditors (SCs) also known as Trade Creditors (TCs). Further. But.are also known as Trade Debtors (TDs).

Accordingly. Steps and Strategies 207 . it could well be brought down from Category A to say. That is. be reviewed periodically. similarly. such that all the sundry debtors of the company may remain under continuous observation and scrutiny. if some perceptible improvement is observed in some category B. such an exercise should not be taken as just a onetime exercise. these may be classified as under: Category Degree of Risk A No risk B Little risk C Some risk D High risk But. Category B. And. I am saying so. about the various ways and means. For this purpose. and revised upward or downward. clilentele) under four different categories. and some urgent remedial measures (of applying some restrictions or liberalization) could be affected. on the basis of their integrity and ability (both intention and strength) to pay in full and in due time. as the case be. we may broadly classify our parties (customers. in terms of promptness in payment. as the case may be. instead. we should vary the quantum and period of credit. as per the company¶s records. if the performance of a particular party in category A seems to be declining. these could as well be promoted to Category A and B respectively.SECTION TITLE Credit Policy While formulating credit policies. before it becomes too late. based upon the past performance. in detail. party-wise. Such classifications must. We would now discuss. or even category C parties. steps and strategies that can be adopted to achieve the desired goal of keeping the sundry debtors at the minimal level.

when the goods invoice have been despatched. as also the relative invoice. Because. can be counted only after the day one begins. (not even a shade less or more). Thus. ways. meticulously and correctly).Step 1 Prompt despatch of goods and invoice: The very first step towards effective supervision and follow-up of sundry debtors is that the goods must be despatched promptly. and such other details are incorporated in the invoice correctly. Step 3 Avoid disputes: Extra care and due precaution must be taken by and at all times. such that no relevant particulars may be lost sight 208 .comprehensive proforma of its invoices.. i. so that may keep all the possible disputes avoided. it would augur well if the company takes care to evolve an all . Any error in these particulars. so as to facilitate the buyer company to connect the matter appropriately. may result in a significant financial loss. Step 4 Standard (printed) invoice porforma with a tear-off portion: With a view to ensuring that all the relevant particulars have been incorporated in the invoice. the 15th day or 60th. Step 2 Correct and unambiguous invoicing: It is of crucial importance that the order number. in despatching the goods of the agreed quality only. (of course. whatever. howsoever all.e. a slight delay of even a day or two delays the payment of the sundry debtors at least by so many day(s). sometimes. particulars (quality and quantity) of goods. due to the avoidable correspondence and the resultant delay in payment.

viz. as also the full and correct postal address of the seller company. would have to just put its rubber stamp (not even signature) on the acknowledgement slip.. Step 5 Entries in the (i) Master Register (all comprehensive) and (ii) Ledger Accounts (partywise): With a view to exercising effective control on all the Working Capital Management sales effected. To facilitate calculation of the due dates of payment. 45 days. This way. That is. is placed in Annexure 5. 90 days. the companies may maintain a Master Register. And.It will be better still. whatsoever. A specimen proforma of the suggested forwarding letter along with the tear off portion containing the acknowledgement slip. an acknowledgement slip could also be provided as a tear off portion of the relative forwarding letter itself. separate sections in the register (or separate files in the computer) should be maintained for parties enjoying the credit for different periods. if separate sub-sections are also maintained for parties falling under different categories like A. and so on. the buyer company. wherein all the relevant particulars details of the various documents. When the efforts of typing acknowledgement letter are involved. that is it. they just do not send any acknowledgement. in serial order. have been duly received by the party.1 at the end of the Chapter. 60 days. at the receiving end. 209 . 75 days. along with the relative bill of exchange and such other documents. because this may facilitate the company¶s effective followup programme in a scientific and systematic manner. are computer-printed at the appropriate place. mostly the buyer companies are found to be adopting the easiest course of action.of. B and C (presuming that the parties falling under the category "D" being the high risk will not be given any credit. with a view to ensuring that the invoice. on a day-to-day basis. 180 days. etc. 15 days. on the basis of the ABC analysis. and to slip the (acknowledgement) slip in the window envelop and post it. 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. whatsoever). So. wherein all the particulars of all the sales effected on a particular day may be entered. 30 days. Besides.

beyond any remedy. a second reminder may be sent with a slightly firm language used. Similarly. in a section / file of 30 days credit period. in case of category A. the due date will be 30 days after the date of sale and so on. Step 2 Further. so as to decide whether some restrictions are required to be imposed on their credit terms. the parties under category B may require somewhat closer follow-up. such that the situation may not get worsened and go out of control. followed by some special strategies to be evolved for some special and specific cases. 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. if the bill does not appear to have been paid even after a week or a fortnight. desiring special attention and specific treatment. and a copy thereof may be endorsed to the Sales Officer/Sales Representative for necessary follow-up action. A General Pattern of Follow-up Measures A general pattern of follow-up of sundry debtors are discussed hereafter.That is. and so on. Step 3 210 . Step 1 By way of a general 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. too much of close follow-up may not be required until their payment pattern calls for their degradation from category A to category B. as the same section / file will have the same due date for the same date of sale. That is. usually a week before the due date of payment. a routine type of computer printed reminder could be sent. of the stipulated due date.

even such reminder does not evoke the desired results. just as test cases. Thus. This way. even civil suits may be filed. Streamlined Enquiry Systems Due care must be taken by the companies to identify one specific official to attend to all the enquiries pertaining to sundry debtors.amounts. just by way of setting an example. the goods despatch section may be instructed to suspend the supply of goods to such party . etc. so as to avoid the situation of accumulation of some huge over. the companies must also maintain a separate ledger account for each party. Step 4 And. till further fuctions. would be incorporated. but only as a demonstration of strong will that mean business. date of payment or return of the bills. a third strict reminder may have to be sent. any call coming for such enquiries may invariably be put through to the right person. and creating some sense of fear. and even if. As has already been stated earlier. if even such strict and firm dealings do not bestir (activate) the parties. along with the master register. though not with the intention of bringing it to its logical conclusion. and all the other officials of the company. particulars of sale.If. by chance. revealed by the ledger account of the party concerned. And. depending upon the review data. it gets connected to 211 . at the earliest. including the telephone operators. to personally follow-up the matter with the party concerned. facilitate the review and revision of the categorization of each party periodically. with a copy thereof endorsed to the Sales Officer/Sales Manager concerned. you will be able to form an opinion regarding each party which may. Step 5 Similarly. in some cases. in turn. during their immediately next visit to the area. legal notice(s) may have to be served on some of them. so as to obtain the payment. so that they (and even other buyers) may not get an impression that they may go scot free so easily. in the mean time. and adopting specific strategies for the continuation of the terms of the credit sales or otherwise. wherein the date of sale. must know it and know it well.

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. in one go. IC-3 Lack of effective monitoring of Sundry Debtors like. an opportunity to introspect and improve upon. all the relevant particulars will be available to the person. 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. etc. care must be taken that you praise your query only after all the queries of the caller have been answered to his entire satisfaction. Now. with the press of a button on the computer. Age-wise/Party-wise analysis and vigorous follow-up. We should. quality control. etc. so that much of the queries could be eliminated. treat all the complaints as a free and frank feed back. therefore. IC-2 Delay in the despatch of the documents / goods. for clarification of any doubt or for replying to any query pertaining to the bills with great ease. But. in almost all the companies. the person concerned would be able to transfer the call to the right person. Main Causes High Sundry Debtors [A] Internal Causes (IC) IC-l Ambiguous/Incorrect invoicing regarding quantity. 212 . price. etc. it may be mentioned here that such enlisting of various complaints received on different counts. the study and analysis may throw-up some light on how to streamline the proforma invoice or such other systems. Incidentally. Besides.some wrong number. Further. instead of the call being tossed over from one person to the other. delayed despatch. may also be used to enable us to take some suitable remedial measures pertaining to after-sales service.

etc. e. IC-9 Overbilling regarding excise duty/sales tax etc. (regarding credit period/cash discount.1 Damage/Loss during transit EC-2 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. noncompliance of the terms and conditions of the purchase order. and such unresolved issues. IC-5 Goods despatched with insufficient documents. IC-6 Defective supplies.g.g. causing further delays. IC. expiry of the warranty period and such other mutually agreed terms and conditions. sub-standard quality/quantity. IC-8 Ambiguity/deficiency in the terms and conditions. please specify).. due to the changes in the Acts. completion of the take delivery of the documents from the bank 213 . pending installation and commissioning. [B] External Causes (EC) (S). valid purchase Order. etc. IC-7 Relevant documents and/or information not readily available for vigorous follow-up.11 Any other internal cause (s). IC-10 Holding back of 5 to 10 per cent of the amount of the bill. e. (please specify) EC.). fixation/re-fixation of prices. especially regarding excise duty/sales tax. insufficient after-sales services. etc.IC-4 Lacunae in the Monitoring Mechanism! Credit Policy. etc.

[C] Dispute Being the Cause (DC) DC-1 Buyers¶ unreasonable rejections on untenable grounds of deficiency in the quality/quantity of goods supplied DC-2 Buyers unduly delaying the inspection of finished goods.7 Instalments collected but not remitted by the collecting agent forcredit of the company¶s account EC-8 Any other external cause (s). 80. etc. disallowed/deducted by the buyers. would be. bank charges. to facilitate all the different departments to submit the periodical performance reports 214 . Internal causes (IC 1 to 11) where the reasons could be the negligence or slackness on the part of some in-house staff 79. demmurages. The added advantage of the listing of the causes. before despatch DC-3 Charges like freight. 78. 81. postage. Dispute being the cause (DC 1 to 5) where the dispute regarding quality and/or quantity or such other factors may be the main causes. with code numbers given in the parentheses. Miscellaneous causes (MC 1 to 3) where the causes are such which do not fall under any of the aforesaid three categories. and are being contested by DC-4 Litigation [D] General Comments Sundry Debtors may be dividend into four categories. insurance. External causes (EC 1 to 8) where the reasons lie somewhere outside the company and its staff. (please specify).EC-6 Instalments due but not collected by the collecting agent EC.

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. This can be best understood by taking some illustrative examples. commonly known as "Day¶s Sales Outstanding" (DSO). or MC1. which. at a price. EC5. or say 30 days. like 1C3. Day¶s Sales Outstanding (DSO) There is yet another method of monitoring and follow-up of sundry debtors. of course. or such other suitable period. by way of the code numbers only. promptly and well in time. in regard to the sundry debtors. It may be represented as under: 215 . mainly in terms of the quantum of interest gained or lost. in consultation with the lower levels of management. this practice may facilitate the analyses of the various causes of high sundry debtors. may go a long way in evolving some appropriate remedial measures. mostly in general terms. with the specific reasons. quoted at the appropriate places. DC2 etc. 60 days and 90 days. 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. such list may force the departmental heads concerned to identify the specific reasons to be quoted in their periodical reports. But. before taking a decision about the period and quantum of giving cash discount. Besides. we must first try to understand and appreciate the financial implications of such a stand taken. instead of the usual practice of giving some causes or the other. which did not convey much sense. Formulation of Credit Policy Credit policies need to be formulated by the top management. Therefore. Cash Discount Cash discount is a very common mechanism of effecting and encouraging speedy payments but of course.

as it is the starting point of the whole chain of events. by the personnel at different levels: top level. a category B (or even category C) customer may be erroneously classified as A category one. middle level and junior level. Let us try to understand this method / tool better with the help of an illustrative example.MAKING Sundry debtors management requires a lot of decision-making exercises. one must guard against some usual types of errors of judgement that may take place sometimes. which differ from case to case. also the main problem area is to take a decision while selecting a new party for dealings for the first time. Assessment of credit-worthiness of the sundry debtors This decision is the most crucial one to make.DSOt = Sundry Debtors at time "t" I Average daily (Credit) Sales. i. right from the point of sales on credit to the point of final realization of the proceeds of the credit sales. A. 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.e. Credit Policy Formulation of credit policy comes within the purview of the top management. (i) Or vice versa. which are discussed hereafter. While assessing the extent and quantum of credit risks involved. DECISION . one by one. in several areas. They are: (i) Either a class A category of customer may be classified as category B or even C. Here. It comprises various aspects of credit policy. 216 ..

Types of Credit Policy Different dimensions of the credit policy may vary in different degrees and shades. or the company may accumulate some more bad debts. as a result thereof.And. the periodical review of the payment pattern of the respective parties may be helpful in reclassification of some parties. the cost of extra concessions granted can well be taken care of. the sales may get somewhat adversely affected. both these errors may prove a little costly in that either a good business may be lost. It may be categorised under three broad types: (i) Liberal Credit Policy: A credit policy may be termed as liberal wherein some other concessions and facilities are granted to the buyers. provided due care is taken at the time of the evaluation of the credit-worthiness of the parties. (ii) Strict Credit Policy: Under such credit policy. But then. all such inter-related facts and factors must be duly considered while taking a decision regarding adoption and execution of a specific credit policy. (and the financial gains therewith). In such cases. hopefully well in time. (iii) Medium (Moderate) Credit Policy: 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 217 . And. with the expectation that this way the sales may pick up. as also the resultant higher blockage of funds in sundry debtors. and thereby rectifying the error. eating into its profitability. at the same time. the decision should be based on the trade-off position of the positive and negative factors. as against the liberal one. and not in general. too. and so will be the extent of blockage of funds in sundry debtors and the collection efforts and expenses. resulting from the extra sales achieved therewith. most suited under the given circumstances. too. and a higher cost of collection. by the additional yield. if any. related with the extra sales effected. the minimum possible concessions and relaxations are granted to the customers. Such errors may take place but only in some cases. Therefore. such liberalization may as well lead to some additional quantum of bad debts. the risk of bad debts may as well be minirnized. Thus. and thereby. But.

etc. The first two options. the company has a variety of choices. They are: (i) Standard of credit. (B) Period of Credit The duration of time (say 30 days. is referred to as the 218 . 45 days. 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. with a view to accepting or rejecting a customer for credit sales. to make the payment of the bill. (ii) Period of credit. ranging from µnone¶ to µall¶ and to "some only". while arriving at the credit policy decision. representing the cost of the goods. as these may either adversely affect the volume and value of the sales. i. Let us discuss all these four different parameters of credit policy one after the other. neither too high nor too low.e. supplied on credit. Standard of Credit The main and most important question that may arise. and (iv) Effective monitoring and follow-up {i. (iii) Cash discount. Collection Efforts}. 60 days.. Thus. but in about just the right measure. of offering credit sales.. is what standard could be considered as the most appropriate and optimal one. do not seem to be right. Here. strict or medium (moderate) credit policy may broadly be classified under four different parameters. obviously.e. Parameters of Credit Policy The various dimensions on the basis of which a company may be said to be adopting a rather liberal. or else may run the high risk of the quantum of bad debts.) allowed to the customers. A.additional sales and the resultant risk of bad debts may be kept at the optimal levels.

some discount is being given. the term of payment will be such that the buyer will get a cash discount at a certain percentage (say 2%).. it is usually represented. while the usual credit period granted is say. for making an early payment. pay the bill on the very last day. that is being paid by the seller. Example (A) From the point of view of the seller: 219 . as per the prevailing practice.e. 180 days. We are here. let us compute the price. The credit period. If such would be the stipulation. to the buyer. as "2/10 net 30. or even more. i. it may be even 90 days. presuming that all the buyers are prudent enough to pay the bill. Under such arrangement. And. not to avail of the cash discount. if he pays within 10 days. and (ii) The degree of trust and credit-worthiness on the part of the customers concerned (C) Cash Discount 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. on the 30th day only. is the interest only). varies mainly on two considerations: (i) The trade practices in the particular line of business. they would. 30 days). We must. (eg. as it. appreciate that to obtain an early payment of the period. And. (or the rate of interest. if they were to decide. however. which means that there is a price to be paid to obtain an early payment. or else he will have to pay the full amount of the bill. if he makes the payment well before the usual credit period granted. therefore. It has generally been seen that the credit period ranges from 15 days to 60 days or even more. if the payment is made after 10 days but within 30 days.. it means that the buyer will get a discount of 2 per cent. in effect. only on the 10th day (and not earlier) so as to reap the maximum benefit out of the cash discount offered. invariably. if he makes the payment within 10 days from the date of the bill. in the case of government departments. Now." To say it again.

find it out. from the point of view of the buyer. "1.5/15 net 60" would mean: (1. he stands to gain Rs. Here. 100 .5 x 360) / [100 (60-15)] = 540/4500 = 0. 98/.. we see that the buyer is a gainer by a slightly higher percentage.(i) 2/10 Net 30 In effect.Rs. That is. 36. (to the seller) by way of interest.only (instead of Rs.36 or 36 % (ii) Similarly. (to the seller) by way of interest. because. he stands to gain(2 x 360) / 98 x 20 = 36. the cost. the rate of interest per annum (presuming 360 days to a year) would come to: (2 x 360) / [100 (30-10)1 = 720/2000 = 0. 2 when he has to actually pay (Rs.666 percent or say. the loss. 100) for 20 days is 2 per cent. to the seller (on Rs. That is. in the case of "2/9 net 45". by way of interest. based upon the very first illustrative example. on an investment or payment of Rs. would be: (2 x 360) / [100 (45-9)] = 720/3600 = 0. "2/10 net 30". 220 .e. Thus. on an annualized basis. the cost. 2/-) = Rs. or else it is a little more or less? Let us.20 or 20% (iv) And. given above. in the case of "1/15 net 45". it means that a discount of 2 per cent is to be given if the bill is paid earlier. Thus. 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). 100).only. he stands to gain Rs. the buyer gains the same amount by investing or paying a little lesser amount than Rs. will be: (1 x 360) / [100 x (45-15)1 = 360/3000 = 0.67 percent. So.12 or 12 % (iii) And. as compared to the seller. 30 less 10 = 20 days). 98/. That is.12 or 12 % (B) From the point of view of the buyer: But. just by 20 days only (i. 2/.in 20 days period.

in general terms. But.e.e.100). 98/-. the credit policy and philosophy have been stated. Further. In most of the cases these are made on an ad hoc basis and mostly remain as unwritten conventions and practices. manufacturing consumer products (with the exception of textile and garment manufacturing companies) may give nil or a limited 221 . Management of Sundry Debtors (Bills Receivable or Accounts Receivable) in India We have so far discussed about the various principles of management and control of sundry debtors. instead of getting Rs.i.. generally being followed by the various companies in India. to boost up the sales. Rs. (ii) In some of the companies. which is privileged to be in the seller¶s market. if a company states its credit policy. while the companies like Premier Motors or Daewoo Motors may offer a much longer credit period. to be followed by the operating staff. (A) Credit Policy (i) Very few companies have been found to have systematically formulated and documented their credit policies.e.. we would like to critically examine as to what are the actual practices and policies that are. 100/. Now. For example. may insist on cash down payments.e. may not give a single day¶s credit.(i. For example. he gets a little less. in the example under consideration. 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). which do not signify any specific stand or standard. like "Our credit policy aims at maximising the growth of sales with the minimal bad debt risks".only). (iii) The credit period offered by various companies differs to a very great extent. 981.. 100/-. Rs. while some of the companies. ranging from 0 day to 60 days or even 90 days. and (C) Monitoring and Control of Sundry Debtors. a company. it does not convey much as a guideline or guiding principle of any practical use and utility. i. i. the loss of the seller is on the full Rs. in too general terms.

by using different tools and techhiques. at least. based upon out: own experiences of their past performance and dealings with us. In fact. to determine the creditworthiness or financial strength and stability of the customers . two or three references. and other developed countries. the practice of offering cash discount (with a view to ensuring early payments) does not seem to be very popular in Indian business scenario. if any. with a view to making a realistic assessment and appraisal of their financial position. etc. as has already been observed earlier. Prospective customers are required to give. the financial position of the present customers should also be reviewed and revised on a regular basis. No serious and sincere effort seems to have been made to meticulously analyse the balance sheet and profit and loss account of the companies. But this seldom seems to have been resorted to. There does not seem to be any systematic and scientific study made. to see through the elements of window dressing.. Besides. but the credibility and dependability of their credit ratings may be a little doubtful. It has hardly been observed that some companies have asked for some break-ups of certain items (say. as opposed to the conditions prevailing in the USA. (iv) Besides.both present and prospective. (B) Assessment of Credit-Worthiness of Customers 82. 86. of inventories or bad debts). ICRA. The credit rating agencies had given satisfactory credit rating to µMS Shoes¶ and µCRB Finance Company¶. but no serious attempt seems to have been made by most of the companies to verify the position from such references. in most of the companies. but. 85. but their assessment had proved to be totally wrong and contrary to facts. appeared on the scene like CRISIL. their opinions. Independent credit rating agencies have. to be able to sell their products. 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. 84. other companies may have to give a much longer credit period. though 222 . Some companies attempt to get the opinion of the bankers on the prospective customers from the letters¶ bank. of late. period.

or to get things done. (C) Effective Monitoring and Control of Sundry Debtors Though the various tools and techniques. cash) by selling book debts (receivables) to a company that specialises in their collection and administration. of effective monitoring of sundry debtors. systematic and scientific lines. A "facto?¶ makes the conversion of receivables into cash possible. It is both a financial as well as a management support to a client. Such a current asset in the balance sheet is. systems and strategies. Some companies have been found to be working out the average collection period.e. very few companies have been found to have evolved some systematic mechanism of effective monitoring and follow-up of sundry debtors on some sound. the function of factors in olden days included stocking. illiquid and serves no business purpose. The term factor has its origin in the Latin word µfacere¶. 223 . are very well known to the executives of most of the companies. Originally.. stock his goods. meaning to make or do. inactive asset (i. but not party-wise. The functions of a factor included finding out customers for the manufacturer¶s products. They facilitated the flow of merchandise from the manufacturers to customers.. hook debts) into a productive asset (viz. are written in such general and vague terms that these do not seem to be of much help and practical utility. cash may become a scarce resource if it takes a long time to receive payment for goods and services supplied by them. Thus. etc. It is a method of converting a non-productive.¶ For a number of companies. They may do the ageing analysis but only in absolute terms and not in terms of percentage. it is much better to sell that asset for cash which can be immediately employed in the business. A lot seems to have been left to be desired. marketing and distribution as well as administration and financing of credit. Factoring Factoring is a unique financial innovation. in fact. leaving the marketing and distribution functions to the manufacturer. factors acted as selling agents.given in strict confidence and without any obligation. sell them and finally collect sales proceeds and remit them to the manufacturer. The modem factor has specialized in credit collection and financial services.

88.Factoring Services While purchase of book debts is fundamental to the functioning of factoring. The factor maintains an account for all customers of all items owing to them. He helps clients to decide whether or not and how much credits to extend to customers. Credit collection and protection against default and bad-debt losses. He also provides full or partial protection against bad debts. competition and customers and helps them to determine the credit worthiness of customers. He provides clients with information about market trends. Factoring thus involves an outright purchase of debts. Financial assistance Often factors provide financial assistance to the client by extending advance cash against book debts. the factor undertakes all collection activity that is necessary. so that collections could be made on due date or before. He makes a systematic analysis of the information regarding credit for its proper monitoring and management. Customers of "clients" become debtors of a factor and have to pay to him directly in order to settle their obligations. the factor provides the following three basic services to clients: 87. and supplies them to clients for their perusal and action. He prepares a number of reports regarding credit and collection. allowing full credit protection against any bad debts and providing financial accommodation against the firm¶s 224 . 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. Sales ledger administration and credit management. 89. He helps and advises them from the stage of deciding credit extension to customers to the final stage of book debt collection. Credit administration A factor provides full credit administration services to his clients. Credit collection and protection When individual book debts become due from the customer. Financial accommodation against the assigned book debts.

In the U. Factoring and Short-Term Financing Although. Factoring is a unique mechanism. as and when he needs cash such flexibility is not available from formal sources of credit. which not only provides credit to the client but also undertakes the total management of client¶s book debts. collection and protection. (ii) interest on advance. (iii) assisting the client in managing its liquidity and preventing sickness. however. factoring involved the purchase of a client¶s book debts with the purpose of facilitating credit administration. (v) providing facilities for opening letters of credit by the client etc. Thus factoring has a cost. Thus the client obtains advance cash against the expected debt collection and does not incur a debts. In view of the services provided by a factor. For these services.A. It is also a means of short-term financing.A factors provide many other services. the factor. the maximum advance a factor provides is equal to the amount of factored receivables less the sum of (i) the factoring commission.A. Factoring and Bills Discounting 225 .. He can obtain cash either immediately or on due date or from time to time. it differs from other types of short-term credit in the following manner: Factoring involves sale of book debts.S.S. 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 20 per cent in the U. It provides protection against the default in -paying for book debts.S. Factoring provides flexibility as regards credit facility to the client. factoring provides short-term financial accommodation to the client. Other services In developed countries like the U. They include: (i) providing information on prospective buyers. (iv) financing acquisition of inventories. (ii) providing financial counselling. charges a fee from the client.

by citing some illustrative examples. Full service recourse factoring 92. bill discounting is a method of financing. However. and as such the client is not protected from bad debts. 97. 96. The client has to undertake the collection of book debts. like factoring. Thus. Explain the effects of liberal and strict credit terms. Name the major terms of payment in practice and briefly describe each of them separately. 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. in each of the cases separately. 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.Factoring should be distinguished from bill discounting. What do you mean by (i) liberalizing and (ii) restricting the credit policies. Distinguish between (i) liberal and (ii) strict credit standards by citing suitable examples in each case. Full service non-recourse (old line) 91. and then discounted it with bank for a charge. Non-notification factoring HAVE YOU UNDERSTOOD? 94. Bill discounting is always µwith recourse. There are several terms of payment prevalent in the business world. 95. it falls short of factoring in many respects. Types of Factoring The factoring facilities available worldwide can be broadly classified into four main groups 90. Factoring is of bills discounting plus much more. Bulk/agency factoring 93. Bill discounting or invoice discounting consists of the client discounting bills of exchange for goods and services on buyers. in terms of the following: - 226 . What are the ramifications of enhancing and reducing the credit period? Explain.

What are the two main types of error that may creep in. What are the main shortcomings and limitations connected with obtaining bank references and what are the pragmatic approaches for overcoming them? 101. Is the credit policy that maximizes expected operating profit an optimum credit policy? Explain.a. 104. 227 . Credit management practices. 100. while assessing the credit risks? Explain each of them by citing suitable illustrative examples. "Ageing Analysis" is an effective tool for monitoring and follow-up of sundry debtors. but also "Party-wise". Bank reference is considered to be one of the major factors for assessing the credit-worthiness of a prospective customer. However. ii. 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? 102. suffer from several deficiencies. Do you agree? Give reasons for your answer. Not only "Period-wise". 103. a. What are these and what are the adverse effects of each of them in actual practice? b. Cash discount c. Period of credit b. it is desirable to do the ageing analysis: i. and Not only in "absolute terms" (of Rs. b. 99. Explain the objective of credit policy? µWhat is an optimum credit policy? Discuss. in Indian Companies. Collection efforts. Explain and illustrate. and d. Credit standards. 98. Proper assessment of credit risks is considered to be one of the most crucial factors in the area of management of credit. Do you agree? Give reasons for your answer. a. for better results.) but also in "percentage terms". by using suitable examples.

second only to the items of plant and machinery.105. Define factoring. How does it differ from bills discounting and short-term financing? Lesson 3 Inventory Management INTRODUCTION 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. 110. 109. c. 106. In terms of percentage of the total assets of a manufacturing company. What credit and collection procedures should be adopted in case of individual accounts? Discuss. Interest rate increases. The general economic conditions slacken. 115. The firm changes its credit terms from "2/10. What benefits and costs are associated with the extension of credit? How should they be combined to obtain an appropriate credit policy? What is the role of credit terms and credit standards in the credit policy of a firm? What are the objectives of the collection policy? How should it be established? What shall be the effect of the following changes on the level of the finn¶s receivables: . net 30" to "3/10. 111. 114. 113. 108. How would you monitor book debts? Explain the pros and cons of various methods.¶ Discuss under what conditions thiscriticism may not be justified. b. net 30. What is factoring? What functions does it perform? Explain the features of various types of factoring." µThe credit policy of a company is criticised because the bad debt losses have increased considerably and the collection period has also increased. Production and selling costs increase. all the three components of 228 . a. 112. 107.

They are: 116. however. is the intermediary stage that comes after the stage of raw materials. Learning objectives After reading this lesson. comprise the end products. 120. Let us now discuss all these three items. the goods at their final stage of production. and Finished goods. 117. process). The finished goods. Inventory planning Various methods of pricing inventories Special techniques like ABC analysis and VED analysis Section Title Components of Inventories The term µinventory¶ comprises three components. but just before the stage of finished goods. one by one. Raw Materials are those basic inputs. which are used to manufacture the finished products. 121. 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. taken together. 119. the importance of effectively managing and controlling the inventory of a company can hardly be over-emphasised. Thus. Raw materials (also consumable stores and spares). Work-in-process (also known as stock-in-process. in turn. Determination of EOQ and Economic production quantity. 229 . 118. Work-in-process. ready for sale in the market.inventory. generally account for around 25 to 30 per cent of the total assets of the company. that is.

comprise the inventory for a retail trader. when the bread is fully baked and is ready for sale. while all the three components. Further. etc. this stage is known as the work-in-process stage. only the finished goods. as these have direct effect on the financial gains of the company. as aforesaid. production department and marketing department. production department. a company is in the business of production of breads. among all the aforesaid four different departments. In this case. And. Thus. comprise the items of inventory for the manufacturing concerns. selling breads. as we have already seen earlier. And. the main responsibility of the finance manager comprises apprising the non-finance executives so as to. however. the inventory comprises only the finished goods. the wheat flour. inventory comprises raw materials. 230 . the policy in regard to the inventory of finished goods is to be formulated by the production department in coordination with the marketing department. and for that matter. It may be noted that in the case of manufacturing companies. Here. The policy in regard to the work-in-process. in financial terms. which in turn. That is why it is said that the management of inventory. baking powder. is not the responsibility of the finance manager alone. like the breads alone. it may be pertinent to mention that the task of inventory management and control is the joint responsibility of the purchase department. but also of the purchase department. would comprise the raw materials. understand the basis of the mechanism and its overall implication in regard to the control of various items of inventory.Supposing. the role of finance manager can be said to be the central coordinating role. and marketing department. in coordination with the materials and production departments. keeping in view the vital importance of inventory management and control. when the flour is put in the relative moulds. at least.. while the policy pertaining to the raw materials is to be formulated by the purchase department. And. the management of working capital as a whole. it comprises the finished goods of the company. is finalised by the production department alone. while in the case of trading concerns or trade merchants or retail traders. Here. of course. on the desired lines. after being wrapped in the packing paper. with a view to ensuring that the inventory management and control are being exercised effectively at the various stages and departments. materials department. work-in-process and finished goods. are placed in the furnace. materials department.

these rods may be drawn total time required for completing all the involved processes (stretched) and. would be: 250 units x 10 days = 2500 units. the aggregate quantum and value of the raw materials. Then. And then. comprise the stocks of process inventory. Thus. multiplied by the time days required to complete all the processes. to be transferred from the factory to the company¶s godowns. thus. the average movement inventories.000 units. all taken together. Thus. or sales depots. and its basic raw material is iron rods. and the average production of the item is 1000 units per day. thus.e. And. 1000 x 10 days = 10. the other end may be flattened to become the head of the nail.. Movement Inventories Movement inventories are usually referred to the inventories of finished goods. Supposing. till these reach the final stage. ten days. warehouses. to become the finished goods. lying at the different stages of production. as the production process involves several stages of production. And.Process Inventories These inventories comprise the various items of raw materials. or 231 . when these may come to the required diameter. i. a company is manufacturing iron nails. if the average daily sales at the company¶s sales depot are 250 units and the transit time (for transporting the finished goods from the factory to the sales depots) is 10 days. as per the aforesaid formula. while one end may be made pointed. the stocks of finished goods are ready for transportation (movement) to the godown(s) or to the company¶s sales outlets. In the drawing machine. lying at the various stages of production. these may become thinner and thinner in three to four processes. these thinner n rods will be cut into pieces of the required length of the nails. after all these required processes are completed in full. if the entire process (from the raw material stage till the stage immediately preceding the finished goods stage) takes say. the average quantity of such process inventories would be equal to: Average stocks-in-process.

12. volume. 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. 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 232 . why should the companies.. are included in the Working Capital process inventories (though these raw materials may actually be put into the production process a little later). Now. these items are excluded from the organisation inventories and these. too. in turn. That is. Thus. 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. comprise the items of raw materials and finished goods stored and stocked in the company¶s godowns. of the specific items of raw materials and finished goods. This also facilitates bifurcation of the functions of purchase of raw materials and production plan into two separate departments.. And. etc. respectively. to be supplied to the factory or to the sales depots. have organization inventories. a natural question. the answer. could be that if the inventory carrying cost is so huge and material to affect the profitability of the company. inaddition to the process inventories and movement inventories.500/Organization Inventories Organization inventories. 5/.x 10 days = Rs. as and when they would requisition for the required number. favourably or unfavourably. weight. if the stocks sometimes are available at a cheaper price during the harvesting seasons of the respective agricultural products. or in the movement inventories (even if the stocks of the finished goods may be lying in the company¶s show-rooms. even more free and flexible. it may be mentioned that the moment the stocks of raw materials and finished goods are issued from the company¶s godown(s).250 units x Rs. while the production department may just give its production schedule to the purchase department. That is. Here. on the other hand. at all. that may arise. too. etc. is very simple and logical. to be managed by the respective experts in each department. unsold).

etc. avail of the bulk discount. as also as to what factors should be taken into consideration (like time-value of money. to meet the immediate demands of production. 233 . etc. if. by virtue of having some organisation inventory of finished foods. inasmuch as all the departments inter-dependent with each other. companies have to keep some items in ready stock so as to be able to supply these to the customers from the shelf. 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. and the balance to be supplied in a week¶s time or so. in an inflationary condition. companies may be able to optimise their profitability. Similarly.. keeping the overall interests and requirements if the other departments. It is a well known fact that. let us discuss about the rationale behind keeping organization inventories of finished goods. expiry of shelf life. in order to have some edge over the competitors. bulk purchases may be made available at a much cheaper rate. Similarly. or to avail of the cash discount. rate of inflation and the total inventory carrying costs. Now. This much about the rationale behind keeping the organisation inventory of stocks of raw materials.). as also production activities from marketing activities. by enabling the experts different departments. at least to meet their immediate requirements. taking into account the quantum of inflation. whenever offered. it would augur well if the purchase people could as well know the fundamentals of cost-benefit analysis. etc. in the fore front. Further. the companies are able to delink the production schedule from marketing activities. to be made in this regard. etc. of course. too. the purchase people may exercise their prudence and expertise to make the purchases of a larger quantity than required. This is important because keeping huge numbers of items in ready stock is fraught with grave risks of obsolescence. the purchase department may make purchases for a week only locally. That is. and delinking the purchase functions and the production functions. if such purchases are going to be sufficiently cheaper today. we can very well appreciate that by delinking the purchase activities and production activities. by that time.

Now. i. These factors. (though these do not constitute a part of organization inventory.e. which may ultimately result in delay in production and non utilisation of the installed capacity at the optimum possible level. will culminate in adversely affecting the financial gains of the company. naturally. at the very outset. some bottlenecks may be caused sometime somewhere in the production process. so as to ensure efficient production schedule and higher capacity utilisation of plant and machinery. in case there is no stock of in-process inventory. i. discussed earlier. (ii) (Inventory) carrying costs. as regards the rationale behind keeping the in-process inventory. They are: (a) Order size.e. too. clarify that though the in-process inventory refers to work-in-process inventory only. Let us. at what level of the stocks should the next order be placed? But.At this stage. 234 . it may be mentioned here that it provides some flexibility and latitude in the scheduling of production. it is different from the process or movement inventory. let us first try to understand the distinguishing features of the three types of costs involved in the management of inventories: (i) Ordering costs. it may be quite pertinent to examine the rationale behind keeping the in-process inventory. before deliberating to find out the answers to the above questions. Further. as such). too.. and (iii) Shortage costs. even though a part of the work-in-process inventory may represent process or movement inventory. Economic Order Quantity (EOQ) In regard to the management of inventories (specially the inventories of raw materials) two primary questions naturally arise. what should be the ideal size of the order? (b) Order Level..

by the same company). typing. despatch. These include the expenses in respect of the following items: (i) Cost of requisitioning items(s) 1. 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.Ordering Costs Ordering costs pertain to placing an order for the purchase of certain items of raw. in case of items manufactured in-house (i. However.e. postage.. Carrying Costs (of inventories) 235 . drafting. etc.e. 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.Let us now discuss these costs. one by one. etc. 2. 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. in detail.

It. 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. however. or the shortage of certain items of finished goods to meet the immediate demands of the customers. It may. Shortage of inventories of raw materials may affect the company in one or more of the following ways: (i) The company may have to pay somewhat higher price. 236 . Shortage Costs (or costs of stock out) 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. out of the existing stocks. (ii) The company may have to compulsorily resort to some different production schedules. however. 3. Stock out of finished goods. may result in the dissatisfaction of the customers and the resultant loss of sales.Inventory carrying costs include the expenses incurred on the following items: (i) Capital cost (i. however. connected with immediate (crash) procurements.e. be mentioned here that the carrying costs usually constitute around 25 per cent of the value of inventories held. which may not be as efficient and economical. etc.. 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.

The estimate of usage (demand or consumption) of the item of inventory for a given period (usually one year) is known accurately. Besides. depending upon various variables and assumptions. with a view to reducing total ordering costs.e. we may have to arrive at the optimal level where the total costs. or shortage costs. a large number of other inventory models. we may have to work out the Economic Order Quantity (EOQ). The usage (demand or consumption of the various items of inventory) is equal (even). That is.This is so because such costs may have ramifications. There are. 123. would go up further. throughout the period. Consequently. total ordering costs plus total inventory carrying costs. To achieve this end result. There is no lead time involved. at the minimum level. there is no likelihood of 237 . Thus. in fact. Assumptions of the Basic EOQ Model It may further be clarified here that the basic EOQ model is based on various assumptions. It has also been observed that some of the companies. in turn. these costs are somewhat intangible in nature. prefer to order larger quantities. and consequently difficult to assess quantitatively. pertaining to management of inventory. Further. which are given hereunder: 122. are minimal. Basic Economic Order Quantity (EOQ) Model At the very outset. both in the short-term as also in the long term. if the company decides to carry a safety stock of inventory so as to mitigate or reduce the stock out costs. and thereby the inventory carrying costs also go up. the item of inventory can be supplied immediately on the receipt of the order itself. one of the simplest inventory models. there being virtually no time lag between placing of an order and the receipt of the goods. with a view to keeping the total costs. i.. But. it is to clarify here that we are going to discuss only the basic EOQ model. its carrying costs. 124. this way the level of inventory becomes higher.

what we have to do is. Further. Eoq Formula vs Trial and Error Method It may be observed that the EOQ can be ascertained in two distinct ways: (i) By trial and error method (discussed immediately hereafter). But. 126. viz. to first substract the rate of inflation from C (the annual inventory carrying cost. And. irrespective of the size of the order. howsoever large the order size be. and (ii) By use of a definite formula (discussed thereafter). the shortage cost (or stock out cost) is not being taken into account. pertaining to inventory. Economic Order Quantity (EOQ) and Optimum Order Quantity (OOQ) The standard EOQ analysis is based on the assumption that no discount is given. 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. as if it is nil. 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. Therefore. a) Ordering cost. Thus.. there remain only two distinct costs involved in computing the total costs. Trial and Error Method Let us understand the "trial and error" method with the help of an illustrative example. Economic Order Quantity (EOQ)and Inflation The EOQ analysis presumes that the cost price per unit is constant. the cost of every order remains uniformly the same. This implies that the incidence of inflation has not been taken into account. and (b) Inventory carrying cost.stock out. In order to account for inflation. finally. 238 . Thus. that the inventory carrying cost is a fixed percentage of the average value of inventory. 127. 125. at any stage.

handling charges like unloading and stacking charges. But. But. let us take a common place example. (ii) Handling Charges That is. etc. at the time of receipt of the goods. some of which are given hereunder: (i) Storage Costs That is.. be used even as paper plates. that why at all do we substract the rate of inflation from C? The reason is simple enough.expressed as a percentage) and apply the standard EOQ formula with this simple modification only. To bring home the point. flood and such other natural calamity insurance. will also be higher. offset the inventory carrying cost. theft insurance. may also go up. (iii) Insurance Premium Similarly. the rental payable will be proportionately higher as more space would be required to store higher level of inventory. etc. the amount of insurance premium payable. when higher stocks will be stored. etc. you may ask. (iv) Wastages It has generally been observed that if more than sufficient stocks of inventory are stored. Components of Inventory Carrying Costs Inventory carrying costs comprise various items. the purchase price of inventory will also go up and this will. and rightly so. at times. these may. 239 . Supposing there is a huge stock of medical bills proforma. resulting in extra avoidable wastages. if these proforma were in short supply. to some extent. In an inflationary condition. involving man power.. there is a usual tendency to consume more than what is actually required. people may take care not to waste a single form. for fire insurance.

may pose liquidity problems to the companies. more than necessary stocks run the risk of becoming obsolete and consequently of much lesser value and use. blocked in inventory. one should not lose sight of the fact that. Lead Time What is meant by lead-time? 240 . above all. It may as well involve some loss by way of payment of interest as also opportunity costs. thus.(v) Damage and Deterioration In the event of storing more than required level of stocks of raw materials and finished goods. like the whiteness of papers gets diminished (it turns yellowish) with the passage of time. at the same time. damages and deterioration. and. Advantages of High Inventories But. it may be argued that there are several reasons which may justify stocking of higher level of inventories of raw materials and finished goods. in rainy season. etc. are fraught with grave risk of turning into stones. becoming useless. But then. there is every chance that the goods may deteriorate in quality. you may get bulk discount. more than necessary funds. Some chemicals or medicines also have limited shelf-life. Thus. (vii) Blockage of Funds And. in such a case. (vi) Technical Obsolescence In the modern age of technological advancements.) which may offset the advantages of bulk purchases. making the average costs of the stocks much cheaper. Bulk Purchase For example. the pace of goods and commodities becoming obsolete has become fast enough. there are several inventory carrying costs involved (like wastages. where after these may turn useless. Stocks of cement. loss of interest and opportunity cost.

the possibility of some error. for doing so accurately. too. supposing it takes say. etc. around 15 days in completing all these processes and the goods are delivered and stored in our godown(s) on the 16th day. And. But. the order can well be placed when the inventory level comes to zero. We can. the factual position is otherwise. Order Point 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. an order is processed at our end and is placed to the supplier today. too. involving stock out costs. 241 .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. howsoever small. But. But. the standard EOQ model presumes as if there is no lead-time involved. This can well be done by introducing a slight modification in the standard EOQ analysis to arrive at a realistic ordering point. make some reasonable estimates. Thus. the lead-time would be said to be 16 days. we should.e. And thus. transportation and unloading. in actual practice. at best. we should decidedly take into account the lead-time. exactly and in definite terms. But. while computing EOQ. The supplier¶s office will also take its own time in processing the order plus loading. 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. Supposing. in the instant case. take into account the element of such uncertainty. Accordingly. Order Point = Lead time (in days) x Daily Usage. And. in that case. Therefore. so as to take care of the lead time involved and thereby to mitigate the risk of shortage of stocks. as seen earlier. i. one can neither estimate the lead time nor the daily usage so accurately and exactly. therefore. can hardly be eliminated completely. Safety Stock But then. to be on the safer side. we should always keep some safety stock with us to meet such eventualities. we may have to know the rate of usage of materials as also the lead-time.

in regard to keeping the safety stock. may resort to some changes in their Selective Credit Control Policies. be high or low. the order point can well be computed as: EOQ + [lead time (in days) x daily usage] + safety stock But. it is easy said than done. in the preceding pages. Other Variable Factors Affecting EOQ In finding out the EOQ or order level or safety stock. The best policy. etc.). or even medium. the considered opinion that. by some trial and error method. does not mean that we should try to cut it too fine. etc. etc. how to compute the safety stock? In fact. instructing the banks to retain higher percentage as margin on the stocks advanced against. wheat. therefore. Therefore. nor "too little". onion. as such. either. They are: 1. as also by fixing some ceiling on the maximum amount that could be advanced against the security 242 . But. in due course of time. However. and the Government of India. we have. It may. Thus. in the nick of time. while taking a particular decision. and incur the avoidable expenses relating to such crash purchases.neither "too much". made certain assumptions that some other factors do not vary. 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. it largely depends upon the inventory policy as also the organisational culture of the company. however. it would always be prudent enough to consider the following variable factors.. with a view to arresting inflation or steep rise in the prices of certain essential commodities. would ideally be . though in the real world they do. but "just right". too. Restrictions Imposed by the Reserve Bank of India (RBI) and the Government: The Reserve Bank of India (RBI). we may be able to arrive at a nearly optimal level of safety stocks. maize. accordingly.And. the order point should be computed by adding the quantum of sufficient safety stocks.. This. Otherwise. like food grains (rice. it is a managerial decision and. too.

Here. Fluctuating Prices: Sometimes the price of certain commodity is expected to rise or fall. Such stocks should naturally be kept at the minimal possible level. and consequently the steep rise in the price. 3. i. 2. as also avoid the risk of obsolescence. it would be a prudent policy to stock a larger quantity of such material so as to avoid the stock-out risk. it would augur well if only a percentage of the market requirements could be kept in the ready stock. jute packing has since been replaced by polythene matting in the carpet industries. retaining higher or lower levels of such inventory.of some commodities specified. Abcanalysis (or Ved Analysis) ABC analysis is a very effective and useful tool for monitoring and control of inventories.e. Expected Scarcity: In case certain material is expected to be in short supply in the near future. Such statutory restrictions exercise limitation on the companies in formulating their inventory policy. so as to restrict hoarding. The risk of obsolescence may be even higher and costlier in the cases of the finished goods. accordingly. a very small percentage of the total number of items of inventory (say 10%) may account for a much larger percentage (say 65%) in terms of value. in the modern age of technological advancements and stiff global competition. This way. as far as possible. the company may meet the competitive challenges. As you must have observed. as also to fix a lower ceiling on the holding of such stocks by a single party.. and adjusted accordingly. As against this. generally speaking. instead of having a huge ready stocks of such finished goods. in cases of certain other items of inventory. Risk of Obsolescence: Certain items of raw materials may become obsolete with the passage of time. 4. to a single borrower. For example. respectively. And. and the balance quantity could be produced on an emergency basis and supplied in a week¶s time or so. a very large percentage of the 243 . to be supplied to the customers immediately. it may be emphasised that even if the policy of meeting the customers¶ demand immediately is taken to be the company¶s marketing strategy. the stocks of inventory of such items should be kept flexible. in the near future.

To put it differently. Categorization of Items for Abc Analysis Now. is to vary the pressure and intensity of control. while the entire stocks (say 100%). B. A. B. of the items in category "A" must be very closely monitored and controlled. a medium percentage of some items (say 20%) may account for a medium percentage (say 25%) in terms of their total value. in terms of the value of the items of inventory. and serially number them. 10% of the items of category "C". in the case of "B" category of items. 244 . And. number of items of inventory (say 70%) may account for a much smaller percentage (say 10%) in terms of their total value. likewise. the monitoring and control of say 25% of the item alone may be taken as sufficient.. The procedure involves the following steps. B and C respectively. These are classified as category A. based upon their annual usage value. And. in a descending order. and C. could be considered enough to serve the purpose. ABC analysis is also referred to as VED (Vital. and C. the monitoring and control of say. 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. in a sequential order: Step 1 Rank all the items of inventory. let us see how do we usually proceed to classify the various items of inventories into the three categories viz. from I to n.

B.Step 2 Record the totals of annual consumption values of all the items separately and store them as a percentage of the total value of consumption. Step 4 We may finalise the classification of the items of inventory into A. (ii) The usage is usually uniform throughout the year. either. there is no risk of stock-out. That is. giving the number of units of inventory and their values in percentage terms. Basic EOQ Model It is based on the following assumptions: (i) The quantum of the usual annual usage of the items of inventories is known. (ii) The lead-time (i. in accurate term. under all the three categories. in the desired manner. the stock-out cost is NIL. with the laid down principles and objectives of the ABC analysis (or VED analysis). too. comprises a reasonable number of items of inventory. and C categories.e. and 245 . please do bear in mind that the cut off point so arrived at. time gap between ordering and receiving) is NIL. (v) Thus. Step 3 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. only two costs are involved: (a) Ordering Cost. (iv) Therefore. b) At the same time.

Trial and Error Method: Trial and Error Method is a very cumbersome and time-consuming process. instead. however. and (b) The Inventory Carrying Cost is a fixed percentage of the average value of Inventories.(b) Inventory Carrying Cost. 000 will be the EOQ or the quantity eligible for bulk discount. (a) When the quantity discount is available at a lower level than the EOQ. if it is higher than EOQ. then EOQ itself will be the 000.e. A New Clue to EOQ: 246 . In Practice: There is no single Economic Order Point (EOP). depending upon which one of these two will be beneficial [i. EOQ Vs. when bulk (quantity) discount is available]. (a) Ordering Cost is uniform.. The formula. makes the procedure rather simple enough. when the resultant difference will be a positive (+ve) figure]. (b) But. 000 (Optimal Order Quantity): [That is. an Economic Order Range (EOR). There is. too. (vi) Further. EOQ Formula vs. irrespective of the order size.

this again. And. Besides. (ii) Seasonal purchases. should be converted into the nearest integer number. which will be the EOQ in real terms. Based on this figure as the number of orders.That is. we should bear in mind the concepts of EOP and EOR. (iv) In inflationary economy. (v) Savings of ordering cost and the connected hazels of loading and unloading. Blockage of funds and cost of capital. we should find out the number of orders. at this stage. and opportunity cost connected therewith. too. being cheaper and sure. it may be gainful. It is an optimal strategy). Advantages of High Inventory: (a) High Stocks of Raw Materials (i) Bulk purchase at cheaper rate with quantity discount. [Better. 247 . etc. we should calculate the EOQ. Components of Inventory Carrying Costs: (i) Storage Cost (ii) Handling Charges (iii) Insurance Charges (iv) Wastages (v) Damage/Deterioration (vi) Technical Obsolescence. after finding out the EOQ in terms of the nearest integer figure. if bulk annual purchase is ordered. (iii) No Stock-out cost and risk. to the mutual advantages of both the parties. but the delivery and payments are to be made in phases.

Lead Time It represents the time lag between placement of order and the actual receipt of goods. (a) Name the three main components of inventory. 248 . the "Golden Mean" is the most basic management mantra. we should place the next order well in advance. Order Point Thus. 16. Estimating and ascertaining the safety stock is a managerial judgement² decision & discretion. to have an edge over the competitors. on priority basis]. (ii) Thus. Thus. It should be sufficient enough. too. pertaining to the management of inventory. and accordingly. when there is some stock left. better to have only a small ready stock and the rest to be produced on receipt of the order. being sufficient enough to take care of the lead time. just about right. (ii) the order point. This could as well be taken into account by modifying the EOQ formula. 17. nor too low. as a prudent manager. and. Safety Stock And. at the point in time. just slightly. thus. Have you understood? 1. so as to take care of some possible fluctuations in both (i) the lead-time.(b) High Stocks of Finished Goods: (i) It may facilitate instant delivery. it would be a better business sense to have some safety stock. too. the safety stock should not be too high. out of the shelf. But. Order Point will be = EOQ + [Lead-time (in days) x Daily Usage] + Safety Stock. [But. 15.

(a) Explain the following terms with the help of some illustrative examples: 249 . The basic EOQ model does not take into account the elements of inflation. in your considered view. need to be made in the basic EOQ model to take care of the elements of inflation? 7. (b) Inventory carrying costs. and (b) finished goods? 3. (c) Shortage costs or stock-out costs? Clarify your points. how the formula has been derived? 6. and "organization" inventories. ceiling fans. What adjustments of modifications. (a) Distinguish between. in each case. are we required to keep stocks of inventories of (a) Raw materials. "process or movement" inventories. (b) What is the rationale behind keeping stocks of "organization" inventories of both raw materials and finished goods? 4.(b) Whether bond papers. Why. What are the various factors) elements involved in the inventory carrying costs? Explain with the help of some illustrative examples. 8. What are they? 5. by citing suitable illustrative examples. at all. What do you understand by the terms? (a) Ordering cost. citing illustrative examples to bring home your points of view. 9. Explain. Write down the formula for EOQ. 2. The basic EOQ model is based on several assumptions. woollen suit lengths and Maruti 800 cars are raw materials or finished goods? Give specific reasons for your answer.

(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.(i) Lead time. (a) What do you understand by the term "ABC Analysis"? Explain with the help of illustrative examples. 13. with the help of some suitable illustrative examples. 14. (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? 12. 11. management and control? Explain. should be adopted by any company? Give reasons for your answer. (i) Cite suitable illustrative examples to clarify your point. monitoring. (ii) Which one of the above noted two approaches. Elucidate your point by citing suitable illustrative examples. Distinguish between EOQ and OOQ (Optimum Order Quantity) when quantity discount is available. the procedure adopted for doing the ABC analysis. in your considered opinion. Distinguish between JIT (Just In Time) and JIC (Just In Case) approaches towards inventory management and control. and (iii) safety stock. The state of affairs in the area of management of inventory in most of the Indian companies leaves a lot to be desired. (b) How is the reorder level ascertained? Explain with the help of an illustrative example. (a) What are the comparative advantages and disadvantages of carrying too high or too low stocks of inventories of: 250 . 10. (ii) order point. (b) What purpose does ABC Analysis serve in the context of inventory policy.

each current asset requires a detailed treatment to understand the issues related to the need and method of its management. It is. learning Objectives 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 SECTION TITLE 251 . Hence. (b) What. various issues regarding management of working capital were discussed. and (ii) finished goods? Explain. In fact. It was explained that current assets form an important aspect of working capital management. with the help of some illustrative examples. Lesson 4 Cash Management INTRODUCTION In the previous unit. therefore. Cash denotes the liquidity of a business enterprise and plays an important role in nurturing and improving the profitability of an organization. effective management ensuring adequate cash is necessary. essential to make a proper estimate of the cash needs and plan for it so as to avoid technical or legal insolvency. in your considered view. In this unit we shall discuss the planning and managing of cash. would be the right approach in this area? Give convincing reasons for your answer. Cash to business is like blood stream in human body. The cash available with the organization should neither be short nor too excessive.(i) Raw materials.

whether by individuals or firms. Higher the predictability of cash. 252 . as idle cash does not earn any income. Determining Optimal Cash Balance Holding of excessive cash is a non-profitable proposition. every organization.g. The precautionary motive is concerned with predictability of cash inflows and outflows. Firms having seasonal business will need greater amount of cash during the season.. has to determine the appropriate or optimum cash balance that it would need. Retail trade. The amount of cash needed. is normally attributed to three behavioral motives. an abnormal increase in prices. The speculative motive for holding cash is concerned with availing the opportunities arising from unexpected developments. 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. Hence. and of taking advantage of other favorable opportunities. However. lower is the amount needed against emergencies or contingencies.Why is Cash Needed? The demand for liquid assets like cash. however. It may even lead to loss of credit-worthiness on account of default in paying liabilities when the same becomes due. the precautionary motive and the speculative motive. requires a higher ratio of cash to sales and of cash to total assets. e. for example. The transaction motive for holding cash is helpful in the conduct of everyday ordinary business such as making of purchases and sales. keeping additional cash for speculative purpose is not common in business. differs from business to business and from firm to firm depending on the frequency of cash transactions. viz. the transaction motive. Similarly shortage of cash may deprive the business unit of availing the benefits of cash discounts. irrespective of its size and nature.

First of all.A firm¶s cash balance. may not be constant overtime. however. the existence of the minimum balance is justified by institutional requirements such as credit ratings. The violation of maintaining a minimum cash balance will create shortage costs. or for purchasing securities. receipts may be more than disbursements or vice versa. no problem is involved. the ending balance will 253 . checking accounts and lines of credit. b) Holding of cash means that it cannot be used to offset financial risks from the short-term debts. Ordinarily. Thereafter. 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. 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. It would therefore be worthwhile to investigate the maximum. Apart from risk aversion. which will be determined by the actions of creditors on account of postponing their payments or non-availing of cash discounts. Hence. c) Excessive reliance on internally generated liquidity can isolate the firm from the short-term financial market. minimum and average cash needs over a designated period of time. Critical minimum cash balance should be conceived below which the firm would incur definite and measurable costs. Now the Finance Manager should understand the benefits and the opportunity costs for holding cash. You are aware that cash is needed for various transactions of the organization. he must proceed to work out a model for determining the optimal amount of cash. Opportunities for such investments may be lost if a certain minimum cash balance is held. generally.

Cash management involves two main questions 128. In actual practice. the receipts and disbursements are not synchronized but the variation is predictable. then the main problem will be that of minimizing total costs. Cash is used to purchase materials from which goods are produced. Goods produced are sold either on cash or credit. Cash Management Cash. and how should any temporary idle cash be invested in interest earning assets? Managing Collections and Disbursements The Cash Cycle In order to deal with the problem of cash management. receipts and disbursements do vary. Suppose. particularly in case of firms having seasonal activities.keep on fluctuating. In the latter case the pending bills are received at a later date. The entire process of this cash flow is known as Cash Cycle. How should the collection and disbursement of cash balances be managed? How should the appropriate cash balance be determined. 129. has to be regulated according to needs. Any deficits (or inadequacies) should be rectified and any excess amount be gainfully invested. This has been illustrated in Figures III and IV. The firm thus receives cash immediately or later for the goods sold by it. Production of these goods involves use of funds for paying wages and meeting other expenses. 254 . The cycle continues repeating itself. being a sensitive asset. we must have an idea about the flow of cash through a firm¶s account.

All cash collected should be directly deposited in one account. the aggregate requirement for cash will be more when 255 .e.The diagram in above figure only gives a general idea about the channels of flow of cash Managing Cash in a business. assuming that it takes 2 days for collection of payment of the cheque. The magnitude of the flow in terms of time is depicted in the diagram given in Figure IV. the time gap between sale of goods and their cash collection should be reduced and the flow be controlled. Speeding up Collections In order to minimize the size of cash holding. dddddd. aaaaaa. bbbbbb. cccccc. The recovery of cash spent till point D is made after 56 days (20+30+2+2+2) as shown between points D to H. the distance of time between points B to D). The material is converted into goods for sale in 37 days (15+2+20) from point B received (i. attention should be paid to the following. Normally. The payment for material purchased can be deferred to 17 days (15+2) after it is Raw material for production is received 10 days after placement of order. The following information is reflected by Figure IV: zzzzz. top speed. certain factors creating time lags are beyond the control of management. all cash receipts should be remitted to the main account with. in order to improve the efficiency. Yet. Compared to a single collection center. to E. The amount of the bill for goods sold is received 36 days (32+2+2) after the sale of goods as is depicted by duration of time between point F to H. If there are more than one collection centers.

The dues can be withheld till the last date. The collecting bank is paid service charges. Similar kind of benefit can be derived by delaying disbursements. either on account of convention or for promoting sales. 256 . The time lag between the dispatch of cheque by the customer and its credit to our account with the bank should be reduced. More important than anything else. In order to minimize time front banks may be asked to devise methods for speeding up the collection of cash. This will improve position of cash balance. Trade credit is a costless source of funds for it allows us to pay the creditors only after the period of credit agreed upon. receivables are created. Concentration of collections at one place will thus permit the firm to store its cash more efficiently. It may however be useful to reduce the amount blocked in receivables by seeing to it that they do not become overdue accounts. In this system the post boxes are hired at different centers where cash/cheques can be dropped in. Recovering Dues After sale of goods on credit.there are several centers. The first part relating to the theory of determining appropriate cash balance has already been discussed earlier. 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. Controlling Disbursements Needless to assert that speeding up of collections helps conversion of receivables into cash and thus reduces the financing requirements of the firm. Incentive in the form of discounts for early payment may be given. Investment of Idle Cash Balances 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. is a constant follow-up action for the recovery of dues. Some firms with large collection transactions introduce lock box system. The local banker can daily collect the same from the lockers.

The experience indicates that cash flows cannot be predicted with complete accuracy. strikes and variations in economic conditions make it difficult to predict cash needs accurately. Competition. the risk involved due to the possibility of default in timely payment of interest and repayment of principal amount. Cash Budgeting Planning cash and controlling its use are very important tasks.e. the asset will be regarded as highly marketable and highly liquid. we must invest it for earning income without depriving ourselves of the benefit of liquidity of funds. are: Government Securities. Cash budget is a useful device for this purpose. we must weigh the advantages of carrying extra cash (i. The assets. unexpected failure of products.Now we shall discuss the investment of idle cash balances on temporary basis. and (iii) the investment has adequate marketability. plan the cash needs and uses. If we know that some cash will be in excess of our need for a short period of time. that is. If an asset can be sold quickly in large amounts at a price determinable in advance. Investment Criteria When it is realized that the excess cash will remain idle. (ii) the investment shall mature in a short span of time. 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. 257 . While choosing the channels for investment of any idle cash balance for a short period. Marketability refers to the ease with which an asset can be converted back into cash. If the future cash flows are not properly anticipated. technological changes. Marketability has two dimensions price and time-which are inter-related. which largely satisfy the aforesaid criteria. The Finance Manager should therefore. 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. It may also result in cash deficits and consequent problems. Bankers¶ Acceptances and Commercial Paper. While doing this. Cash by itself yields no income. it should be seen that (i) the investment is free from default risk. it is likely that idle cash balances may be created which may result in unnecessary losses. whether predictable or unpredictable.

viz. operating cash flows and financial cash flows. Have you understood? 135. redemption of securities.(a) Operating: cash sales. Sales Work Sheet Sales bring in a major part of cash inflows. interest payments. Effective cash management is facilitated if the cash budget is further broken down into monthly. 136. Preparing a Cash Budget There are two components of a cash budget²cash inflows and cash outflows. What are the three motivations behind holding cash? Explain briefly. 138. purchase of marketable securities and tax payments. Some common elements of each are as follows: Cash Inflows . and capital expenditure (b) Financial: dividend payments. payments of bills and accounts payable. (b) Financial: interest receipts. it is a common experience that the total amount of sales is recovered over a period of time. the Finance Manager faces the problem of compromising the conflicting goals of liquidity and profitability". Cash Outflows -(a) Operating: wage payments. In both these components there are two types of flows. credit sales are quite common. issue of new securities.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. All sales may not be against cash. weekly or even daily basis. Comment. 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. sale of marketable securities. What is optimum cash balance and how can it be arrived at? What is cash cycle and how can it be reduced? 258 . a quarter or a half-year. loan repayments. receivable collections. What strategy should the Finance Managers develop to solve this problem? 137. "In managing cash. Each business establishment has its own credit policy for promoting sales.

what advice would you render to the firm? 140.139. (ii) financial intermediaries/institutions and (iii) financial markets. Learning Objectives on going through this lesson. Conceptually. What is a cash budget and in what way can it be helpful in liquidity planning? How would you judge the efficiency of cash management of a company? UNIT ± V LONG TERM SOURCES OF FINANCE: LONG TERM SOURCES OF FINANCE Lesson I Indian Capital and Stock Market INTRODUCTION Capital markets are a sub-part of the financial system. The functioning of financial market. The main elements of the financial system are a variety of (i) financial instruments/assets/securities. If a firm estimates that it will have some idle cash balances from time to time. It may be said to be made of all those channels through which savings become available for investments. 259 . you will be conversant with: The nature of financial assets. 141. the financial system includes a complex of institutions and mechanisms which affects the generation of savings and their transfer to those who will invest. The rate of financial intermediaries.

The securities issued by manufacturing companies are direct assets (e. Based on the type of issuer. The functions of stock exchange. a financial asset represents a claim to future cash flows in the form of interest. which results in institutionalisation of personal savings. Financial Intermediaries Financial Intermediaries are institutions that channelise the savings of investors into investments/loans.g. units of mutual funds). The prevalence of a variety of securities to suit the investment requirements of heterogeneous investors. They are a claim on a stream of income and/or particular assets. term loans.g. dividends and so on. Depending upon the nature of claim/return. As institutional source of finance. debentures. The derivative instruments include options and futures. Indirect assets are claims against financial intermediaries (e. (ii) equity (security) shares and (iii) hybrid security such as preference shares and convertibles. shares/debentures). an instrument may be (i) debt (security) such as bonds.The relationship between new issue markets and stock exchange. The issue mechanism followed in Indian markets. offers differentiated investment choice to them and is an important element in the maturity and sophistication of the financial system. furniture vehicles and so on. Their main function is to convert direct financial assets into indirect securities. machines. 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¶. they act as a link between the savers and the investors. While the value of a tangible/physical asset depends on its physical properties such as buildings. the security may be (1) direct (2) indirect and (3) derivative. SECTION TITLE Financial Assets 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. The indirect securities offer to the individual investor better investment alternative than the direct/primary security by pooling 260 .

maturities on units would conform more with the desires of the investors than those on primary securities. 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. experienced and specialised management together with continuous supervision. as a result of the redemption/repurchase facility available to unitholders of mutual funds. financial intermediaries place the individual investors in the same position in the matter of expert management as large institutional investors.which it is created. Lower Risk The lower risk associated with indirect securities results from the benefits of diversification of investments. Expert Management Indirect securities give to the investors the benefits of trained. Low Cost Low cost is the benefits of investment through financial intermediaries are available to the individual investors at relatively lower cost due to the economies of scale. They divide primary securities of higher denomination into indirect securities of lower denomination. They also transform a primary security of certain maturity into an. (ii) lower risk. 261 . In effect. The services/benefits that tailor indirect financial assets to the requirements of the investors are (i) convenience. 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. indirect security of a different maturity. In effect. (iii) expert management and (iv) lower cost. for example. For instance. Convenience Financial intermediaries convert direct/primary securities into a more convenient vehicle of investment. units of mutual funds.

suppliers in the financial market know where their funds are being lent/invested. both life and non-life/ general.The major financial intermediaries are banks. mutual funds. individuals. Financial Markets Financial markets perform a crucial function in the financial system as facilitating organisations. While the loans and investments of financial intermediaries are made without the direct knowledge of the suppliers of funds (i. Reserve Bank of India) intervention for influencing liquidity in the economy. It exists because investors (i. 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. 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 funds. At the same time.e. Unlike financial intermediaries. The money market brings together these suppliers and demanders of short. The broad objectives of money market are three-fold: An equilibrating mechanism for evening out short-term surplus and deficiencies in the financial system.g. other entities/ organisations find themselves in need of seasonal/ temporary financing. non-banking financial companies and so on. A focal point of intervention by the central bank (e. The two key financial markets are the money market and the capital market.term liquid funds. insurance organisations. Capital Market 262 . business entities. 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. investors).e. Money 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.

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. namely. therefore. both individuals and institutions. that is. the capital market comprises of (I) stock/security exchanges/markets (secondary markets) and (2) new issue/primary market [initial public offering (IPO) market]. Relationship Between New Issue Market (NIM) and Stock Exchange The industrial securities market is divided into two parts. derives its name from the fact that it makes available a new block of securities for public subscription. The stock market. The usual procedure is that when an enterprise is in need of funds. It is a market for long-term funds. Mechanisms for efficiently offering and trading securities contribute to the functioning of capital markets which is important to the long-term growth of business. The stock exchanges. funds with maturities exceeding one year) to make transactions. to subscribe to its issue of capital. is a market for old securities which may be defined as securities which have been issued already and granted stock exchange quotation. in 263 . therefore. The relationship between these parts of the market provides an insight into its organisation. on the other hand. Included among long-term funds are securities issues of business and Government.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. securities which were not previously available and are.e. provide a regular and continuous market for buying and selling of securities. They have some similarities also. There are. (ii) Nature of financing and (iii) Organisation. The market. it approaches the investing public. Thus. The securities thus floated are subsequently purchased and sold among the individual and institutional investors. NIM and stock market. therefore. One aspect of their relationship is that they differ from each other organisationally as well as in the nature of functions performed by them. Differences The differences between NIM and stock exchanges pertain to (i) Types of securities dealt. New vs Old Securities The NIM deals with new securities. offered to the investing public for the first time.

Organisational Differences The two parts of the market have organisational differences also. the secondary markets can in no circumstance supply additional funds since the company is not involved in the transaction. The stock exchanges have. The NIM has neither any tangible form any administrative organisational set up like that of stock exchanges. to that extent. two stages involved in the purchase and sale of securities. The usual course in the development of industrial enterprise seems to be that those who bar the initial burden of financing a new enterprise. lend liquidity and marketability. In the first stage. the securities are acquired from the issuing companies themselves and these are. It is recognised only by the services that it renders to the lenders and borrowers of 264 . The NIM is not rooted in any particular spot and has no geographical existence. pass it on to others when the enterprise becomes well established. This. while secondary market covers the second stage of the dealings in securities. organisationally speaking. physical existence and are located in a particular geographical area. institutional facilities for the continuous purchase and sale of securities and. In contrast. Nature of Financing Another aspect related to the separate functions of these two parts of the securities market is the nature of their contribution to industrial financing. in the second stage. play an important part in the process. its contribution to company financing is direct. The section of the industrial securities market dealing with the first stage is referred to as the NIM. 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. Their role regarding the supply of capital is indirect. does not mean that the stock markets have no relevance in the process of transfer of resources from savers to investors. nor is it subjected to any centralised control and administration for the consummation of its business. 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. therefore. however.other words. The existence of secondary markets which provide.

encourage holdings of new securities and. The precise nature of the specialised institutional facilities provided by the NIM is described in a subsequent funds at the time of any particular operation. one of the conditions to which a prospectus is to conform is that it should contain a stipulation that the application has been made. 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. thus. The facilities provided by the secondary markets. widen the initial/primary market for them. Economic Interdependence 265 . 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. 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. 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. Similarities Nevertheless. In terms of regulatory framework related to dealings in securities. Stock Exchange Listing 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. If the new issues do not conform to the prescribed stipulations. for instance. in spite of organisational and functional differences. In India. the stock exchanges would refuse listing facilities to them. the NIM and the stock exchanges are inseparably connected. or will be made in due course for admitting the securities to dealings on the stock exchange. therefore. Control The stock exchanges exercise considerable control over the organisation of new issues.

the behavior of the stock exchanges has a significant bearing on the level of activity in the NIM and. (ii) Market place and (iii) Continuous price formation. 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. therefore. 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. Their mutual interdependence from the economic point of view has two dimensions. exert a dominant influence on price determination. that 266 . 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. 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. 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. they are the nexus between the savings and the investments of the community. Functions of Stock Exchanges (Secondary Markets Stock exchanges discharge three vital functions in the orderly growth of capital formation: (i) Nexus between savings and investments. economically. as distinguished from flow-demand-and-supply curves.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 flow of new savings into new securities is profoundly influenced by the conditions prevailing in the old securities market²the stock exchange. an integral part of a single market² the industrial securities market. Nexus between Savings and Investment First and foremost. It is the preference of investors for individual units as well as industry groups. Thus. and so on. One. appreciation of capital. which is reflected in the share price.The markets for new and old securities are. The securities market represents an important case where the stock-demand-and-supply curves.

decides the mode of investment. keeping the subscription list open for a minimum period of days. 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. making provision for receiving applications at least at the prescribed centres. try to procure subscription from investors spread all over the country. and (ii) as underwriters. This guarantees saleability to one who has already invested and surety of purchase to the other who desires to invest. Stock exchanges render this service by arranging for the preliminary distribution of new issues of capital. offered through prospectus. 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. allotting the shares against applications on a fair and unconditional basis) are duly complied with Members of stock. inter alia. in an orderly and systematic manner. Exchanges also assist in the flotation of new issues by acting (i) as brokers. Market Place The second important function discharged by stock markets/exchanges is that they provide a marker place for the purchase and sale of securities. as also offers for sale of existing securities. shuffling their investment portfolios to gear up for the ever changing market situations. a seller has a ready purchaser and a purchaser has a ready seller at a price which can he said to be competitive. 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. Continuous Price Formation 267 . with a multiplicity of buyers and sellers at any point of time. in which capacity they. by ensuring that the various requisites of listing (such as offering at least the prescribed minimum percentage of capital to the public. They themselves administer the same. Since the point of aggregate sale and purchase is centralised. and so on. by and large. Stock companies also provide a forum for trading in rights shares of companies already listed. thereby enabling their free transferability through several successive stages from the original subscriber to the neverending stream of buyers.

268 . discharged by the stock exchanges is the process of continuous price formation. altered. In fact. closely related to the second. resulting in the emergence of a large number of buyers and sellers at any point of time. The process is an unending one. Functions of New Issues/Primary Market 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. with today¶s prices being yesterday¶s prices. the NIM should not. by constantly measuring its progress or otherwise. however. Henderson. The ever changing demand and supply conditions result in a continuous revaluation of assets. The collective judgement of many people operating simultaneously in the market. Conceptually. and adjusted. be conceived as exclusively serving the purpose of raising finance for new capital expenditure. and those by whom they are applied to productive uses. does not bear any relation to the age of the company. 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. Stock exchanges thus act as a barometer of µthe state of health of the nations economy. and tomorrow¶s values being again today¶s values altered. The first of new issues are by new companies and old companies. at any point of time. the value of the investments and plan his personal needs accordingly. corrected. thereby evening out wide swings in prices. has the effect of bringing about changes in the levels of security prices in small graduations.The third major function. 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. corrected and adjusted. 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. An investor can always have his eyes turned towards the stock exchanges to know. New issues can be classified in various ways. The distinction between new also called initial and old also known as further. This classification was first suggested by R.F. 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.

it may be used wholly or partly to repay debt. The term new money issues refers to the issues of capital involving newly created shares. into three services (i) Origination. no new money issues represent the sale of securities already in existence and sold by their holders. Origination The term origination refers to the work of investigation and analysis and processing of new proposals. and Henderson. The new money issues provide funds to enterprises for additional capital investment. This money may not be used for additional capital investment. new money issues and no new money issues. These two functions8 are performed by the specialist agencies which act as the sponsors of issues. namely. can be split from the operational stand-point.while those issued by companies which already have stock exchange quotation. and. bonus/ capitalisation issues which represent only book-keeping entries. This is to ensure that 269 . the channelling of investible funds into industrial enterprises. However. The new issues by corporate enterprise can also be classified on the basis of companies seeking quotation. According to Merrett and others. on the other. and (iii) Distribution. namely.(ii) Underwriting. One aspect is the preliminary investigation which entails a careful study of technical. economic. and legal aspects of the issuing companies. the NIM facilitates the transfer of resources by providing specialist institutional facilities to perform the triple-service function. The institutional set-up dealing with these can be said to constitute the NIM organisation. The differences in the approaches by Merrett and others. second. 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. financial.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. exchange issues by which shares in one company are exchanged for securities of another. either by public issue or by rights to existing shareholders. The general function of the NIM. two types of issues are excluded from the category of new issues. are referred to as further or old. In other words. First. Henderson was interested only in the latter. on the one hand. 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.

Thus. by itself. The sale of securities to the ultimate investors is referred to as distribution. On the thoroughness of investigation and soundness of judgement of the sponsoring institutions depends. some services of an advisory nature that go to improve the quality of capital issues. 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. as a second function. therefore. is only a stopgap arrangement to guarantee the success of an issue. 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. The ability of the NIM to cope with the growing requirements of the expanding corporate sector would depend on the presence of specialist 270 .it warrants the backing of the issue houses in the sense of lending their name to the company and. which can best be performed by brokers and dealers in securities. (iii) methods of Rotation. will not. the NIM is a complex of institutions through which funds can be obtained by those who require them from investors who have savings. 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. It is a specialist job. to a large extent. depends on the issues being acquired by the investing public. Distribution Underwriting. has good market prospects. 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. To ensure success of an issue. thus. and so on. guarantee the success of an issue. Underwriting The origination howsoever thoroughly done. in the ultimate analysis. is well-managed and is worthy of stock exchange quotation. who maintain regular and direct contact with the ultimate investors. and (iv) technique of selling. give the issue the stamp of respectability. to satisfy themselves that the company is strongly based. (ii) the timing and magnitude of issues. In the process of origination. however. the allocative efficiency of the market. the sponsoring institutions render.

While the nature of the services provided by an organised NIM is the same in all developed countries. and in the case of existing companies. The foundation of the public issue method is a prospectus. it may sometimes include a premium amount. the resources of the underwriters are sufficient to meet the underwriting obligations. It also provides both civil and criminal liability for any misstatement in the prospectus. Additional disclosure requirements are also mandated by the SEBI. (ii) Existing and proposed activities. partly.agencies to perform the triple-service-function of origination. underwriting and distribution. if any. Another feature of public issue method is that generally the issues are underwritten to ensure success arising out of unsatisfactory public response. and economic environment. as they are determined partly by history and partly by the particular legal. include: (i) Name and registered office of the issuing company. (vii) Name of broker. from whom application forms along with copies of prospectus can be obtained. which in the case of new companies is invariably the face value of the securities. The contents of the prospectus. (ii) Tender/Book building. (vi) Dates of opening and closing of subscription list. 271 . subscribed and proposed issue of capital to public. Public Issue through Prospectus 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. (v) Authorised. (iii) Board of directors. and others. if any. The methods by which new issues are made are: (i) Public issue through prospectus. underwriters. (ix) Names of underwriters. Issue Mechanism The success of an issue depends. on the issue mechanism. the minimum contents of which are prescribed by the Companies Act. 1956. (iv) Location of the industry. political. along with a statement that in the opinion of the directors. the issuing companies themselves offer directly to the general public a fixed number of shares at a stated price. Under this method. (iii) Offer for sale (iv) Placement and (v) Rights issue. the type of institutions found and the actual procedures followed differ from country to country. (viii) Minimum subscription.the degree of development and specialisation of market organisation. social. inter alia.

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. Tender/Book Building Method The essence of the tender/book building method is that the pricing of the issues is left to the investors. brokerage. The issues are. widely distributed and the danger of an artificial restriction on the quantity of shares available is avoided. Under this method. accountancy charges. registration charges. Moreover. The investors are required to quote the number of securities and the price at which they wish to acquire. mortgage deed registration fee and postage and so on). travelling expenses. The cost of flotation involves underwriting expenses. Offer for Sale Another method by which securities can be issued is by means of an offer for sale. In view of the high cost involved in raising capital. 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 administrative cost includes printing charges of prospectus. instead of the issuing company itself offering its shares directly to the public. thus. stamp duty. bank charges. thereby contributing to the prevention of concentration of wealth and economic power. It would ensure that the share ownership is widely diffused. is that it is a highly expensive method. listing fee. the public issue method is suitable for large issues and it cannot he availed of in case of small issues. 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. A serious drawback of public issue. advertisement/publicity charges. and other administrative expenses. filling of document charges. as a method to raise capital through the sale of securities. legal charges. The modus operandi of the offer of sale is akin to the public issue method in that 272 . it offers through the intermediary of issue houses/merchant banks/investment banks or firms of stockbrokers. a fixed quantity of stock has to be allotted among applicants on a non-discriminatory basis.

as in offer for sale method. and a known quantity of shares are distributed to the applicants in a nondiscriminatory manner. the cost of advertisement and prospectus. represents the remuneration of the issuing houses. 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. thus acquired by the sponsoring institutions. 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. The securities are sold to the investing public usually at a premium. they 273 . securities are acquired by the issue houses. it suffers from another serious shortcoming. The securities are offered to the public at a price higher than the price at which they were acquired from the company. and so on. 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. Moreover. The margin between the amount received by the company and the price paid by the public does not become additional funds. Under this method. the issues are underwritten to avoid the possibility of the issue being left largely in the hands of the issuing houses. like the public issue method. The offer for sale method shares the advantage available to public issue method. The sale of securities with an offer for sale method is done in two stages. are resold. technically called as turn. In the case of public method. by the issuing houses to the ultimate investors. The difference between the sale and the purchase price. In the first stage. the issuing company sells the securities to the issuing houses or stockbrokers at an agreed fixed price and the securities. Placement Method 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". in the second stage. whereas these are borne by the companies themselves in the case of public issue method. But the mechanism adopted is different. Apart from being expensive. but instead of being subsequently offered to the public.the prospectus with strictly prescribed minimum contents which constitutes the foundation for the sale of securities. Although this is theoretically possible. but it is pocketed by the issuing houses or the existing shareholders.

When the securities to be placed are newly quoted. Placing of securities Securities that are unquoted is known as private placing. and so on are avoided. Thus. as a method of issuing new securities. when taken together. many of the items of expenses in public issue and offer for sale methods like underwriting commission. the method is officially known as stock exchange placing. The securities are usually in small companies but these may occasionally be in large companies. the turn is their remuneration. Another feature of placing is that. is its relative cheapness. though rarely. that is. both individual and institutional 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 market. expense relating to applications and allotment of shares. The issue houses usually place the securities at a higher price than the price they pay and the difference. 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.are placed with the clients of the issue houses. constitute a prospectus/offer document and the information concerning the issue has to be published. the placing letter and the other documents. Alternatively. In this method. 274 . Its weakness arises from the point of view of distribution of securities. shares are acquired by the issuing houses and in the second stage. the stock exchange requirements relating to contents of the prospectus and its advertisement are less onerous in the case of placing. they may arrange the placing in return for a fee and act merely as an agent and not principal. the flotation of the securities involves two stages: In the first stage. The main advantage of placing. Moreover. This is partly because. 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. As the securities are offered only to a select group of investors. they are made available to their investor-clients.

with the placement method. either after two years of its formation or after one year of first issue of shares whichever is earlier. Rights Issue The methods discussed above can be used both by new companies as well as by established companies. A company can. Rights issues are not normally underwritten but to ensure full subscription and as a measure of abundant precaution. dispense with this requirement by passing a special resolution to the same effect. The method is suitable in case of small issues which cannot bear the high expenses entailed in a public issue. It is.The placement method is advantageous to the issuing companies but it is not favorably received by the investing public. and also in such issues which are unlikely to arouse much interest among the general investing public. This underscores the relevance of this method from the viewpoint of the market. The chief merit of rights issue is that it is an inexpensive method. 1956 provides that where a company increases its subscribed capital by the issue of new shares. shares can be offered to the existing shareholders. Thus. In the case of companies whose shares are already listed and widely held. a few companies have resorted to underwriting of rights shares. This is called rights issue. This offer is made by circular to µexisting shareholders¶ only. Advertising expenses have to be incurred only for sending a letter of rights to 275 . The usual expenses like underwriting commission. 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. the existing shareholders are offered the right to subscribe to new shares in proportion to the number of shares they already hold. Section 81 of the Companies Act. The experience of these companies has been that underwriters were not called upon to take up shares in terms of their obligations. In India. these have to be first offered to the existing shareholders with a right to renounce them in favour of a nominee. therefore. however. Under this method. brokerage and other administrative expenses are either non-existent or are very small. 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 preemptive right of existing shareholders may conflict with the broader objective of wider diffusion of share-ownership. 5. this method can be used only by existing companies and the general investing public has no opportunity to participate in the new companies. Explain briefly the two key financial markets. 6. 9.Term Sources of Finance INTRODUCTION Long-term capital is capital with maturity exceeding one year. Public limited companies meet their long-term financial requirements by issuing shares and debentures and through borrowing and 276 . What are the functions of the stock exchanges? 8. The above discussion shows that the available methods of flotation of new issues are suitable in different circumstances and for different types of enterprises. Explain briefly financial assets/instruments. Long-term capital is used to fund the acquisition of fixed assets and part of current assets.shareholders. What are the similarities between the NIM and the stock market? 7. 2. The issue mechanism would vary from market to market. 3. Write a brief note on the differences between the new issue market and the stock exchanges. Discuss the main elements of the financial system. What are the different methods of flotation of issues in the primary market? Lesson 2 Long . The management of applications and allotment is less cumbersome because the number is limited. As already mentioned. Briefly discuss the functions of the NIM. HAVE YOU UNDERSTOOD? 1. Describe briefly the functions of financial intermediaries. 4.

towing from the financing institutions and lease finance). 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. Short-term sources of finance consists of trade credit. Otherwise it is called new issues market. Raising capital through issue of shares. debentures or bonds is known as primary capital sourcing. debenture capital. Different modes of capital issues SEBI Guidelines on public issues.public deposits. The required fund is to be mobilized and utilized systematically by the companies. Share capital is considered as ownership or equity capital whereas debentures and loans constitute borrowed or debt capital. long term loans from finance corporations and other creditors). a company can have two main sources of funds. 277 . Internal sources refer to sources from within the company External sources refer to outside sources. LEARNING Objectives On going through this lesson. External sources consists of share capital. SECTION TITLE Sources of Capital Broadly speaking. short-term loans from banks and financial institutions and public deposits. loans and advances (short term loans from commercial banks and other creditors. Long-term sources of finance consist of ownership securities y shares and preference shares) and creditor-ship securities (debentures. general reserve fund or free reserve ² retained earnings or the saving of the company. Internal sources consist of depreciation provision. Internal and external.

Debentures.Long-Term Capital Instruments Corporate securities also known as company securities are said to be the documentary media of raising capital by the joint stock companies. Retained earnings also constitute owned capital. Equity capital represents ownership capital. Equity Shares Equity shares are instruments to raise equity capital. are instruments of debt or borrowed capital. 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. The equity shareholders¶ liability. The capital raised in this way is called µowned capital¶. Ownership 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 equity share capital is also termed as the venture capital on account of the risk involved in it. and Creditor-ship securities. commercial papers etc. Equity shareholders collectively own the company. The equity share capital is the backbone of any company¶s financial structure. Capital raised through creditor-ship securities is known as µborrowed capital¶. Creditor-ship Securities 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. They enjoy the reward of ownership and bear the risk of ownership. Advantages of Equity Share Capital 278 . Equity shares and securities like the irredeemable preference shares are called ownership securities. These are of two classes: Ownership securities. notes. bonds.

Equity dividend is payable from post-tax earnings. Hence cost of equity is high Sometimes. the larger the equity base. Unlike interest" paid on debt capital. In general. unlike debt capital which is risk-burdening. further rising cost of equity share capital. Equity share capital strengthens the credit worthiness and borrowing or debt capacity of the company. 3. 6. Hence. dividend tax is paid. other things being equal. as the limited group of risk. Equity capital market is now expanding and the global capital market can be accessed. 5. the expectation of the equity shareholders is also high as compared preference shares or debentures. Equity capital is the risk-bearing capital. Equity shares attract only those classes of investors who can take risk. It represents permanent capital. 4. Payment of dividend to equity shareholders depends on the availability of profit and the discretion of the Board of Directors. 2. The cost of servicing equity capital is generally higher than the cost of issuing preference shares or debenture since on account of higher rise. underwriting commission. the higher the ability of the company to secure debt capital. 279 .seeking investors need to be attracted and targeted. Cost of issue of equity shares is high. brokerage costs and other issue expense¶ are high for equity capital. It is the µheart¶ to the business. Disadvantages of Equity Shares capital 1. Equity share capital constitutes the µcorpus¶ of the company. 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. there is no problem of refunding the capital. 3. Conservative and cautious investors do not subscribe for equity issues.1. Equity share capital does not involve any fixed obligation for payment of dividend. 2. Equity shares do not create any charge on the assets of the company and the assets may be used as security for further financing. 7. rising up issue cost. dividend is not deductible as an expense from the profit for taxation purposes.

the balance of it will be used for paying dividend to ordinary shares. Excessive reliance on financing through equity shares reduces the capacity of the company to trade on equity. 5. Types of Preference Shares There are many forms of preference shares.In times of depression. Only after the payment of dividend at a fixed rate is made to the preference shareholders. The rate of dividend preference shares is mentioned in the prospectus. The excessive use of equity shares is likely to result in over capitalization of the company. Ir-redeemable preference shares 9. Preference Shares 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 rights. 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. The issuing of equity capital causes dilution of control of the equity holders. Cumulative convertible preference shares 280 . The preference shareholders are entitled to receive the fixed rate of dividend out of the net profit of the company. Non-participating preference shares 5. Convertible preference shares 6.4. These are: 1. Redeemable preference shares 8. Participating preference shares 4. dividends on equity shares reach low be which leads to drastic fall in their market values. Non-Cumulative preference shares 3. Cumulative preference shares 2. Non-convertible preference shares 7.

Issue of preference shares does not create any charge against the assets of the company. Preference shares have variety and diversity. 9. In the case of cumulative preference shares. 8. If the assets of the company are not of high value. The public deposit of companies in excess of the maximum limit stipulated by the Reserve Bank can be liquidated by issuing preference shares. 3. preference share capital is a very expensive source of financing because the dividend paid to preference shareholders is not. The preference shares have the merits of equity shares without their limitations. The promoters of the company can retain control over the company by issuing preference shares. Companies thus have flexibility in choice. 5. 2. there is the advantage that the amount can be repaid as soon as the company is in possession of funds flowing out of profits. Usually preference shares carry higher rate of dividend than the rate of interest on debentures. a taxdeductible expense. In the case of redeemable preference shares. 10. Additional equity base increases the ability of the company to borrow in future. unlike equity shares. It is a permanent burden on the profits of the company. 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. Compared to debt capital. debenture holders will not accept them as collateral securities. Demerits of Preference Shares 1. 7. 2. Hence the company prefers to tap market with preference shares. arrears of dividend accumulate. 281 .Merits of Preference shares 1. Preference shares are particularly useful for those investors who want higher rate of return with comparatively lower risk. since the preference shareholders have only limited voting rights. Preference shares add to the equity base of the company and they strengthen the financial position of it. 3. 4. 6. unlike debt interest.

Unsecured debentures 5. Not even 1% of total corporate capital is raised in this form. Redeemable debentures 282 . 6. They are also entitled to redemption of their capital as per the terms. Instead of combining the benefits of equity and debt. Types of debentures Debentures can be various types. Debentures are instruments for raising longterm debt capital. according to the Companies Act. It is an acknowledgement of the company¶s indebtedness to its debenture-holders. In India. perhaps combines the benefits of equity and debt. Preference shares have to attraction. 1956. Under section 117 of the companies Act. From the investor¶s point of view. Debentures 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.4. Usually debentures are secured by charge on or mortgage of the assets of the company. the term debenture includes "debenture stock. They are: 1. 1956. 5. Their interest may be damaged by equity shareholders in whose hands the control is vested. Registered debentures 2. Debenture holders are the creditors of the company. debentures with voting rights cannot be issued. Secured debentures 4. 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. preference shares may be disadvantageous because they do not carry voting rights. No voting rights are given to debentureholders. preference share capital. Bearer debentures or unregistered debentures 3.

Registered debentures are not transferable by mere delivery.6. They are transferable by mere delivery and registration of transfer is not necessary. value and types of debentures held by the debenture-holders. Partly convertible debentures 10. Bearer or Unregistered debentures: The debentures which are payable to the bearer are called bearer debentures. Non-convertible debentures 9. which do not have charge on the assets of the company. Bearer debentures are negotiable. Fully convertible debentures 8. Fixed rate debentures 14. Legal debentures 12. Zero coupon debentures 16. 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. Equitable debentures 11. Registered debentures are not negotiable. Unsecured debentures: Unsecured debentures are those. Irredeemable debentures 7. Secured debentures: 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. Transfer of ownership of these types of debentures cannot be valid unless the regular instrument of transfer is sanctioned by the Directors. The names of the debenture-holders are not recorded in the register of debenture-holders. Foreign currency convertible debentures Registered debentures: Registered debentures are recorded in a register of debenture-holders with full details about the number. 283 . Floating rate debentures 15. Preferred debentures 13.

Fully convertible debentures: Convertible debentures can be converted into equity shares of the company as per the terms of their issue. LIBOR etc. Preferred debentures: Preferred debentures are those which are paid first in the L time of winding up of the company. 284 . one time be payment) or periodic repayment debentures. 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. Irredeemable debentures can be redeemed in the event of the company¶s winding up. security for the loans. They are al known as perpetual debentures.Redeemable debentures: The debentures which are repayable after a certain period are called redeemable debentures. Floating rate debentures: Floating rate debentures carry floating interest rate coupons. Non±convertible debentures: Non-convertible debentures are not convertible They remain as debt capital instruments. Partly convertible debentures: Partly convertible debentures appeal to investors who want the benefits of convertibility and non-convertibility in one instrument. Legal Debentures: Legal debentures are those in which the legal ownership of property of the corporation is transferred by a deed to the debenture holders. The debentures have priority over other debentures Fixed rate debentures: Fixed rate debentures carry a fixed rate of interest Now a days this class is not desired by both investors and issuing institutions.e. The rates float over some benchmark rates like bank rate. Redeemable debentures may be bullet repayment debentures (i. Equitable debentures: Equitable debentures are those which are secured by deposit of title deeds of the property with a memorandum in writing to create a charge. Irredeemable debentures: The debentures which are not repayable during lifetime of the company are called irredeemable debentures.

6. Hence. 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. The burden of servicing debentures. 3. Interest on these is paid on maturity called as deep-discount debentures. Failure to meet these payment jeopardizes the solvency of the firm. 4. ADR or plain equity. Merits of debentures 1. Later these are converted into equity. either GDR. Debentures provide funds to the company for a long period without diluting its control. In a period of rising prices. 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. 7. Debentures are suitable to the investors who are cautious and who particularly prefer a stable rate of return with no risk. Debentures provide funds to the company for a specific period. debenture issue is advantageous. since debenture holders are not entitled to vote. 2. Since debentures are generally issued on redeemable basis. 285 . 5. Even institutional investors prefer debentures for this reason. the company can avoid overcapitalisation by refunding the debt when the financial needs are no longer felt. Foreign Currency convertible debentures: Foreign currency convertible debentures are issued in overseas market in the currency of the country where the flotation takes place. the company can appropriately adjust its financial plan to suit its requirements. decreases in real terms as the price level increases.Zero-coupon debentures: Zero-coupon debentures are merest coupons. Demerits of Debentures 1. which entail a fixed monetary commitment for interest and principal repayment. The post-tax cost of debt is thus lowered. Debenture interest and capital repayment are obligatory payments.

4.2. vi. Generally a company cannot buy its own shares but it can buy its own debentures. Debenture financing enhances the financial risk associated with the firm. Convertible Issues 286 . In case of such company raising funds through debentures. iv. may lead to considerable fluctuations in the rate of dividend payable to the equity shareholders. It becomes a great burden on the finances of the company. v. Debentures are particularly not suitable for companies whose earnings fluctuate considerably. since they do not have voting rights. iii. Debentures offer variety and in dull market conditions only debentures help gaining access to capital market. Interest on debentures is allowed as a business expense and it is tax. This may increase the cost of equity capital. Debenture financing is cheaper since the rate of interest payable on it is lower than the dividend rate of preference shares. (iv) if debt capacity is low and (v) dilution of control isn¶t a problem or does not rise. 5. ii. interest has to be paid to the debenture holders irrespective of the fact whether the company earns profit or not. A company may prefer debenture financing compared to equity shares financing for the following reasons: i. In the case of debentures.deductible. Debentures can be redeemed in case the company does not need the funds raised through this source. (iii) if financial risk perception is high. (ii) if equity is preferred by the market forces. This is done by placing call option in the debentures. Financing Through Equity Shares and Debentures Comparison A company may prefer equity finance (i) if long gestation period is involved. Generally the debenture-holders cannot interfere in the management of the company. 3. 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.

the stock cannot be estranged again for bonds or preferred stock. the convertible security will be priced higher than its conversion value. Issue of convertible preference shares and convertible debentures are called convertible issues. The convertible debentures are not likely to have a good investment appeal.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. 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. are called convertible preference shares. By convertible debentures. In addition. 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. The difference between the issue price and the conversion value is known as conversion premium. Convertible debentures: Convertible debentures provide an option to their holders to convert them into equity shares during a specified period at a particular price. but market wants equity. as the rate of interest for convertible debentures is lesser than the non-convertible debentures. At the time of issue. 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. Convertible preference shares: The preference shares which carry the right of conversion into equity shares within a specified period. a company 287 . being a residual claimant of the company. convertible issues add sweeteners to sell debt securities to the market which want equity issues. 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. Significance of convertible issues: The convertible security provides the investor with a fixed return from a bond (debenture) or with a specified dividend from preferred stock (preference shares). Once converted into common stock. The issue of convertible preference shares must be duly authorized by the articles of association of the company. So. The convertible preference shares and convertible debentures are converted into equity shares.

preference shares or debentures/bonds. the company gets a tax advantage. Rights issues and Bonus issues.. the company goes on promoting the issue. From the investors¶ point of view. When there is over-subscription a part of the excess subscription. A private company cannot adopt this route to raise capital. may be equity shares. In the western countries such kind of promoting the issue is called µroad-show¶. So. can be retained and allotment proceeded with. for every 200 share applied 100 shares allotted) may be adopted. If the public applies for more than the number of shares/debentures offered. i. When there is over-subscription. Let us briefly explain these different modes of issues. Public Issues Only public limited companies can adopt this issue when it wants to raise capital from the general public.e. Otherwise.e. shares and debentures can be issued to the market by adopting any of the four modes: Public issues. Private placement. Prior to issue of shares/debentures and until the subscription list is open. the situation is called over subscription. namely. Different Modes of Capital Issues Capital instruments. This is called as green-shoe option. i. usually upto 15% of the offer. say when there is 200% subscription. For good companies coupled with better market conditions. over ²subscription results. A company must receive subscription for at least 95% of the shares/bonds offered within the specified days. Convinced public apply to the company for specified number of shares/debentures paying the application money. The prospectus shall give an account of the prospects of investment in the company. 288 . till the debentures are converted. the issue has to be scrapped.gets relatively cheaper financial resource for business growth. Debenture interest constitutes tax deductible expenses. 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. In under subscription public subscribes for less number of shares/debentures offered by the company.. convertible debentures prove an ideal combination of high yield. low risk and potential capital appreciation. money payable at the time of application for the shares/debentures usually 20 to 30% of the issue price of the shares/debentures. pro-rata allotment (proportionate basis allotment.

from securities regulatory bodies (SEI3J in Indian. Usually the company co-opts authorities from stock-exchange where listing is done. General public¶s savings directed into corporate investment. Public issues enable broad-based share-holding. to enable the company to issue additional capital to public. partially or fully. And good price for the share¶ and competitive interest rate on debentures are quite possible. where at any time after the expiry of two years from the formation of a company. 1956. company and individual investors benefit. in finalizing mode of allotment. Gentrally the Articles or Memorandum of Association of the Company gives the right to existing shareholders to participate in the new equity issues of the company. are holders of the equity shares of the company. the shareholders may by a special resolution forfeit this right. Thus the existing shareholders have a pre-emptive right to subscribe to 289 . SEC in USA and so on) etc. The company management does not face the challenge of dilution of control over the affairs of the company. This is required in India under section 81 of the Companies Act. fill scale allotment for some applicants and nil allotment for rest of applicants can also be followed. whichever is earlier. or at any time after the expiry of one year from the allotment of shares being made for the first lime after its formation. Under section 81 of the Companies Act 1956. then such further shares shall be offered to the persons who. pro-rata allotment for some applicants. This right is known as µpre-emptive right¶ and such offered shares are called µRight shares¶ or µRight issue¶. Economy. it has to be offered in the first instance to the existing shareholders on a pro-rata basis. it is proposed to increase the subscribed capital of the company by allotment of further shares.Alternatively. to the capital paid on those shares at that date. at the date of the offer. in proportion as nearly as circumstances admit. When a company issues additional share capital. However. Right Shares Whenever an existing company wants to issue new equity shares. the existing shareholders will be potential buyers of these shares. A right issue involves selling securities in the primary market by issuing rights to the existing shareholders.

3. The holder of rights can sell them fully or partially. ensure the following: 1. Rights can be exercised only during a fixed period which is usually less than thirty days. The price of rights issues is generally quite lower than market price and that a capital gain is quite certain for the share holders. Rights are negotiable. A company shall.the new issues made by a company. The number rights required to subscribe to an additional share is determined by the issuing company. 7. The number of rights that a shareholder gets is equal to the number of shares held by him. 4. Reserves created by revaluation of fixed assets are not capitalized 3. All contingent liabilities disclosed in the audited accounts which have bearing on the net profits. Significance of rights issue 1. Bonus Issues Bonus issues are capital issues by companies to existing shareholders whereby no fresh capital is raised but capitalization of accumulated earnings is done. 2. 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. 290 . 5. 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. The shares capital increases. Rights issue gives the existing shareholders an opportunity for the protection of their prorata share in the earning and surplus of the company. 2. so that his interest in the company is not diluted. The bonus issue is made out of free reserves built out of the genuine profits and shares premium collected in cash only. There is more certainty of the shares being sold to the existing shareholders. 4. shall be taken into account in the calculation of the residual reserve. but accumulated earnings fall. 6. The development rebate reserves or the investment allowance reserve is considered as free reserve for the purpose of calculation of residual reserves only. while issuing bonus shares.

The 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. 12. Consequent to the issue of bonus shares if the subscribed and paid-up capital exceed the authorized share capital. convertible fully or partly. The residual reserves after the proposed capitalisation shall be at least 40 per cent of the increased paid up capital. are made fully paid-up. 6. The bonus issue is not made unless the partly paid shares. etc.5. 15. The declaration of bonus issue. and if not the company shall pass a resolution at its general body meeting making decisions in the Articles of Association for capitalisation. Sebi General Guidelines for Public Issues 291 . gratuity or bonus. in lieu of dividend is not made. 8. The 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. 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. 14. if any existing. 13. A 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. 9. 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 issues. 10. 7. a resolution shall be passed by the company at its general body meeting for increasing the authorized capital. There should be a provision in the Articles of Association of the Company for capitalisation of reserves. No bonus shall be made which will dilute the value or rights of the holders of debentures. 11.

Rights issues shall not be kept open for more than 60 days. whether through a right or public issue. Discuss the features of preference shares and evaluate preference share capital from the company¶s point of view. The provisions in the Companies Act. except the special case of exercise of green-shoe option. Rights and Indian public should not exceed 30 days. Subscription list for public issues should be kept open for at least 3 working days and disclosed in the prospectus. enhance the quality of disclosures and to bring about transparency in the primary market. 2. Have you understood? 1. The gap between the closure dates of various issues eg. Critically evaluate equity shares a source of finance both the point of (i) the company and (ii) investing public. SEBI will have right to prescribe further guidelines for modifying the existing norms to bring about adequate investor protection. Define µdebenture¶ and bring out its salient features as an instrument of corporate financing. 8. 3. 292 . 5.. No retention of over subscription is permissible under any circumstances. 3.1. 2. SEBI shall have right to issue necessary clarification to these guidelines to remove any difficulty in its implementation. What are right shares? Explain the significance of the same from the company¶s and investors¶ view point. 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. 4. shall not exceed the amount specified in the prospectus/letter of offer. 5. 4. 7. 1956 and other applicable laws shall be complied in connection with the issue of shares and debentures. Any violation of the guidelines by the issuers/intermediaries will be punishable by prosecution by SEBI under the SEBI Act 9. 6. The quantum of issue. Discuss the sources of long-term finance of a company.

where necessary 2.6. wherever necessary 3. What are the advantages and disadvantages of debenture finance to a company? 8. SECTION TITLE Essential Requirements: The essential requirements insisted upon by the financial institutions before taking up a request for financial assistance for consideration are: 1. merits and demerits of public deposits The regulations of RBI regarding public deposits. The applicant concerned include the following should have obtained industrial license or should have made some kind of commitment. The applicant should have obtained/applied for permission of the Securities and Exchange Board of India to issue capital. 7. The applicant should have obtained the approval of the Government regarding the terms of technical and/or financial collaboration agreement. Explain the different types of debentures that may be issued by a company. 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. Lesson 3 Lending Procedures of the Term Lending Financial Institutions INTRODUCTION Under this head we shall see the lending procedure practiced by long-term finance Learning Objectives After reading this lesson. 293 . List out the SEBI guidelines for issuing bonus shares. if any.

skilled and unskilled labour and in relation to the market to be served by the product/service. power.Technical Appraisal The technical appraisal of the project involves a critical analysis of the following: 1. Whether the process proposed for selection is technically sound up-to-date etc. financial. 8. Another important feature of technical appraisal relates to the technology to be adopted for the project. economic. The applicant should have a clearance from the Capital Goods Committee in respect of the machinery proposed to be imported 5. Adequacy of the plant and machinery and their specifications 4. Provision for the disposal of factory effluents and utilisation of byproducts if any. The applicant should have selected a site for the location of the factory and has prepared a detailed µproject report¶. water. transport. attention is to be paid to the terms and conditions. if necessary 6. 7. Feasibility of the selected technical project and its suitability in Indian conditions. Availability of skilled and unskilled labour and arrangements for training for the labourers. 2.4.Economic Appraisal 294 . the project is appraised by a team of technical. Appraisal by Financial Institution: 1. Adequacy of the plant layout 5. financial and economic officers of the Corporation from several angles ² technical. Location of the project in relation to the sources and availability of inputs ² raw materials. 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. managerial and social. In case of new technical processes adopted from abroad. Arrangements for securing technical know-how. 3. 2.

Projects break-even level of operation and time required to reach that level of operation. if any. abandonment value at the end of different levels of milestones or years of operation. A critical study of the existing and future demand for the products proposed to be manufactured. in regard to production. 2. 5. 7. payback period. the level of competition etc. 3. Financial plan with reference to capital structure. Consideration of natural and industrial property of the project and contribution to the national economy of the country in terms of contribution to GDP. Crucial examination of the investments made outside the business and justification therefore. the licensed and installed capacity. Employment potential. Projections of cash flow.The economic appraisal of a project involves: 1. promoter¶s contribution. debt-service coverage and projected dividends on share capital. 4. both during the construction and the operation periods. 4. 5. Savings in foreign exchange or prospects of exports. 3. 1.Managerial Appraisal 295 . down stream and upstream projects. Scrutiny of the project in relation to the import and export policies of the Government and various other factors like regulatory controls. Internal rate of return. 6. direct and indirect 4.Financial Appraisal 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. Estimation of future profitability in the light of competition and product service obsolescence. Estimated cost of the project 2. debt-equity ratio and the availability of other resources. 3. prices and raw materials.

effectiveness and excellence of the project. integrity and resourcefulness of the management are well established. The social benefits are more. 296 . The borrower (applicant) has to obtain all relevant Government clearances such as licensing.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. import license. 2. 5. etc. projects located in totally less developed areas and projects that stimulated small scale industries are considered to serve the society well. which provide large employment opportunities and canalize the income of the agricultural sector for productive use. the borrower etc. it has been remarked that appraisal of management is the touch stone of term credit analysis. administrative ability. 5. is also to be weighed. the borrower has to satisfy all the institutions participating in lending 3. The expertise. experience and earnestness of the management tells in the efficiency. As long as the loan is outstanding. 4. The projects. clearance from pollution control board. Therefore. Conditions for Assistance from Financial Institutions Different financial institutions stipulate different kinds of conditions depending on the nature of the project. the loan application gets the most favourable consideration. The social cost of pollution consumption of scarce resources. The main conditions of a term loan are as follows: 1. Where the technical competence. The term loan agreement may stipulate the debt-equity ratio to be followed by the company.Social Appraisal The social objectives of the project are considered keeping in view the interest of the general public. etc. For consortium loan. Concurrence of the financial institution is necessary for repayment of any existing loan or long-term liabilities. capital goods clearance for imported machines. the declaration of dividend is made subject to the institution¶s approval.

The term lending institution reserves the right to nominate one or more directors in the management of the company. consultancy. many companies were not getting as much money in the 1980s as they are used to getting in the past. the fixed deposits from the public are unsecured. The credit available to companies through public deposits is not affected by such consideration. The financial institutions may appoint suitable personnel in the areas of marketing. the availability and volume of bank credit are restricted by considerations of margin. the cost of deposits to the company is less than the cost of borrowings from bank. 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. 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. So. 7. While to the depositor the rate offered is higher than that offered by banks. The promoters cannot dispose their shareholders without the consent of the lending institutions. collaboration agreement. Moreover. selling agency agreement etc. the borrowing company need not mortgage or 297 . and further expansion need the concurrence of the term lending institution. Once the loan agreement is signed. depending upon the nature of the project. 9. 8. from the banks. any major commercial agreements such as orders for equipment. security offered. 10. research and development. Of these the more important one are the deposits accepted by trading and manufacturing companies. This is stipulated for keeping the promoters involved as long as the institutions are involved in the business.6. public deposits are a major source of finance to meet the working capital needs. public deposits came handy as working capital funds for the businesses. Puplic Deposits Deposits with companies have come into prominence in r cent years. There is no problem of margin or security. The growth of public deposits has been considerable. Since. From the company¶s point of view. periodical submission of statements etc. The borrower is not permitted to create any additional charge on the assets without the knowledge of the financial institutions. restricting credit.

Public deposit is a less costly method for raising short-term as well as medium term funds required by the companies. Merits of Public Deposits The merits of public deposits are as follows: 1. 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 298 . ii. This mode of financing. 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. These deposits are available for comparatively longer terms than bank credit. There is no need of creation of any charge against any of the assets of the company for raising funds through public deposits. depositors have no assurance of getting their money back. Public deposits are unsecured deposits and in the event of a failure of the company. sometimes. Demerits of Public Deposits The main demerits of the public deposits are as follows: i. puts the company into serious financial difficulties. 4. iii. Easy availability of fund encourages lavish spending. No questions are asked about the uses of public deposits. 2. 5. because of less restrictive covenants governing this as against bank credits. Tax leverage is available as interest on public deposits is a charge on revenue.hypothecate any of its assets to raise loans in this form. 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. RBI Regulations for Public Deposit The RBI regulation of public deposits has six main aspects: i. 3.

Similarly. But the 1973 amendment reduced the period to less than 6 months. Formerly. The Reserve Bank has made obligatory on the part of the companies accepting deposits to regularly file the returns. etc. 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. their repayment. respectively. giving detailed information about them. iv. of the paid-up capital and free reserves. 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 25 per cent. The second aspect of the Reserve Bank¶s regulation is the limit on the period of such deposit.can lead a company into financial difficulties. Now such advertisements would be illegal and attract penal provision prescribed in this behalf. companies were prohibited from accepting deposits for a period of less than 12 months. certain specified information regarding the financial position and the working of the company must accompany. 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". In the beginning the definition of deposits was quite narrow and excluded unsecured loans accepted from the public and guaranteed by the directors. 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. 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. 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. ii. The Reserve Bank has stipulated that while issuing newspaper advertisements (or even the application forms) soliciting such deposits. in order to avoid direct competition with short-term public deposits. so that the Reserve Bank can verify whether the companies adhere to the restrictions. 299 . iii.

The success of any organization mainly depends on how well financial resources are being used.V. Nationalization of commercial bank. From 1970 on wards an uninterrupted rise in the industrial. 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. 2. to carry out their regular activities to achieve their objectives. Later FERA Act. 1973. high inflationary pressures and set back in industrial and finance sector. In the early 60s both primary and secondary market were functioning on traditional basis and were inactive and unorganised. it is considered as lifeblood of economic activities. 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. Explain the types of appraisal to be made in sanctioning project finance. What do you mean by Public Deposits? Explain their merits and But during the 90s the country faced severe balance of payments crisis. Have you understood? 1. finance is defined as the provision of money at the time when it is required. establishment of IDBI have contributed greatly to the growth of primary and secondary markets. In the year 1991. Finance is required for all types of project and non-profit organizations. agricultural and service sector growth was found. Hence. Sri P. Lesson 4 Venture capital Financing INTRODUCTION In present day economy. The financial services in India have undergone drastic changes in the last 50 years. 300 . The same trend continued even in the 80s. The Reserve Bank has issued a broad "RBI Directives on Company Deposit in order to clarify its role in protecting the depositors. This led to the introduction of different types of financial instruments in the market.

This resulted in the witnessing of new financial instruments in the market Viz.Liberalization in industrial licensing. 301 . All these attracted the financial sector. Competitive financial market was created focusing on needs of customers. Leasing. SECTION TITLE Definition Venture Capital 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. Technology in banks and customer service have improved.. Hire-purchase Factoring. Forfeiting. Learning objectives On going through this lesson. Venture capital etc. New financial products were introduced.. foreign technology agreements. 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 Guidelines on venture funds capital Present scenario of venture capital financing The new financial instrument µVenture Capital¶ is discussed in detail. Global Depository Receipts. disinvestment of public sector units and MRTP Act amendments were introduced. foreign investment. The new import and export policy brought series of changes in the economic environment. Both primary and secondary markets started functioning as per the requirements of the market.

Risk is associated with such capital investment and as such it is termed as venture capital. Hence. Generally. Equity investment enables the investor to the investment into cash when required. venture capital implies an investment in the form of equity for high risk projects with the expectation of higher returns. Venture Economics. warrants. editor of the well known industry publication. The 1995 Finance Bill. The risk associated with the enterprise could be so high as to entail total loss or be so insignificant as to lead high gains. 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. The European venture capital association describes it as risk finance for entrepreneurial growth oriented companies. Steven James Lee. It is investment for the medium or long-term seeking to maximize medium or long-term return for both parties. 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. High technology industry is more attractive to venture 302 . the investment is made in the form of equity with the prime objective being capital gains as the business prospers. Capital investment may assume the form of either equity or debt or both as a derivative instrument. which carries elements of risk and insecurity and the probability of business hazards. defines Venture capital as long-term equity investment in novel technology. defines Venture capital as µproviding seed. based projects which display potential for significant growth and financial returns. The investment is made through the private placement with the expectation of risk of total loss or huge returris. 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". Meaning Venture Capital means many things to many people Jane Koloski Morris. defines it as actual or potential equity investments in companies through the purchase of stock.The term µVenture Capital¶ refers to capital investment made in a business or industrial enterprise. options or convertible securities.

venture capital investor normally discusses the investment plan for the project with the banker. with his know how prepares a project report establishing there in the possibility of marketing a commercial product. During this stage close net work is expected from the management team. professional or a merchant banker. to implement the project. project under venture capital has following steps. Characteristic Features · Investments are made in equity in high tech. Detailed Approval: In addition to the close discussion with the management team. Establishment of contact between the entrepreneur and the venture capitalist: The Prospective entrepreneur. · Venture capital funds need not be repaid in the course of business units. Techno-economic feasibility will be examined by involving 303 . The business consists of five important feasibility reports namely. 2. Preliminary Evaluation: After the preliminary evaluation of the report is completed. · Venture capital investor does not interfere in the day-to-day business affairs but closely watch the performance of the business unit. Industry and wait for 5. They are: 1. Venture Capital Investment Process Financing of a High tech. The formal application in duplicate will be submitted to venture capital investor. Technical. Financial. This can be done with the help of auditor.7 years to reap the benefit of capital gains.. (stock exchange). 3. Marketing and Socio-economic feasibility. but they are realised through exist route. The main object of investing equity is to get high capital profits at saturation because of high returns. · 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. a detailed appraléal of project is undertaken. Managerial.

4. They may µbe in the form of: 1. project in the form of venture capital financing is done in several stages. As the technocrat is well versed only with know how and not 304 . Sensitivity analysis helps the evaluators to predict the probable risks and returns associated with the project. Monitoring the Project and post investment support: The venture capitalist role begins with financing the project.. Stages of Venture Capital Financing The financing of high-tech. Investment in the project: The terms and conditions of venture capital assistance will be finalised according to the requirement of the project. The executive director assists the project in developing strategies. The risks and threats will be evaluated by using sensitivity analysis. decision-making and planning. The process of interaction with the technocrat increases the healthy environment in carrying the day-to-day business affairs. Early-stage financing 2. It is a general practice of the Investor to appoint an executive director to have closer look in to the project.the executives of the Venture capital Investor and the management professional. The amount of funds required. 5. Later stage financing (1) Early-stage financing This stage of financing is done to the new project or to the new technocrat who wishes to commercialize his research talents. profile of the business. A formal agreement is entered between the technocrat and investor stating therein the role of and share of management in the new project. This formally clears the project for investment. If required they may even consult the experts In the similar field to take a decision. the life time technology and the possible competition in the business will be looked into. 6. Sensitivity Analysis: The Forecasted results of sales and profits are tested and analysed.

At 305 .with capital. unsecured loans and optionally convertible securities. venture capitalists assists the firm in general administrative activities and allow the technocrat to concentrate on production and marketing. 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. Hence. other means of financing. it requires more time in getting different elements ie. The total investment required commercializing the product and time required to get suitable returns etc. This stage is not simple to execute. The main instruments used for such financial assistance would be in the form of equity contribution.. This stage of venture capital financing consists of seed capital. This stage requires more time to complete the process. In. All these components are very essentially needed to launch the product effectively. (patent rights. going for debt at this stage increases the risk of entrepreneur and affect the health of the business unit.. trade marks. (b) Start-up stage financing: At this stage innovator requires finance to commercialize the product. starting from all initial conceptual stage. start-ups and second round financing. (c) Second round of financing: This type of financing is required when the project incurs loss or inability to yield sufficient profits. it is not advisable for young entrepreneurs to go in for such loans. Because the entrepreneur made an effort to the maximum to meet the market potentiality. (a) Seed capital: Seed capital financing includes the implementation of research project. Therefore. Therefore external equity in preferred. venture capital investor evaluates the projects carefully and negotiate the terms and conditions with the entrepreneur with regard to sharing the management. the research must also be done to evaluate the probable opportunities to exploit the market. On the other hand. design and copy rights) which are very essential to bring the product in the market. The reasons could be due to internal or external factors. possible threats of new technology in the near future. the obligation to repay the loans along with interest starts immediately with lending. The key factors that influence equity financing at this stage are: The technology used in the project. Once the financing is done. Hence. Different aspects of the product life cycle. time and finance is needed.

management buy out and turn around capital. Lot of bargaining has be done to coordinate the financing with original investor and with the technocrat or promoter. If the company is unlisted. (2) Later Stage Financing Later stage financing is considered to be the easy means of assistance. the product launched has not only reached the boom period but also indicator further expansion and growth. the promoter may prefer to buy the entire equity stake of the project by approaching some other financiers. Replacement capital) is normally preferred at the time of public issues. This means of is also known as expansion finance. 306 . In management buy out. venture capitalist help the management of a company to buy or take over the ownership of the business. Hence it is a easy means of financing with low risk profile. (a) Expansion finance: Later stage financing is executed to expand the market. (b) Replacement capital): Under this stage. he should decide on second round financing. production or to establish warehouses etc. He may also wish to increase his holding by buying more number of equity shares. if the venture capitalists is fully aware of the genuine reasons for the loss.. getting capital gains on the fresh issues needs more time. 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. µManagement buy out¶ or µManagement buy int.this stage. This would help the management to reshuffle or reengineer the entire project. The reason being. or he may seek the support of new investor. (c) Management Buy out (MBO): This may be offered in two ways namely. Export trade activities may also be considered for financing the project. replacement capital. 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. tilt then replacement capital can be obtained in the form of convertible preference shares from the second financier.

This means of financing is risky in nature and the investor may ask for major changes in the management. provides Rs. TDIC uses the funds for venture capital which is supplied by UTI and ICICI. Types of Venture Capital Organizations On the basis of ownership. The investor in such contribution expects huge capital gains. (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. All these venture capital investors perform their activities independently. 25. 1DBI used captive funds to assist venture capital. This means of financing is less risky. To avail such benefits the product innovated should be of national importance. Independent Venture Capital Funds: All these funds are raised by group individuals venture capitalists. management and rising of funds. RCTC used the funds of UTI and IFCI. 307 . In India. rather than regular income of dividends. The assistance will be given to promoter at the initial stages to complete research and developmental activities.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 Karnataka Council of Technological upgradation scheme. (d) Rescue Capital: 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. outsides prefers to buy the existing business. venture capital organization are categorised on the following groups: Captive Venture Capital Funds: These organizations are wholly owned by financial institutions and are operated as subsidiaries.g.In management buy in strategies.. venture capital financing for MBO and turnout are rarely seen. These funds are close-ended with minimum capital base and equity oriented instruments. as the majority of the investor prefers to invest only in later stages. The amount invested in the project will be realised through the exist route.) Government Funds: These venture capital organizations are wholly owned by the government. The parental institutions supply funds for venture capital assistance e. Government of Karnataka through the Central Government scheme. it is not considered as venture capital and has wide criticism.

The main benefit of going public increases the liquidity of the business firm.Exit Route of Venture Capital 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. its social responsibility 308 . The public issues provides another opportunity for the business firm to list its shares in the stock market. The exit route will be well thought by the investor at the stage of marking investments. The expenditure incurred during the course of the issue in also substantially high. it could be done easily through the public issue. this could be a sales threat with the global competition. The main motto of venture capitalist is find exit at µmaximum profit or if it is unavoidable with µminimum loss¶. The company must also disclose part a considerable ar1t of information at the time of issuing the shares. Exit means realization of investment through the issue of equity shares to the public. This liquidity will increase the percentage returns over the private placements. However. They are: Going public Sale of shares to entrepreneurs Sale of the company to another company Finding a new investor Liquidation (a) Going Public: Most of the venture capital assisted firms prefers to go in for public issue to recover their investments with profits. which may affect the profitability. going public is not an easy route to exit or venture capital assisted units because. Once the shares are listed. There are alternative routes of disinvestment practiced in a real life situation. it has to observes several legal for¶ of stock exchange. If the firm wishes to raise additional capital for expansion and growth. This process not only help the entrepreneur but also the investor in different ways. (If it were sold through private placements). it increases and attracts efficient persons to work in the organization. it increases the image of the organization. the commercial banks and financial institutors will forward to offer different types of loans. As the company is going for public issue. In addition to this. In addition to this. Employees may ask for better comfort with huge hike in the salaries and perks.

Hence it is considered to be a better method when compared to PIE ratio and percentage on sales method. assisted may be done as several methods.T. 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.. an entrepreneur himself prefers to buy the entire shares. the value of the business is determined by multiplying the cash flow of the business by a multiplies which is similar to the industry.C. the total average sale of the industry is taken into consideration.increases and they have to be accountable to all the organs of the society. (iii) Percentage of sales method: 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. C. If the sales figures are highly volatile. percentage of sale method is used. He may purchase the shares with a view of entering in to the primary market at the later stage. Viz. In certain circumstances. If necessary. the price is fixed on the basis of book value method or a predetermined multiple applied to determine the book value (ii) Price-earning ratio: This method is widely in practice. On such circumstance. (b) Sale of shares to entrepreneur: Some times. 309 . which burdens the financial affairs of the company. Over The Counter Exchange by entering into bought out deals with the member of O. (iv) Multiple of cash flow method: According to this method. (i) Book value method: According to this method. The price at which the stake of the V. The price of the share is determined as the basis of multiplying the price earning ratio to earning per share. promoter may prefers to have exit route through. the entrepreneur may approach financial institutions for loans. With all these demerits or bottlenecks going public for exit route is widely used in seal life situations.

Define the term µVenture Capital¶ 2. 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. 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 (e) Liquidation: This is a lender of last resort. poor management by the entrepreneur etc.. stiff competition. venture capitalist and the entrepreneur decides to close down the operations. The modalities of such a sale will be made on the basis of level of operations and. This is a traditional and simple method. Explain the process Venture Capital investment.(v) Independent Valuation: Sometimes. Hence.. He may find it difficult to operate the business profitably. HAVE YOU UNDERSTOOD? 1. At the time of managerial difficulties he may search for a new company which is having similar line of business. The reason for such a exercises would be many viz. (Realisable value) (vi) Agreed to this method: Venture capitalist and the entrepreneur follow the price that was determined mutually at the time of launching business. which may be acceptable to both the parties. The reasons could be many viz. What is early stage financing? Explain. 3. (d) Finding a new investor: Under this method. it takes the firm to liquidation. in other words if it incurs continuous cash loss over the years. the entrepreneurs may prefer to undertake some other new company. the nature of venture. 310 . technological failure. venture capitalist and the entrepreneur may agree together to sell the business unit to some other company. Mention the different characteristic features of Venture Capital 4.. (c) Sale of a company to another company: On many occasions. when a firm performs very badly.

311 . What is later stage financing? Explain.5.

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