Undergraduate Course: University of Madras

SUBA201
UNDERGRADUATE COURSE
B.B.A.
BUSINESS ADMINISTRATION
SECOND YEAR
THIRD SEMESTER
CORE PAPER - V
FINANCIAL MANAGEMENT
INSTITUTE OF DISTANCE EDUCATION

UNIVERSITY OF MADRAS
B.B.A PAPER - V
SECOND YEAR - THIRD SEMESTER FINANCIAL MANAGEMENT
WELCOME
Warm Greetings.
It is with a great pleasure to welcome you as a student of Institute of Distance

Education, University of Madras. It is a proud moment for the Institute of Distance education
as you are entering into a cafeteria system of learning process as envisaged by the University
Grants Commission. Yes, we have framed and introduced Choice Based Credit
System(CBCS) in Semester pattern from the academic year 2018-19. You are free to
choose courses, as per the Regulations, to attain the target of total number of credits set
for each course and also each degree programme. What is a credit? To earn one credit in
a semester you have to spend 30 hours of learning process. Each course has a weightage
in terms of credits. Credits are assigned by taking into account of its level of subject content.
For instance, if one particular course or paper has 4 credits then you have to spend 120
hours of self-learning in a semester. You are advised to plan the strategy to devote hours of
self-study in the learning process. You will be assessed periodically by means of tests,
assignments and quizzes either in class room or laboratory or field work. In the case of PG
(UG), Continuous Internal Assessment for 20(25) percentage and End Semester University
Examination for 80 (75) percentage of the maximum score for a course / paper. The theory
paper in the end semester examination will bring out your various skills: namely basic
knowledge about subject, memory recall, application, analysis, comprehension and
descriptive writing. We will always have in mind while training you in conducting experiments,
analyzing the performance during laboratory work, and observing the outcomes to bring
out the truth from the experiment, and we measure these skills in the end semester
examination. You will be guided by well experienced faculty.
I invite you to join the CBCS in Semester System to gain rich knowledge leisurely at
your will and wish. Choose the right courses at right times so as to erect your flag of
success. We always encourage and enlighten to excel and empower. We are the cross
bearers to make you a torch bearer to have a bright future.
With best wishes from mind and heart,
DIRECTOR
(i)
B.B.A PAPER - V
SECOND YEAR - THIRD SEMESTER FINANCIAL MANAGEMENT
COURSE WRITER
Dr. S. Usha
Assistant Professor in Management Studies,
University of Madras
Chennai - 600 005.
COORDINATION AND EDITING
Dr. B. Devamaindhan
Associate Professor in Management Studies
Institute of Distance Education
University of Madras
Chennai - 600 005.
© UNIVERSITY OF MADRAS, CHENNAI 600 005.
(ii)
B.B.A.
SECOND YEAR
THIRD SEMESTER
Paper - V
SYLLABUS
UNIT I
Meaning, objectives and Importance of Finance – Sources of finance – Functions of financial

management – Role of financial manager in Financial Management.
UNIT II
Capital structures planning - Factors affecting capital structures – Determining Debt and
equity proportion – Theories of capital structures – Leverage concept.
UNIT III
Cost of capital – Cost of equity – cost of preference capital – Cost of debt – Cost of
retained earnings – weighted Average (or) composite cost of capital (WACC)
UNIT IV
Dividend policies – Factors affecting dividend payment - Company Law provision on

dividend payment –Various Dividend Models (Walter’s Gordon’s – M.M. Hypothesis)
(iii)
UNIT V
Working capital – components of working capital – working capital operating cycle – Factors
influencing working capital – Determining (or) Forecasting of working capital requirements.
Reference Books :
1. Financial Management - I.M. Pandey
2. Financial Management – Prasanna Chandra
3. Financial Management – S.N. Maheswari
4. Financial Management – Y. Khan and Jain
(v)
B.B.A.
SECOND YEAR
THIRD SEMESTER
Paper - V
SCHEME OF LESSONS
Sl.No. Title Page
1 Introduction 1
2 Finance Functions 12
3 Sources of Finance 20
4 Time Value of Money and Mathematics of Finance 36
5 Cost of Capital 44
6 Computation of Cost of Capital 50
7 Leverages 61
8 Capital Structures 70
9 Features of Capital Structure 83
10 Dividend and Dividend Policy 92
11 Working Capital Management 103
12 Cash Management 119
(vi)
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LESSON - 1
INTRODUCTION
Learning Objectives
After completing this lesson, you must be able to
 Provide the meaning of business finance and financial management
 Explain the nature and scope of financial management
 Discuss the importance and objectives of financial decision making
Structure
1.1 Introduction
1.2 Meaning and Definitions
1.3 Nature of Financial Management
1.4 Scope of Financial Management
1.5 Importance of Financial Management
1.6 Objectives of Financial Management
1.7 Summary
1.8 Keywords
1.9 Review Questions
1.1 Introduction
Finance is called the ‘life blood of business. Financial management is the science of
money management. Financial management deals with the efficient ways by which money
could be acquired and the efficient ways by which it could be used. It deals with the principles
and the methods of obtaining, control of money from those who have saved it, and of
administering it by those into whose control it passes. It is the process of conversion of
accumulated funds to productive use. It is that managerial activity which is concerned with
planning and controlling of the firm’s financial resources. In other words it is concerned with
acquiring, financing and managing assets to accomplish the overall goal of a business enterprise.
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Business finance
Business finance is that activity which is concerned with the acquisition and conservation
of capital funds in meeting the financial needs and overall objectives of a business enterprise.
Business Finance is the activity concerned with planning, organizing, raising, controlling
and administering of funds used in the business. Finance is called “The science of money”. It
studies the principles and the methods of obtaining, control of money from those who have
saved it, and of administering it by those into whose control it passes. It is the process of
conversion of accumulated funds to productive use.
Financial management is the science of money management .It is that managerial activity
which is concerned with planning and controlling of the firms financial resources. In other words
it is concerned with acquiring, financing and managing assets to accomplish the overall goal of
a business enterprise.
1.2 Meaning and Definitions

Financial management is that part of management activity which is concerned with the
planning and controlling of the firm’s financial resources. It is broadly concerned with the
acquisition and use of funds by a business firm.
Financial management is concerned with the efficient use of an important economic

resource namely capital fund. - Solomon
Financial management is concerned with the managerial decisions that result in the
acquisition and financing of long term and short term credits for the firm. Financial management
is that managerial activity which is concerned with the planning and controlling of the firm’s
financial resources. In other words it is concerned with acquiring, financing and managing
assets to accomplish the overall goal of a business enterprise (mainly to maximise the
shareholder’s wealth). “Financial management is concerned with the efficient use of an important
economic resource, namely capital funds” - Solomon Ezra & J. John Pringle.
“Financial management is the operational activity of a business that is responsible for

obtaining and effectively utilizing the funds necessary for efficient business operations”- J.L.
Massie.
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“Financial Management is concerned with managerial decisions that result in the acquisition
and financing of long-term and short-term credits of the firm. As such it deals with the situations
that require selection of specific assets (or combination of assets), the selection of specific
liability (or combination of liabilities) as well as the problem of size and growth of an enterprise.
The analysis of these decisions is based on the expected inflows and outflows of funds and
their effects upon managerial objectives”. - Phillippatus.
‘Financial Engineering’ The creation of new and improved financial products through
innovative design or repackaging of existing financial instruments. Financial engineers use
various mathematical tools in order to create new investment strategies. The new products
created by financial engineers can serve as solutions to problems or as ways to maximize
returns from potential investment opportunities.
1.3 Nature of Financial Management

 It is an indispensable organ of business management.
 Its function is different from accounting function.
 It is a centralized function.
 It is Helpful in decisions of top management.
 It is applicable to all types of concerns.
 It is related with different disciplines like economics, accounting, law, information,

technology, mathematics etc.
 It needs financial planning, control and follow-up.
1.4 Scope of Financial Management

The scope of financial management has undergone changes over the years. Until the
middle of this century, its scope was limited to procurement of funds. In the modern times, the
financial management includes besides procurement of funds, the three different kinds of decision
as well namely investment, financing and dividend.
1. Estimating financial requirements: Estimate short-term and long-term financial

requirements by preparing a financial plan for present and future.
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2. Deciding Capital structure: The capital structure refers to the kind and proportion
of different securities for raising funds.
3. Selecting a Source of Finance: Selecting appropriate source of finance from various

available sources i.e., share capital , debentures, financial institutions, commercial
banks, etc.
4. Selecting a pattern of Investment: It is concerned with the use of funds. The

funds has to be usually spent on fixed assets retaining a part for working capital.
5. Proper cash management: Assess various cash needs at different times
6. Implementing Financial Controls: Involves the use of various financial control

devices namely, Budgetary control, Ratio Analysis, Break Even Analysis, etc
7. Proper Use of Surpluses: A judicial use of surpluses is essential for maintaining

proper growth of profit.
Other areas include

 Estimating the total requirements of funds for a given period.
 Increasing the firm’s competitive financial strength in the market;
 Awareness to all the latest developments in the financial markets;
 Interfacing with the capital markets;
 Maximizing the wealth of the shareholders over the long term;
 Repaying lenders on due dates;
 Paying interest on borrowings;
 Ensuring a satisfactory return to all the stake holders;
 Managing funds and treasury operations;
 Collecting on time from debtors and paying to creditors on time;
 Funding day-to-day working capital requirements of business;
 Investing the funds in both long term as well as short term capital needs;
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 Cost effectiveness;
 Adhering to the requirements of corporate governance.
Financial management has undergone significant changes over years. In order to have
better exposition to these changes, it will be appropriate to study both the traditional approach
and modern approach to the finance function:
I. Traditional Approach
(1) Arrangement of funds from financial Institutions.
(2) Arrangement of funds through financial instruments, viz shares, bonds, etc.
(3) Looking after the legal and accounting relationship between a corporation and its
sources of funds.
As the traditional approach ignored the following aspects, such as
(1) Routine problems,
(2) Non corporate enterprises,
(3) Working capital financing,
(4) Allocation of funds, etc
So the modern approach was formulated.
II. Modern Approach
The finance manager has to arrange sufficient finances for meeting short -term and long
- term needs. These funds are procured at minimum costs so that profitability of the business is
maximized. According to this approach, a financial manager will have to concentrate on the
following areas of finance function. (Refer Figure 1.1)
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Finance Manager
Maximisation of
Share Value
Financial Decision
Funds Financing Investment Dividend

requirement Decision Decision Decision
Decision
Return Risk
Trade Off
Market
Value of
The Firm
Figure 1.1 Finance Function
Financial decisions
1. Funds requirement decision
This is the most important function performed by the finance manager. A careful estimate
has to be made about the total funds required by the enterprise taking into account both the
fixed and the working capital requirements. The estimations should be based on sound financial
principles and by forecasting the physical activities of the enterprise, so that neither there are
inadequate nor excess funds with the concern as both the cases will lead to serious problems.
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2. Financing decision
Provision of funds required at the proper time is one of the primary tasks of the finance
manager. Every business activity requires funds and hence every financial manager faces this
problem. He has to identify the sources from which the funds can be raised, the amount that
can be raised from each source and the cost and other consequences involved in raising it.
3. Investment decision
The decision related to various investments are taken by the finance manager after
evaluating the different capital investment proposals and select the best keeping in view the
overall objective of the enterprise. This would involve fixing the criteria for evaluating different
investment proposals, fixing priorities, committing funds for them, etc.,
The investment in the current assets will depend on the credit and inventory policies of
the enterprise. The credit policy is determined keeping in view the need of growth in sales, and
the availability of finance. Similarly, the inventory policy will be set up by taking into account the
requirements of production, the market trend of the price of the raw materials and the availability
of funds.
4. Dividend decision
The establishment of dividend policy is another important function of finance manager.

The dividend decision involves the determination of percentage of profits earned by the enterprise,
which is to be paid to its shareholders. Factors like the market price of the shares, the trend of
earnings, the tax position of the shareholders, etc plays an important role in the determination
of the dividend policy of a business enterprise.
Apart from the above areas the scope of finance manager also includes the following
1.5 Importance of Financial Management

It is indispensable in the organization as it helps in
1. Financial planning and successful promotion of an enterprise.
2. Acquisition of funds as and when required at the minimum possible cost.
3. Proper use and allocation of funds.

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4. Taking sound financial decisions
5. Improving the profitability through financial controls
6. Increasing the wealth of the investors and the nation
7. Promoting and mobilizing individual and corporate savings.
1.6 Objectives of Financial Management

Effective procurement and efficient use of finance lead to proper utilization of the finance
by the business concern. It is the essential part of the financial manager. Hence, the financial
manager must determine the basic objectives of the financial management. Objectives of
Financial Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.
Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional
and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize
the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible
ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows
the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favourable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the
business concern:
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(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.
Unfavourable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade
practice, etc.
(iii) Profit maximization objectives leads to inequalities among the stake holders such
as customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does not consider the time
value of money or the net present value of the cash inflow. It leads certain differences between
the actual cash inflow and net present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business concern.
Risks may be internal or external which will affect the overall operation of the business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations
and improvements in the field of the business concern. The term wealth means shareholder
wealth or the wealth of the persons those who are involved in the business concern. Wealth
maximization is also known as value maximization or net present worth maximization. This
objective is an universally accepted concept in the field of business.
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Favourable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated with
the business concern. Total value detected from the total cost incurred for the business operation.
It provides extract value of the business concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavourable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it may not
be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of
the profit maximization.
(iii)Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the profitable position of
the business concern.
On account of the above reasons, these days profit maximization is not considered to be
an ideal criterion for making investment and financing decisions. So, Wealth maximization is
the objective of the Financial management. Wealth is the difference between gross present net
worth and the amount of capital investment required to achieve the benefits.
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Other objectives:
 Ensuring a fair return to shareholders.
 Building up reserves for growth and expansion.
 Ensuring maximum operational efficiency by efficient and effective utilization of

finances.
 Ensuring financial discipline in the organization.
 Maintaining the liquidity position of the company.
1.7 Summary
Finance is the life blood of any business. It is the process of conversion of accumulated
funds to productive use. The meaning and definitions are also explained. The objectives and
scope of Financial Management discussed in this lesson.
1.8 Keywords
Business Finance
Finance
Financial Management
Capital Structure
Profit
Wealth

(1) Define the terms business finance and financial management.
(2) Explain the nature of financial management.
(3) What are the objectives of financial management?
(4) Discuss the major decisions taken by the finance manager.
(5) Explain the scope of financial management.

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LESSON - 2
FINANCE FUNCTIONS
Learning Objectives
After completing this lesson, you must be abl to
 Brief the relationship between financial management and other functional areas
 Explain the functions of a finance manager
Structure
2.1 Introduction
2.2 Financial Management and other Functional Areas
2.2.1 Financial Management and Economics
2.2.2 Financial Management and Accounting
2.2.3 Financial Management and Mathematics
2.2.4 Financial Management and Production Management
2.2.5 Financial Management and Marketing
2.2.6 Financial Management and Human Resource
2.3 Functions of a Finance Manager
2.3.1 Functions of Controller
2.3.2 Functions of Treasurer
2.3.3 Other Functions
2.4 Summary
2.5 Keywords
2.1 Introduction
In the previous lesson, the nature and scope of Financial Management was explained.
The objectives of Financial Management were listed out. The functions of a Finance Manager
13
are discussed in this lesson. The relationship between Financial Management and other
Functional areas are also explained.
2.2 Financial Management and other Functional Areas

Financial management is one of the important parts of overall management, which is
directly related with various functional departments like human resources, marketing and
production. Financial management covers wide area with multidimensional approaches.
2.2.1 Financial Management and Economics
Economic concepts like micro and macro economics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager.
Financial management also uses the economic equations like money value discount factor,
economic order quantity, etc. Financial economics is one of the emerging area, which provides
immense opportunities to finance, and economical areas.
2.2.2 Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence,
we can easily understand the relationship between the financial management and accounting.
In the olden periods, both financial management and accounting are treated as a same discipline
and then it has been merged as Management Accounting because this part is very much helpful
to finance manager to take decisions. But nowadays financial management and accounting
discipline are separate and interrelated.
2.2.3 Financial Management and Mathematics
Modern approaches of the financial management applied large number of mathematical

and statistical tools and techniques. They are also called as econometrics. Economic order
quantity, discount factor, time value of money, present value of money, cost of capital, capital
structure theories, dividend theories, ratio analysis and working capital analysis are used as
mathematical and statistical tools and techniques in the field of financial management.
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2.2.4 Financial Management and Production Management
Production department is involved in the activities relating to the conversion of input into
output. It is the operational part of the business concern, which helps to multiple the money into
profit. Profit of the concern depends upon the production performance. Production performance
needs finance, because production department requires raw material, machinery, wages,
operating expenses etc. These expenditures are decided and estimated by the financial
department and the finance manager allocates the appropriate finance to production department.
The financial manager must be aware of the operational process and finance required for each
process of production activities.
2.2.5 Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this,
the marketing department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.
2.2.6. Financial Management and Human Resource
Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should carefully
evaluate the requirement of manpower to each department and allocate the finance to the
human resource department as wages, salary, remuneration, commission, bonus, pension and
other monetary benefits to the human resource department. Hence, financial management is
directly related with human resource management.
2.3 Functions of a Finance Manager

1. Deciding the capital structure
The capital structure refers to the kind and proportion of different securities for raising
funds. After deciding the amount of finance required, it should be decided which type of securities
should be raised. A decision about the kind of securities to be employed and the proportion in
which these should be used is an important decision which influences the short-term and long-
term financial planning of an enterprise.
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2. Proper cash management
Cash Management is also an important task of a finance manager and he has to access
the various cash needs at different times and to make arrangements for cash. The cash
management should be such that neither there is shortage of it nor it is idle. Any shortage will
damage the credit worthiness of the enterprise and the idle cash with the business will mean
that it is not properly used.
3. Implementing financial controls
An efficient system of financial management facilitates the use of various control devices
like
(i) Return on investment
(ii) Budgetary control
(iii) Break-even Analysis
(iv) Cost Analysis
(v) Ratio analysis
(vi) Cost and Internal audit
to evaluate the performance of the company and to take corrective measures.
4. Proper use of surpluses
The utilisation of surplus is also an important factor in financial management. A judicious

use of surpluses is essential for expansion and diversification plans and also in protecting the
interests of the shareholders.
5. To ensure supply of funds to all parts of the organization
It is also one of the important finance functions to ensure that the funds are available to
every part of the organization as and when it needs them so as to help in smooth operations of
the activities of the organization.
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6. Evaluation of financial performance
The financial performance of the various units of the organization is to be evaluated from
time to time to detect any fault in the financial policy and take the remedial action at appropriate
time, if necessary.
7. To negotiate with the bankers, financial institutions and other suppliers

of credit
Bankers, financial institutions and other suppliers of credit are the different sources of
funds. It is necessary for the company to negotiate with them so as to obtain the funds at the
most favorable terms.
8. To keep track of stock exchange quotations and behavior of stock

market prices.
Stock exchange quotations are the barometers of the economy as a whole. By keeping
an eye on the stock market, the finance manager is in a position to plan the policy of the
business enterprise with regard to finance more effectively.
Organization of The Finance Function
A firm should give proper attention to the structure and organization of its finance
department. If financial data are missing or inaccurate, the firm may not in a position to identify
the serious problems face the firm at any time for corrective action. Organisation of the finance
function varies from company to company depending on their respective needs and its financial
philosophy.
An Organisation chart of the Finance department of a large organization is given below:
The Head of the Finance department exercises his functions through his two duties known
as:
1. Controller
2. Treasurer
The controller is concerned with the management and control of the firm’s assets and his
duties include providing information for formulating the accounting and financial policies,
preparation of financial reports, direction of internal auditing, budgeting, inventory control, taxes
etc.
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The Treasurer is mainly concerned with managing the firm’s funds and his duties include
forecasting the financial needs, administering the flow of cash, managing credit, floating
securities, maintaining relations with the financial institutions and protecting funds and securities.
Fig. 2.1 Organisation Structure
2.3.1 Functions of Controller

1. Planning and control
To establish, coordinate and administer, as part of management, a plan for the control of
the operations. This plan should provide information like the extent of finance required in the
business, profit planning, programmes for capital investing and financing, sales forecasts and
expense budgets.
2. Reporting and interpreting
To compare the actual performance with the operating plans and standards, and to report
and interpret the results of operations to all levels of management and to the owners of the
business.
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3. Tax administration: To establish and administer tax policies and procedures.
4. Government reporting: To supervise or co-ordinate the preparation of report to the

Government agencies.
5. Protection of assets: To ensure protection of business assets through internal control,

internal auditing, and assuring proper insurance coverage.
6. Economic appraisal: To appraise economic and social forces and government

influences and their impact on business.
2.3.2 Functions of Treasurer

1. Provision of Finance: To establish and execute programmes for the provision of
finance required by the business, including negotiating its procurement and maintaining the
required financial arrangements.
2. Investor relations: To establish and maintain an adequate market for the company’s
securities and to maintain relationship with the investors.
3. Short-term financing: To maintain adequate sources for the company’s current

borrowings from the money market.
4. Banking and custody: To maintain banking arrangements, to receive, to have custody

of and disburse the company’s money and securities.
5. Credit and collections: To direct the granting of credit and the collection of accounts
receivables of the company.
6. Investments:
o To invest the company’s funds as required and
o To establish and coordinate policies for various investments.
7. Insurance: To provide insurance coverage as may be required.
2.3.3 Other Functions

1. Financial forecasting and planning: He has to estimate the financial requirements
of the business.
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2. Acquisition of funds: It refers to the selection of an appropriate source to acquire

fund.
3. Investment of funds: The channels which generate higher returns are preferred.
4. Helping in valuation decisions: Assist management in valuation(valuing shares,

debentures)
5. Maintain proper liquidity: He is required to determine the need for liquid assets and
arrange them without making scarcity of funds.
2.4 Summary
Financial management is one of the important functions in any organisation. It is directly
related with other functional areas such as Marketing, Human Resources, Production and
Systems. It is also related with Economics and Accounting. The function of a Finance Manager
is explained in this lesson.
2.5 Keywords
Accounting
Human Resources
Economics
Marketing
Production
Controller
Treasurer

1. Discuss the role of financial manager.
2. Explain the controller functions of the finance manager.
3. Discuss the treasurer functions of the finance manager.
4. Explain the functions of financial management elaborately.
5. How financial management is interrelated with other functions?

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LESSON - 3
SOURCES OF FINANCE
Learning Objectives
 Elaborate the various sources of finance
 Explain the functions of a finance manager / the finance department
Structure
3.1 Introduction
3.2 Security Financing
3.2.1 Shares
3.2.1.1 Preference shares
3.2.1.2 Equity shares
3.2.2 Debentures
3.2.3 Differences between Debentures and Shares
3.3 Internal Financing
3.3.1 Depreciation
3.3.2 Retained Earning or Ploughing Back of Profits
3.4 Loan Financing
3.4.1 Trade Credit
3.4.2 Commercial Banks
3.4.3 Public Deposits
3.4.4 Finance Companies
3.4.5 Accrual Accounts
3.4.6 Indigenous Bankers
3.4.7 Advances from Customers
3.5 Term Loans

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3.6 Summary
3.7 Keywords
3.1 Introduction
The sources from which a business meets its financial requirements can be classified as
follows:
I. According to period
(a) Long-term sources eg: shares, debentures, long-term loans etc.
(b) Short-term sources eg: advances from commercial banks, public deposits, advances
from customers and trade creditors etc.
II. According to Ownership
(a) Own capital eg: Share capital, Retained earnings and surpluses etc.
(b) Borrowed capital eg: Debentures, Public deposits, Loans etc.
III. According to the source of generation
(a) Internal sources eg: Retained earnings and depreciation funds.
(b) External sources eg : Shares, Debentures, Loans etc.
IV. According to the type of financing
(a) Security financing eg: Shares and Debentures.
(b) Internal financing eg: Depreciation funds and Retained Earnings.
(c) Loan financing eg: Short-term and long-term loans.
3.2 Security Financing

3.2.1 Shares
A share may be defined as one of the units into which the share capital of a company has
been divided. According to Sec 2(46) of the companies Act,” A share is the share in the capital
22
of a company and includes stock except where a distinction between stock and share is expressed
or implied”.
A Public Company issue only two types of shares. They are
(i) Preference Shares
(ii) Equity Shares
The person holding the share is called a shareholder. He receives the dividend from the
company for investing money in the business. However, Payment of dividend is not legally
compulsory. The Board of Directors has the power to declare dividend. It is declared in the
Annual general meeting before the shareholders who may reduce the rate of dividend but
cannot increase it.
3.2.1.1 Preference Shares
Meaning:. Preference shares are those, which carry the following preferential right over
the other classes of shares:
(i) A Preferential right in respect of fixed dividend.
(ii) A Preferential right as to repayment of capital in the case of winding of the company
in priority to other classes of shares.
Types: Preference shares may be
(i) Cumulative (ii) Non - cumulative (iii) Participating
(iv) Non - Participating (v) Redeemable (vi) Irredeemable
 Cumulative Preference shares: The dividend goes on accumulating unless paid.

The accumulated dividend will be paid before anything is paid out of the profits to
the holders of any other class of shares.
 Non-cumulative Preference shares: The right to claim dividend lapses if there

are no profits in a particular year. i.e. they are not entitled to claim arrears of dividend.
 Participating Preference shares: They also get a share out of the surplus profits
remaining after paying dividend to the equity shareholders at a fixed rate as
determined by the company.
 Non-Participating Preference shares: They do have the above rights.

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 Redeemable Preference shares: These shares be redeemed during the lifetime

of the company.
 Irredeemable Preference shares: These shares can be redeemed only when the
company goes for liquidation.
Merits of Preference Shares

 Financing through Preference shares is flexible as the payment of dividend is not a
legal obligation. If the earnings decline or if the financial condition of the company is
not good, the company can omit to pay dividend.
 Preference shares have no final maturity date. And this provides sufficient flexibility
for the company and also enables the company for proper financial planning.
 Preference shares form the equity base of the company and hence strengthens the
financial position of the company.
 Preference share capital is a cushion to the debenture holders and saves the
company from paying higher rate of debenture interest.
 Preference shareholders do not have any charge on the assets of the company.
 Preference shares are entitled to a fixed rate of dividend.
 Preference shareholders cannot disturb the existing pattern of control as they are
entitled to vote only on such resolutions, which directly affect their interests.
 Financing through Preference shares is cheaper as compared to any other sources

of capital like Equity shares.
 Preference shares are particularly useful for those investors who want higher rate
of return with comparatively lower risk.
 The company can use its surplus funds to redeem the redeemable Preference
shares as per the provisions of the Companies Act.
Demerits of Preference Shares

 Preference dividend is not deductible as an expense for taxation purpose.
 If the preference shares are cumulative, arrears of dividend have to be cleared

before anything can be paid to the equity shareholders of the company.
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 Preference shares may pave the way for the insolvency of the company if the
Directors continue to pay Dividends to the Preference shareholders inspite of the
lower profits.
3.2.1.2 Equity Shares

 These shares do not have any preferential right and they are ranked after the
Preference shares for the purpose of dividend and repayment of capital in the event
of company’s winding up.
 The rate of dividend of these shares is not fixed.
 Equity Shareholders enjoy good dividends in times of prosperity and also face the
risk of earning nothing in the case of adversity.
 Equity shareholders can control the company as they are entitled to vote in the
AGM.
 Persons who prefer risk to better return and also wish to have control in the
management of the company prefer equity shares.
Merits of equity shares

 Financing through equity shares does not impose any burden on company since
payment of dividend depends on the availability of profits and to the discretion of
the Directors.
 Equity shares do not carry any charge on the assets of the company.
 Capital raised through equity shares is not repayable during the lifetime of the
company. It is repayable only in the event of company’s winding up and it is helpful
for the company’s financial planning.
 The company does not face the risk of magnifying the losses in case of adversity.
 Financing through equity shares also provides the company with sufficient flexibility
in the utilisation of its profits as neither the payment of dividend nor the repayment
of principal is compulsory.
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Demerits of equity shares

 Financing through equity shares is costly as compared to financing through
preference or debenture.
 The expectation of the equity shareholders may be high.
 The equity shareholders can easily manipulate the control of the company.
 Conservative management often avoids issue of equity shares to raise additional

funds, as there may be too much control in the hands of the equity shareholders.
 Excessive reliance on equity capital will result in overcapitalization of the company.
 The cost of underwriting and distributing the equity share capital is generally higher
than that of the preference share capital and debenture.
3.2.2 Debentures
Meaning
 A debenture is a document issued by a company as an evidence of a debt due from
the company with or without a charge on the assets of the company.
 It is a certificate issued by a company under its seal acknowledging a debt due by it

to its holders.
 According to the Company’s Act, the term debenture includes “ debenture stock,
bonds and any other securities of a company whether constituting a charged on the
assets of the company or not”.
Types of debentures
 Naked Debenture: Naked Debentures are those which do not carry any charge on
the assets of the company.
 Mortgage Debenture: These are secured by a mortgage or a charge on the assets

of the company.
 Convertible Debenture: These debentures can be converted into equity shares of

the company according to the terms specified.
· Non - convertible Debenture: These debentures cannot be converted into equity

shares.
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Merits
1. Debenture provides funds to the company for a specific period. So, the company can
appropriately adjust its financial plan to suit its requirements.
2. Debenture provides funds to the company for a long period without diluting its control.
3. Debentures enable the company to take the advantage of trading on equity and thus
pay to the equity shareholders dividend at a rate higher than overall return on investment.
4. Debentures are more suitable for investors who are cautious and conservative and
who particularly prefer a stable rate of return with little or no risk.
Demerits
1. Raising funds through debenture is risky, since in the event of failure of the company
to pay interest or the Principal installment in time, the debenture holder may resort
to the extreme remedy of filing a petition for winding up of the company.
2. Debentures are not suitable for companies whose earnings fluctuate considerably.
3. Every additional issue of debentures becomes more risky and costly on account of
higher expectation of debenture holders and they may even demand higher rate of
interest.
3.2.3 Differences Between Debentures and Shares
S.No Shares Debentures
1 Shares are a part of the capital Debentures constitute loan to the

company.
2 Shareholders are the owners Debenture holders are the creditors of the
of the company company.
3 A shareholder enjoys all rights of A Debenture holder does not enjoy such
the membership of a company rights.
such as right to vote etc.
4 Second priority is given for First priority is given for payment of

payment of dividend. debenture interest.
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5 Second priority is given for First priority is given for Principal

Principal repayment during the repayment during the winding up of the
winding up of the company. company.
6 Shareholders do not have any Debenture holders have charge on the

charge on the assets of the assets of the company.
company.
7 Dividends are payable only when Interest on debenture are payable even if
the company earns profits. there are no profits.
8 Dividends are not payable out Interest on debentures are payable even
of capital. out of capital.
9 Rate of dividends may fluctuate Debentures carry a fixed rate of interest.

from year to year according to
the amount of profits earned by
the company.
10 Shareholders have control over Debenture holders do not have voting

the company as they have voting rights and so they do not have control over
rights in the AGM. the company.
11 Shares are not usually redeemed. Debenture can be purchased and

redeemed.
3.3 Internal Financing

A company has only external sources of finance. However, an existing company can also
generate finance through its internal sources. The two important sources of internal financing
are Depreciation and Retained Earnings.
3.3.1 Depreciation
Depreciation means decrease in the value of asset due to wear and tear, lapse of time,
obsolescence, exhaustion and accident. The amount of cash allocated to depreciation is treated
as a source of finance.
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Merits
1. Depreciation does not generate funds but it only saves funds.
2. Depreciation reduces taxable income and decreases the income-tax liability for that
period.
3.3.2 Retained Earnings or Ploughing Back of Profits
According to the latest provisions of the Companies Act, a certain percentage (not
exceeding 10%) of the Net Profit after tax should be transferred to the Reserves by a company.
This amount serves as a source of finance for a company.
Merits
1. It involves less cost as it does not involve any floatation cost as in the case with
raising of funds by issuing different types of securities.
2. It enhances the reputation and increases the capacity of the business to face the
unexpected and sudden business shocks.
3. This is mainly useful for expansion and improvements.
4. This source of finance does not carry any fixed obligation regarding payment of
interest or dividend.
Demerits
1. The management to manipulate the value of the company’s shares in the stock
exchange and also to cover their inefficiency in managing the affairs of the company
can misuse the retained earnings.
2. Excessive use of retained earnings continuously for a long period may result in
converting the company into a monopolistic organization.
3. The method of financing through retained earnings may prove harmful to the social
interest, as the society does not get the chance of investing them through capital
market, which may be more useful to the society.
4. The shareholders may also object the use of retained earnings as a source of
finance as it affects their regular income.
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3.4 Loan Financing
3.4.1 Trade Credit
Trade Credit is a form of short-term financing common to almost all types of business
firms. Most sellers allow credit to the buyer and this is called as Trade credit. This credit may
take the form of
(a) An Open Account credit arrangement: In this, the buyer does not sign a formal debt
instrument as an evidence of amount due to by him to the seller. This is generally made available
to the
(b) Acceptance credit arrangement: The buyer accepts a bill of exchange or a promisory
note for the amount due by him to the seller.
Merits
1. It is readily available.
2. It is available on a continuing and informal basis.
3. There is no need to create any charge against the firm’s assets for obtaining trade
credit.
4. It is very flexible, as the firm does not have to sign a note, pledge securities, or
adhere to strict payment schedule.
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Demerits
1. Sometimes, the cost of the trade credit is very high.
2. Availability of liberal trade credit may induce a firm to overtrading which may later
prove to be disastrous for the firm.
3.4.2 Commercial Banks
Commercial Banks make advances in the following forms:
1. Loans: A Loan is a kind of advance with or without security. It is given for a fixed
period at an agreed rate of interest. Repayments mat be made in installments or at
the expiry of a certain period.
2. Cash credit: A Cash Credit is an arrangement by which a banker allows his customer
to borrow money up to a certain limit. It is usually made against the securities of
goods hypothecated or pledged with the bank.
3. Pledge: In the case of pledge, the goods are placed in custody of the bank with its
name on the godown where they are stored. The borrower has no right to deal with
them.
4. Hypothecation: In this case, the possession of goods is not given to the bank. The
goods remain at the disposal and in the godown of the borrower. The bank is given
access to goods whenever it so desires.
5. Overdrafts: The customer may be allowed to overdraw his current account, with or
without a security if he requires temporary loan.
6. Bills discounting: The Bank also gives advances to their customers by discounting
their bills with or without a security. The net amount after deducting the amount of
discount is credited to the account of the customer.
Merits
1. It is cheap.
2. Different schemes are available and so flexibility can be maintained.
3. Concessional rates are available for special schemes as per the directives of the
Reserve Bank of India.
4. Commercial Banks also act as friend, philosopher and guide to their borrowers.
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Demerits
1. Financing from commercial banks requires signing of a number of documents
involving cost as well as time.
2. Commercial banks rarely grant unsecured credit to business firms.
3. A commercial bank takes a very critical view of even small irregularity committed by
its customer in payments.
3.4.3 Public Deposits
Many companies accept deposits for short periods from their Members, Directors and
general Public. The rate of interest is fixed and the deposits are taken for an agreed period.
Merits
1. Financing through public deposit is simple without much of complicated formalities

involved.
2. It is less costly.
3. There is no need to create any charge on the assets of the company for raising
funds through public deposits.
4. The rate of interest on public deposits is fixed.
Demerits
1. Raising finance through public deposits is not a reliable and a definite source.
2. Even a slight rumour that the company is not doing well may result in rush of the
public to the company for getting premature payments of the deposits made by
them.
3. This system may prove injurious for the growth of a healthy capital market.
3.4.4 Finance Companies
Finance companies are involved in arranging finance for the industry in the following
manner:
1. Leasing and Hire Purchase: Finance companies help industry in acquisition of

capital assets like Plant and Machinery, Vehicles, Office equipments Through leasing
or Hire Purchase facilities.
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2. Merchant Banking: Merchant banking is basically Service Banking, concerned

arranging funds rather than providing them.
 Project counseling: A merchant banker helps an entrepreneur in conception of

idea, identification of projects, preparation of project feasibility reports, fixing location,
obtaining money, Sanctions/approvals from State and Central Governments.
 Sponsor of issue: Merchant bankers act as a sponsor of issues by preparing

prospectus, getting the approval from SEBI, underwriting, broking and banking for
issue.
 Credit Syndication: Merchant bankers undertake preparation of project files, loan

application for financial assistance on behalf of the promoters from different financial
institutions for meeting long-term as well as working capital requirements of their
clients.
 Servicing of issues: Merchant bankers keep register of shareholders and debenture

holders of their client companies, act as paying agents for the dividends, debenture
interest.
 Investment management: Merchant Bankers render advice in matters pertaining

to investment decisions, effects on taxation and inflation on securities. They also
undertake the functions of buying and selling securities for their client companies.
 Arrangement for fixed deposits: Merchant Bankers help companies to raise finance
by way of fixed deposits from the public. They also act as brokers for mobilization of
public deposits.
 Other Specialist activities: This includes
 Corporate counseling
 Services to NRIs for suitable investment opportunities in India
 Assistance in Negotiation of foreign collaboration
 Arranging technology, finance etc.
3. Equity Research and investment counseling: A common investor is not able to

apply his mind for analysis of financial statements and future prospects of various
companies for investment decisions. In order to provide this, many finance companies
have established advisory services to potential investors at a nominal cost and thus
indirectly help the companies to raise resources.
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3.4.5 Accrual Accounts
Accrual accounts are spontaneous source of finance since they are self generating. The
most common accrual accounts are wages and taxes. In both cases the amount becomes due
but is not paid immediately and thus used for the regular operations of the business.
Merits
 It is costless or interest free source of financing.
Demerits
 The company cannot indefinitely postpone the payment of taxes of the Government
without attracting penalties.
 Similarly, The trade unions also resent if the wages are not paid to the workers.
Postponement of wages also will affect the morale of the employees resulting in
absenteeism reducing the efficiency and higher Labour turnover.
3.4.6 Indigenous Bankers
Indigenous bankers are private individuals engaged in the business of financing shortterm
and medium-term loan to small and local business units. They are considered as a last resort of
finance as they charge higher rate of interest.
3.4.7 Advances from Customers
This is a cost-free source of finance and really useful for business and the manufacturers
receive advance payment from the customers.
3.5 Term Loans

The term “Term loans is used for both medium as well as long-term loans. Medium term
loans are for periods ranging from 1 to 5 years while longterm loans are for period from 5 to 15
years.
The term loans are offered by Financial institutions like IFCI, SFCs, SIDCs, ICICI, IDBI,
UTI, IRBI, SIDBI, HDFC, EXIM BANK.
34
Special features of long-term loans:
 Objective: The term loans are granted for any one of the following reasons:
o Establishment, renovation, Expansion, modernization of industrial units.
o For meeting the Working capital requirements.
o For Repayment of bonds, debentures etc.
 Security: Term loans are usually secured and they either have a floating or fixed
charge on the assets of the company.
 Time period: The term loans are granted for a period of 1 to 15 years and the
repayments is made in easy installments to enable the borrower to pay without any
difficulty.
 Formal agreement: The term loan is granted on the basis of formal agreement and
this contains the terms of granting loan and provides for certain protective clauses
fro the benefit of the lender.
 Participation basis: If the amount of loan is substantial, the financial institutions

participate in the credit on a syndicate basis.
 Introduces financial discipline: Term loans introduce proper financial discipline in

the borrower. The borrower has to forecast his cash flows so that he can repay the
 loan and interest as per the agreed schedule.
 Refinance facility: Commercial banks are granted refinance facility from IDBI on
the term loans granted by them. The risk is faced by the commercial bank.
 Project oriented approach: Financial institution engaged in term lending are involved
in appraising of the projects and assess their merits and sanctions loan only when
the project satisfy their tests.
 Special conditions: In order to safeguard against time and cost overruns the loan
agreements usually require the borrower to undertake certain special conditions.
3.6 Summary
The Financial requirements of an organisation can be met from different sources. They
are classified into Security, Financing, and Internal Financing Security Financing may be classified
into shares and debentures. These are two types of Internal Financing. They are short term
Financing and long term Financing. Short term loans can be obtained from Commercial Banks,
advances, Public deposits, accrual accounts, trade credits and Loan from Finance Companies.
35
3.7 Keywords
Accurals
Debentures
Share
Depreciation
Retained Earnings

1. Explain the various sources of financing.
2. Explain the merits and demerits of preference shares?
3. What are the merits and demerits of an equity share?
4. Bring out the differences between a share and a debenture.
5. Explain the different types of loans in detail.
6. What are the various financial institutions? Explain their functions in detail.
7. What are the features of a debenture?
8. Explain the merits and demerits of a debenture.
9. Define the terms share and debenture.
10. What are the different types of preference shares?
11. What are the different types of debenture?
12. What is meant by mortgage debenture?
13. Explain the difference between a convertible and a non-convertible debenture.
14. What is meant by security financing?
15. What is debt financing?
16. Critically examine the advantages and disadvantages of equity shares.
17. Discuss the features of equity shares.
18. What are the merits of the deferred shares?
19. Explain the importance of financial management in the current industrial scenario.
36
LESSON - 4
TIME VALUE OF MONEY AND
MATHEMATICS OF FINANCE
Learning Objectives
 Explain the time value of money
 Analyse the compounding and discounting aspects of money
 Differentiate the concepts of risk and return
 Discuss the present and future value of money concepts
Structure
4.1 Introduction
4.2 Compounding and Discounting
4.3 Present Value of a Single Flow
4.4 Present Value of a Future Sum
4.5 Present Value of an Annuity for n Payment Periods
4.6 Present Value of a Growing Annuity
4.7 Concept of Risk and Return
4.8 Summary
4.9 Keywords
4.1 Introduction
The time value of money is the value of money figuring in a given amount of interest
earned over a given amount of time. The time value of money is the central concept in finance
theory. Rs. 100 in hand today is more valuable than Rs. 100 receivable after a year.
37
We will not part with 100 now if the same sum is repaid after a year. But we might part with
100 now if we are assured that 110 will be paid at the end of the first year. This “additional
Compensation” required for parting 100 today, is called “interest” or “the time value of money”.
It is expressed in terms of percentage per annum.
Money should have time value for the following reasons:
 Money can be employed productively to generate real returns;
 In an inflationary period, a rupee today has higher purchasing power than a rupee
in the future;
 Due to uncertainties in the future, current consumption is preferred to future

Consumption.
The three determinants combined together can be expressed to determine the rate of
interest as follows :
Nominal or market interest rate = Real rate of interest or return (+)

Expected rate of inflation (+)
Risk premiums to compensate for uncertainty
(1) Compounding: We find the Future Values (FV) of all the cash flows at the end of the
time period at a given rate of interest.
(2) Discounting: We determine the Time Value of Money at Time “O” by comparing the
initial outflow with the sum of the Present Values (PV) of the future inflows at a given rate of
interest.
4.2 Compounding and Discounting

The method uses to know the future value of a present amount is known as Compounding.
The process of determining the present value of the amount to be received in the future is
known as Discounting. Compounding uses compound interest rates while discount rates are
used in Discounting.
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Basis for Compounding Discounting

Comparison
Meaning The method used to determine The method used to

the future value of present determine the present value
investment is known as of future cash flows is
Compounding. known as Discounting.
Concept If we invest some money today, What should be the

what will be the amount we amount we need to invest
get at a future date. today, to get a specific
amount in future.
Use of Compound interest rate. Discount rate
Known Present Value Future Value
Factor Future Value Factor Present Value Factor or

or Compounding Factor Discounting Factor
Formula FV = PV (1 + r)^n PV = FV / (1 + r)^n
Future Value of a Single Flow
It is the process to determine the future value of a lump sum amount invested at one point
of time.
FVn = PV (1+i)n
Where,
FVn = Future value of initial cash outflow after n years
PV = Initial cash outflow
i = Rate of Interest p.a.
n = Life of the Investment
and (1+i)n = Future Value of Interest Factor (FVIF)

39
Example
The fixed deposit scheme of Punjab National Bank offers the following interest rates :
Period of Deposit Rate Per Annum
46 days to 179 days 5.0
180 days < 1 year 5.5
1 year and above 6.0
An amount of Rs. 15,000 invested today for 3 years will be compounded to :
FVn = PV (1+i)n
= PV × (1.06)3
= 15,000 (1.191)
= 17,865
4.3 Present Value of a Single Flow

n
PV = FVn / (1 +i)
Where, PV = Present Value
FVn = Future Value receivable after n years
i = rate of interest
n = time period
Example
Calculate P.V. of 50,000 receivable for 3 years @ 10%
P.V. = Cash Flows × Annuity @ 10% for 3 years.
= 50,000 × 2.4868
= 1,24,340/-
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4.4 Present Value of a Future Sum

The present value formula is the core formula for the time value of money; each of the
other formulae is derived from this formula. For example, the annuity formula is the sum of a
series of present value calculations. The present value (PV) formula has four variables, each of
which can be solved for:
1. PV is the value at time = 0
2. FV is the value at time = n
3. i is the discount rate, or the interest rate at which the amount will be compounded
each period
4. n is the number of periods (not necessarily an integer)
The cumulative present value of future cash flows can be calculated by summing the
contributions of FVt, the value of cash flow at time=t
Note that this series can be summed for a given value of n, or when n is . This is a very
general formula, which leads to several important special cases given below.
4.5 Present Value of an Annuity for n Payment Periods

In this case the cash flow values remain the same throughout the n periods. The present
value of an annuity (PVA) formula has four variables, each of which can be solved for:
1. PV(A) is the value of the annuity at time = 0

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2. A is the value of the individual payments in each compounding period
3. i equals the interest rate that would be compounded for each period of time
4. n is the number of payment periods.
To get the PV of an annuity due, multiply the above equation by (1 + i).
4.6 Present Value of a Growing Annuity

In this case each cash flow grows by a factor of (1+g). Similar to the formula for an
annuity, the present value of a growing annuity (PVGA) uses the same variables with the addition
of g as the rate of growth of the annuity (A is the annuity payment in the first period). This is a
calculation that is rarely provided for on financial calculators.
Where i  g :
To get the PV of a growing annuity due, multiply the above equation by (1 + i).
Where i = g :
Present value of a perpetuity
When , the PV of a perpetuity (a perpetual annuity) formula becomes simple

division.
4.7 Concept of Risk and Return

Return expresses the amount which an investor actually earned on an investment during
a certain period. Return includes the interest, dividend and capital gains; while risk represents
the uncertainty associated with a particular task. In financial terms, risk is the chance or probability
42
that a certain investment may or may not deliver the actual/expected returns. Investors make
investment with the objective of earning some tangible benefit. This benefit in financial terminology
is termed as return and is a reward for taking a specified amount of risk.
Risk is defined as the possibility of the actual return being different from the expected
return on an investment over the period of investment. Low risk leads to low returns. For instance,
in case of government securities, while the rate of return is low, the risk of defaulting is also low.
High risks lead to higher potential returns, but may also lead to higher losses. Long-term returns
on stocks are much higher than the returns on Government securities, but the risk of losing
money is also higher.
The risk and return trade off says that the potential return rises with an increase in risk. It
is important for an investor to decide on a balance between the desire for the lowest possible
risk and highest possible return.
Rate of return on an investment can be calculated using the following formula
Return = (Amount received - Amount invested) / Amount invested
The functions of Financial Management involves acquiring funds for meeting short term
and long term requirements of the firm, deployment of funds, control over the use of funds and
to trade-off between risk and return.
4.8 Summary
Time value of money is very important concept in business. The differences between
compounding and discounting are explained in the lesson. The concepts of risk and return are
also discussed.
4.9 Keywords
Time Value of Money
Risk
Return
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1. Explain the time value of money concepts.
2. Assuming a rate of 10% annually, find the FV of Rs.1,000 after 5 years.
3. What is the investment’s FV at rates of 0%, 5%, and 20% after 0, 1, 2, 3, 4, and 5
years?
4. Find the PV of Rs.1,000 due in 5 years if the discount rate is 10%.
5. What is the rate of return on a security that costs Rs.1, 000 and returns Rs.2,000
after 5 years?
6. Five banks offer nominal rates of 6% on deposits; but A pays interest annually, B
pays semiannually, C pays quarterly, D pays monthly, and E pays daily. Suppose
you don’t have the Rs.5,000 but need it at the end of 1 year. You plan to make a
series of deposits-annually for A, semiannually for B, quarterly for C, monthly for D,
and daily for E-with payments beginning today. How large must the payments be to
each bank?
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LESSON - 5
COST OF CAPITAL
Learning Objectives
 Define cost of capital
 Explain the significance of cost of capital
 Discuss the different types of costs of capital
 Enumerate the approaches in determining the cost of capital
Structure
5.1 Introduction
5.2 Importance of Cost of Capital
5.3 Classification of Cost of Capital
5.4 Approaches in Determining the Cost of Capital
5.5 Summary
5.6 Keywords
5.1 Introduction
The term Cost of Capital refers to the minimum rate of return a firm must earn on its
investments so that the market value of the company’s equity shares does not fall. This is
possible only when the firm earns a return on the projects financed by the equity shareholder’s
funds at a rate at which is at a rate which is at least equal to the rate of return expected by them.
If a firm fails to earn return at the expected rate, the market value of the shares would fall and
thus result in reduction of overall wealth of the shareholders. A firm’s cost of capital may be
defined, as “the rate of return the firm requires from investment in order to increase the value of
the firm in the market place”.
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5.2 Importance of Cost of Capital

The determination of Cost of Capital is important from the point of view of both capital
budgeting as well as capital planning decisions.
(a) Capital Budgeting Decisions
In Capital budgeting decisions, the cost of capital is often used as a discount rate on the
basis of which the firm’s future cash flows are discounted to find out their present values. Thus,
the cost of capital is the very basis for financial appraisal of new capital expenditure proposals.
(b) Capital Structure Decisions
The finance manager must raise capital from different sources in a way that optimises the
risk and cost factors. The sources of funds, which have less cost, involve high. Therefore, It is
necessary that cost of each source of funds is carefully considered and compared with the risk
involved in it.
5.3 Classification of Cost of Capital

1. Explicit cost: It is the discount rate that equates the present value of the funds received
by the firm net of underwriting costs, with the present value of the expected cash outflows.
2. Implicit cost: It is the rate of return associated with the best investment opportunity for
the firm and its shareholders that will be foregone if the project presently under consideration
by the firm were accepted.
3. Future cost: It refers to the expected cost of funds to finance the project.
4. Historical cost: It is the cost, which has been already incurred for financing a particular
project.
5. Specific cost: The cost of each component of capital (i.e., equity shares, Preference
shares, debentures, loans etc.) is known as specific source of capital.
6. Combined or composite cost: It is inclusive of all cost of capital from all sources, i.e.,
equity shares, preference shares, debentures and other loans.
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7. Average cost: It is the weighted average of the costs of each component of funds
employed by the firm. The weights are in proportion of the share of each component of capital
in the total capital structure.
8. Marginal cost: It is the weighted average cost of new funds raised by the firm.
5.4 Approaches in Determining the Cost of Capital

I. Traditional approach
According to this approach, a firm’s cost of capital depends on the level of financing or its
capital structure. A firm can change its overall cost of capital by increasing or decreasing the
debt-equity mix.
For example, if a company has 9% debentures, the cost of funds raised from this sources
comes only 4.5% ( assuming tax rate 50%). Funds from equity and preference shares also
involve cost, but the raising of finance through debentures is cheaper because of the following
reasons:
 Interest rates are usually lower than the dividend rates.
 Interest is shown as a tax-deductible expense.
The traditional approach argues that the weighted average cost of capital will decrease
with every increase in the debt content in the total capital employed. However, the debt content
in the total capital employed should be maintained at a proper level because cost of debt is a
fixed burden on the profits of the company and may lead to adverse consequences when the
company has low profits.
II. Modigliani and Miller approach
According to this approach, the company’s total cost of capital is constant and is
independent of the method and level of financing. In other words, this approach says that the
change in the debt-equity ratio does not affect the total cost of capital. According to the traditional
approach, the cost of capital is the weighted average cost of debt and equity and a change in
the debt-equity ratio will change the cost of capital.
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For eg, the capital structure of a company is as follows:
9% debentures Rs. 1, 00,000
Equity share capital Rs.1, 00,000
Dividend 12%
The company has at present even debt-equity ratio. In case, the debt-equity ratio changes
to say 60% debt and 40% equity, the following consequences will follow:
1. The debt being cheaper, the overall cost of capital will come down.
2. The expectation of the equity shareholders from present dividend of 12%, will go up
because they will find the company now more risky.
Thus, the overall cost of capital of the company is not affected by the change in the debt-
equity ratio. Modigilani and Miller, therefore argue that within the same risk class, mere change
of debt-equity ratio does not affect the cost of capital and the following theories has been given
by them:
1. The total market value of the firm and its cost of capital are independent of its
capital structure. The total market value of the firm can be computed by capitalising
the expected stream of operating earnings at discount rate considered appropriate
for its risk class.
2. The cut-off rate for investment purposes is completely independent of the way in
which investment is financed.
Assumptions under Modigilani-Miller approach

(i) Perfect capital market:
The securities are traded in perfect capital markets. This implies that:
 The investors are free to buy or sell securities.
 The investors are completely knowledgeable and rational persons. They know all
information and changes in conditions immediately.
 The purchase and sale of securities involve no costs such as broker’s commission,
transfer, fees etc.
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 The investors can borrow against securities without restrictions on the same terms
and conditions as the firms can.
(ii) Firms can be grouped in homogenous risk classes:
All the firms can be categorised according to the return they give and a firm in each class
is having the same degree of financial risk.
(iii) Same expectation:
All investors have the same expectation of firm’s net operating income (EBIT) Which is
used for evaluation of firm. There is 100% dividend pay-out i.e., the firms distribute all of their
net earnings to the shareholders.
(iv) No corporate Taxes
In M.M. Model, there are no corporate taxes. In conclusion, it may be said that inspite of
the correctness of the basic reasoning of the Modigilani-Miller, the traditional approach is more
realistic on account of the following reasons:
(a) The companies are subject to income-tax and therefore due to tax effect, the cost of
debt is lower than the cost of equity capital.
(b) The basic assumption of Modigilani-Miller approach that capital markets are perfect,
is seldom true.
On account of the above reasons Modigilani-Miller approach has come under several
criticisms and it has been suggested by financial analysts that the company’s cost of capital is
independent of its financial structure is not valid.
5.5 Summary
The term Cost of Capital refers to the minimum rate of return a firm must earn on its
investments so that the market value of the company’s equity shares does not fall. This is
possible only when the firm earns a return on the projects financed by the equity shareholder’s
49
funds at a rate at which is at a rate which is at least equal to the rate of return expected by them.
If a firm fails to earn return at the expected rate, the market value of the shares would fall and
thus result in reduction of overall wealth of the shareholders. A firm’s cost of capital may be
defined, as “the rate of return the firm requires from investment in order to increase the value of
the firm in the market place”. The importance and classification of cost of capital is explained.
The approaches in determining cost of capital is also described in this lesson.
5.6 Keywords
Component Cost
Explicit Cost
Future Cost
Implicit cost
Historical Cost
Specific Cost

1. Define cost of capital.
2. What are implicit and Explicit Costs?
3. What are Average and Marginal Costs ?
4. What is Modigilani - Miller approach to the problem of capital structure? Under what
assumptions do their conclusion hold good?
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LESSON - 6
COMPUTATION OF COST OF CAPITAL
Learning Objectives
 Compute Costs of specific sources of capital - Equity, Preferred stock and debt
 Explain the method of calculating weighted average cost of capital
Structure
6.1 Introduction
6.2 Computation of Specific Cost of Capital
6.2.1 Cost of Debt
6.2.2 Cost of Preference Capital
6.2.3 Cost of Equity Capital
6.3 Weighted Average Cost of Capital
6.4 Summary
6.5 Keywords
6.1 Introduction
In the previous lesson, classification of cost of Capital and approaches to determine cost
of Capital were discussed. Let use compute the cost of Capital in this lesson.
Computation of cost of capital involves:
(i) Computation of cost of each source of finance (specific cost).
(ii) Computation of composite cost (weighted average cost).
6.2 Computation of Specific Cost of Capital

Cost of each sources of finance, viz, debt, preference capital and equity capital can will
be discussed below.
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6.2.1 Cost of Debt
Debt may be issued at par, at premium or discount. It may be Perpetual or redeemable.
(a) Debt issued at par
The Computation of cost of debt issued at par is comparatively easy. It is the explicit
interest rate adjusted further for the tax liability of the company and is computed as follows:
Kd = (1-T) R
Where Kd = Cost of debt
T = Tax rate
R = Debenture Interest rate.
The tax is deducted out of the interest payable, because interest is treated as an expense
while computing the firm’s income tax for tax purposes.
(b) Debt issued at premium or discount
In case the debentures are issued at premium or discount, the cost of debt should be
calculated on the basis of net proceeds realised on account of issue of such debentures or
bonds. Such cost may further be adjusted with the tax rate applicable to the company.
Cost of debentures are calculated using the following formula:
I
Kd = (1  T )
NP
Where Kd = cost of debt
I = Annual Interest Payment
NP = Net proceeds of loans or debentures
T = Tax rate.
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(c) Cost of redeemable debt
(i) If the debentures are redeemable after the expiry of a fixed period the cost of debt
before tax can be calculated as follows:
I  ( P  Np ) / n
Kd =
( P  NP ) / 2
Where I = annual interest Payment
P = Par value of debentures
NP = Net Proceeds of debentures
n = Number of years to maturity.
(ii) The cost of debt after tax can be calculated as follows:
I  ( P  Np ) / n
Kd = (1-T)
( P  NP ) / 2
Where T = Tax rate.
In order to keep sufficient earnings available to equity shareholders for maintaining their
present value, the company should see that it earns on the funds provided by raising loans at
least equal to the effective interest rate payable on them. If the company earns less than the
effective interest rate, earnings available for the equity shareholders will decrease and this
would adversely affect the market price of the company’s equity shares.
6.2.2 Cost of Preference Capital
In case of borrowings, there is a legal obligation on the firm to pay fixed interest while in
case of preference shares, there is no such legal obligation. But it cannot be concluded that
preference share capital does not involve cost as the Preference dividend is generally paid
whenever the company earns sufficient profits.
The failure to pay dividend may be serious concern as they have the first preference and
accumulation of arrears of Preference dividend may adversely affect the payment of dividend
to the equity shareholders.
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(a) On account of these reasons, the cost of Preference share capital may be
computed as follows:
Dp
Kp =
NP
Where Kp = Cost of preference share capital
Dp = Annual Preference dividend
Np = Net proceeds of Preference shares
(b) Cost of redeemable preference shares
In case of redeemable preference shares, the cost of capital is the discount rate that
equals the net proceeds of sale of preference shares with the present value of future dividends
and principal repayments. Such cost can be calculated as follows:
D  ( P  NP ) / n
Kp = ( P  NP ) / 2
Where D = Preference dividend
P = Par value of Preference shares
NP = Net proceeds of Preference shares
n = Number of years to maturity
The cost of preference share capital is not adjusted for taxes, since dividend on preference
capital is taken as an appropriation of profits and not as a charge against profits. Thus, the cost
of preference capital is higher than the cost of debt.
6.2.3 Cost of Equity Capital
The Dividends are paid to the equity shareholders only if the company earns profits and
so there is an argument that the Equity share capital does not involve any cost . But this is not
correct. Because, the equity shareholders invest money with the expectation of getting dividends
and the market value of the share depends on the return expected by the shareholders.
Moreover, the company issues Equity shares and pays dividend to increase the market
value of the firm.
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Therefore, the Cost of Equity share capital can be defined as the minimum rate of return
that a firm must earn on the equity financed portion of an investment project in order to leave
unchanged the market price of such shares.
In order to determine the cost of equity capital, it may be divided into the following two
categories:
 The external equity or new issue of equity shares.
 The retained earnings.
(A) The External Equity or New Issue Of Equity Shares
In order to determine the cost of equity capital, the shareholders expectation from their
investment has to be determined first. The following are some of the approaches for the
computation of cost of equity capital.
(1) Dividend Price (D/P) approach
According to this approach, the investor arrives at the market price of an equity share by
capitalising the expected dividends payments. Cost of equity capital has therefore defined as
“the discount rate that equated the present value of all expected future dividends per share with
the net proceeds of the sale of a share.”
In other words, the cost of equity capital will be that rate of expected dividends which
will maintain the present market price of the equity shares.
Ke is computed as follows:
D
Ke =
NP
Where Ke = Cost of equity capital
D = Dividend per equity share
NP= Net proceeds of an equity share.

55
Limitation:
This approach ignores the fact that retained earnings also have an impact on the market
price of the equity shares.
In case of existing shares, it will be appropriate to calculate the Ke based on the market
price of the equity shares. It is computed as follows:
D
Ke =
MP
MP = Market Price of an equity share.
(2) Dividend Price plus growth (D/P + g) approach
According to this approach, the cost of equity capital is determined on the basis of the
expected dividend rate plus the rate of growth in dividend. The rate of growth in dividend is
determined on the basis of the amount of dividends paid by the company for the last few years.
The computation of cost of equity capital is done as follows:
D
Ke = g
NP
NP = Net Proceeds per share
G = Growth in expected dividend.
In the case of existing equity shares the cost of equity can be calculated as follows:
D
Ke = g
MP
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MP = Market Price of an equity share.
G = Growth in expected dividend.
(3) Earning price (E/P) approach
According to this approach, it is the earning per share, which determines the market price
of the shares. This is based on the assumption that the shareholders capitalize a stream of
future earnings in order to evaluate their shareholdings. Hence, the cost of equity capital should
be related to that earning percentage which would keep the market price of the equity shares
constant. This approach takes into account both the dividends as well as retained earnings.
The formula for calculating the cost of equity capital is as follows:
E
Ke =
NP
E = Earnings per share
NP = Net Proceeds of an equity share.
However, in case of existing equity shares, it will be appropriate to use market price (MP)
instead of Net Proceeds (NP) for determining the cost of equity capital.
(4) Realised Yield approach
According to this approach, the cost of equity capital should be determined on the basis
of return actually realized by the investors in a company on their equity shares. Thus, according
to this approach, the past records in a given period regarding dividends and the actual capital
appreciation in the value of equity shares held by the shareholders should be taken to compute
the cost of equity capital. This approach gives fairly good results in case of companies with
stable dividends and growth records. In case of such companies, it can be assumed that the
past behavior will be repeated in the future also.
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(B) Cost of Retained Earnings
The companies do not generally distribute the entire profits earned by them by way of
dividend among their shareholders. They retain some profits for future expansion of the business.
There is an assumption that the retained earnings is absolutely cost free. This is not the correct
approach because the amount retained by the company, if it had been distributed by way of
dividend, would have given them some earning. The company has deprived the shareholders
of these earnings by retaining a part of profit with it.
Thus, the cost of retained earnings is the earning foregone by the shareholders i.e., the
opportunity cost of retained earnings may be taken as the cost of retained earnings. It is equal
to the income that the shareholders could have otherwise earned by placing these funds in
alternative investments.
For eg., if the shareholders have invested the funds in alternative channels, they could
have got a return(say 10%) and this return has not earned by them as the company has
retained the earnings without distributing them. The cost of retained earnings may, therefore be
taken as 10%.
The following adjustments are made for ascertaining the cost of retained earnings:
 Income Tax adjustment
The dividends receivable by the shareholders are subject to income tax. Hence, the
dividends actually received by them are not the gross dividends but the amount of net dividend,
i.e., gross dividends less income tax.
 Brokerage cost adjustment
Usually the shareholders have to incur some brokerage cost for investing the dividends
received. Thus, the funds available with them for reinvestment will be reduced by this amount.
The opportunity cost of retained earnings to the shareholders is therefore, the rate of
return that they can obtain by investing the net dividends (i.e., after tax and brokerage) in
alternative opportunity of equal quality.
The cost of retained earnings after making adjustment for income tax and brokerage
cost payable by the shareholders can be determined by the following formula:
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Kr = Ke (I-T) (I-B)
Where Kr = Required rate of return on retained earnings
Ke = Shareholder’s required rate of return
T = Shareholder’s marginal tax rate
B = Brokerage cost.
The computation of the cost of retained earnings, after making adjustments

for tax liabilities, is a difficult process because personal income tax will differ from shareholder
to shareholder. So in order to avoid this, ‘External yield criterion’ has been recommended by
some authorities. According to this approach the opportunity cost of retained earnings is the
rate of return that can be earned by investing the funds in another enterprise by the firm. But
this method is not universally acceptable.
6.3 Weighted Average Cost of Capital

After calculating the cost of each component of capital, the average cost of
capital is generally calculated on the basis of weighted average method. This may also be
termed as the overall cost of capital. The computation of the weighted average cost of capital
involves the following steps:
1. Calculation of The Cost of Specific Source of Capital
This involves the determination of cost of debt, equity and preference capital. This can be
done either on “before tax” basis or “after tax” basis. But it will be appropriate to calculate on the
“after tax” basis. Because the shareholders get dividends only after the taxes have been paid.
2. Assigning Weights to Specific Costs
This involves the determination of the proportion of each source of funds in the total
capital structure of the company and this done in any one of the following methods:
(a) Marginal Weights Method
In this method weights are assigned to each source of funds, in proportion of financing
inputs the firm intends to employ. However, this method is suffering from the following limitations:
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 The weightage is given only for the new capital and not for the already existing
capital and so the weighted average cost of capital so earned may be different from
the actual cost of capital.
 A firm should give due attention to long-term implication while designing the firm’s
financial strategy. But this method does not consider the long-term implications of
the firm’s current financing.
(b) Historical Weights Method
In this method, the relative proportions of various sources to the existing capital structure
are used to assign weights. This is based on the assumption that the firm’s present capital
structure is optimum and it should be maintained in the future also. Weights under this method
may be either
 Book value or
 Market value weights.
The weighted average cost of capital will be different depending upon whether book
value weights are used or market value weights are used.
The use of market value weights has the following advantages and practical difficulties:
Advantages:
(i) The market values of the securities are closely approximate to the actual amount to
be received from the sale of such securities.
(ii) The cost of specific source of finance that constitutes the capital structure is
calculated according to the prevailing market price.
Limitations:
(i) The market value of the securities fluctuates considerably.
(ii) Market values are not readily available as compared to the book values. The book
values can be taken from he published records of the firm.
(iii) The analysis of the capital structure of the company, in terms of debt-equity ratio, is
based on the book value and not on the market value.
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3. Adding of the Weighted Cost of All Sources of Funds to get an Overall
Weighted Average Cost of Capital
6.4 Summary
Computation of specific cost of capital includes cost of debt, cost of preference capital
and cost of equity capital. Debt may be issued at par, premium or discount. The steps to compute
weighted average cost of capital is also explained in this lesson.
6.5 Keywords
Discount
Debt
Equity Capital
Preference Capital
Premium

1. State how you would determine the weighted average cost of capital of a firm.
2. Discuss briefly the different approaches for the calculation of cost of equity capital.
3. Why is that the ‘debt’ is the cheapest source of finance for a profit making company?
4. Discuss briefly the different approaches for the calculation of cost of debt capital.
5. Discuss briefly the different approaches for the calculation of cost of preference
capital.
6. Explain how the cost of retained earnings is determined where such retained earnings
are proposed to distribute as bonus shares to the existing shareholders.
7. Explain the Modigilani – Miller approach to the capital structure of a company.
8. Explain the different sources of capital in detail.
9. Explain the concept of Weighted average cost of capital in detail.
10. What are the steps involved in calculating overall cost of capital? Discuss the
conditions that should be satisfied for using a firm s overall cost of capital for
evaluating new investments.
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LESSON - 7
LEVERAGES
Learning Objectives
 Give the meaning of leverage
 Explain the different types of leverage
 Discuss the significance of leverages
 Discuss the methods of computing the leverages
 Discuss the importance and objectives of financial decision making
Structure
7.1 Introduction
7.2 Types of Leverages
7.2.1 Operating Leverage
7.2.2 Financial Leverage
7.2.3 Composite Leverage
7.3 Significance of Operating and Financial Leverages
7.4 Examples
7.5 Summary
7.6 Keywords
7.1 Introduction
The term leverage refers to “An increased means for accomplishing some purpose”. It is
used to describe the firm’s ability to use fixed cost assets or funds to magnify the return to its
owners. James Horne has defined leverage as “The employment of an asset or funds for
which the firm pays a fixed cost or fixed return”.
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7.2 Types of Leverages

Leverages are of three types:
(i) Operating leverage
(ii) Financial leverage
(iii) Composite leverage.
7.2.1 Operating Leverage
The operating leverage may be defined as the tendency of the operating profit to vary
disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of
volume of output or sales. The firm is said to have a high degree of operating leverage if it
employs a greater amount of fixed costs and a lesser amount of variable costs and vice versa.
Thus, the degree of operating leverage depends on the amount of fixed elements in the cost
structure.
Operating leverage is a function of three factors:
1. The amount of fixed costs.
2. The contribution margin.
3. The volume of sales.
There will be no operating leverage if there are no fixed costs.
Computation: The Operating leverage can be calculated as follows:
Operating leverage measures the sensitivity of EBIT to changes in Q.
Contribution C
Operating leverage = OR
Operating Profit OP
Where
Contribution = Sales - Variable cost
Operating Profit = “Earnings before interest and Tax” (EBIT)
Operating leverage may be favourable or unfavourable. In case the contribution exceeds

the fixed cost, it is favourable and in the reverse case, it is unfavourable.
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Degree of Operating leverage:
The degree of Operating leverage may be defined as the percentage change in the
profits resulting from a percentage change in the Sales.
Percentage change in profits

Degree of Operating leverage =
Percentage change in sales
Where EBIT = Total revenue - Total Variable cost - Fixed cost
= QxP-QxV-F
= Q(P-V)-F
Where Q = Quantity produced and Sold
P = Selling price per unit
V = Variable cost per unit
F = Fixed cost
Uses:
The Operating leverage indicates the impact of change in sales on operating income. If a
firm has a high degree of Operating leverage, small changes in sales will have large effect on
operating income i.e., the operating profits (EBIT) of such a firm will increase at a faster rate
than the increase in sales. Similarly the operating profits of such a firm will suffer a greater loss
as compared to reduction in its sales.
Generally it is not advisable to have a high degree of operating leverages there is risks of
decreasing the profits even for a sight drop in sales.
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7.2.2 Financial Leverage
The financial leverage may be defined as the tendency of the net income to very
disproportionately with the operating profit. It indicates the change that takes place in the taxable
income as a result of change in the operating income.
It signifies the existence of fixed interest/dividend bearing securities in the total capital
structure of the company. Thus, the use of debt capital, preference capital along with the owner’s
equity in the total capital structure of the company is described as the financial leverage. If the
fixed interest/dividend bearing securities are greater as compared to the equity capital, the
leverage is said to be larger. In a reverse case the leverage will be said to be smaller.
Favourable and Unfavourable Financial Leverage
The leverage may be considered to be favourable if the firm earns more on the assets
purchased with the funds than the fixed costs of their use. Unfavourable or negative leverage
occurs when the firm does not earn as much as the funds cost.
Trading on Equity and financial leverage:
Financial leverage is also sometimes termed as “trading on equity”.
Computation:
It can be computed by the following methods:
(i) Where the capital structure consists of equity shares and debt:
Financial leverage measures the responsiveness of EPS to changes in EBIT.
In this case, the financial leverage an be computed as follows:

OP
Financial Leverage = or OP/EBT
PBT
Where
OP = Operating Profit or Earnings before Interest and Tax (EBIT).
PBT = Profit before tax but after Interest.

65
Degree of Financial Leverage:
Degree of Financial Leverage may be defined as the percentage change in taxable profit
as a result of percentage change in “operating profit.” It can be computed as follows:
Percentage change in the taxable income

Degree of Finanacial Leverage 
Percentage change in the operating income
(ii) Where the capital structure consists of preference shares and equity shares:
The formula for computing computation of financial leverage can also be applied to a
financial plan having preference shares. The amount of preference dividends will have to be
grossed up (as per the tax rate applicable to the company) and then deducted from the earnings
before interest and tax.
(iii) Where the capital structure consists of equity shares, preference shares and debt:
In this case, the financial leverage can be computed after deducting from operating profit
both interest and preference dividend on a before tax basis.
Alternative definition of financial leverage:
“The ability of a firm to use fixed financial charges to magnify the effects of changes in
EBIT on the firm’s Earning per share.”
Percentage change in Earning per share (EPS)

Degree of Financial Leverage 
Percentage change in the EBIT
Where
( EBIT  I )(1  T )  Dp
EPS = Earning per share =
N
Where
EBIT = Earnings before interest and tax

I = Interest paid on debt
T = Tax rate
Dp = Preference dividend
N = Number of equity shares
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7.2.3 Composite Leverage
Operating leverage measures the percentage change in the operating profit due to
percentage change in sales and it explains the degree of operating risk. Financial leverage
measures the percentage change in taxable profit (or EPS) on account of percentage change
in operating profit (EBIT) and it explains the financial risk.
Both these leverages are closely concerned with the firm’s capacity to meet its fixed costs
(both operating and financial). If both the leverages are combined, the result obtained will disclose
the effect of change in the sales over change in taxable profit (EPS).
Composite Leverage thus explains the relationship between revenue on account of sales
(i.e., contribution or Sales less Variable cost) and the taxable income. It helps in finding out the
resulting percentage change in taxable income on account of percentage change in sales.
Computation:
Composite Leverage = Operating Leverage x Financial Leverage.
C OP C
Composite Leverage = x =
OP PBT PBT
Where C = Contribution (i.e., Sales - Variable cost)
OP = Operating profit or Earnings before Interest and Tax (EBIT)
PBT = Profit before tax.
7.3 Significance of Operating and Financial Leverages

The operating leverage and the financial leverage are the two important quantitative tools
used by the financial experts to measure the return to the owners (EPS) and the market price of
the equity shares.
The financial leverage is superior of these two tools as it focuses on the market price of
the shares, which the management always tries to increase by increasing the net worth of the
firm. When there is increase in EBIT, the price of the equity shares also increases. If a firm goes
on increasing the debt capital, the marginal cost of debt also will increase as the lenders will
demand higher rate of interest.
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A company should try to have a balance of the two leverages because they have got
tremendous acceleration and deceleration effect on EBIT and EPS. It may be noted that a right
combination of these leverages is a very big challenge to for the management. A proper
combination of both operating and financial leverages is a blessing for a firm’s growth while an
improper combination may prove to be a curse.
A high degree of operating leverage together with a high degree of financial leverage
makes the position very risky. This is because on the one hand it is employing excessive assets
for which it has to pay fixed costs and at the same time it is also using a large amount of debt
capital. The fixed costs towards using assets and fixed interest charges bring a greater risk, as
the company may not be able to meet in case of declined earnings.
The existence of operating leverage will result in more than proportionate change even
for a small change in sales. The Presence of high degree of financial leverage causes a more
than proportionate change in EPS even on account of a small change in EBIT. Thus firms
having a high degree of operating leverage and financial leverage has to face the problems of
liquidity or insolvency in one year or the other year. It does not however mean that a firm should
opt for low degree of financial leverage. This may indicate the cautious policy of the management,
but the firm will be losing profit-earning opportunities.
A firm having high operating leverage should not have high financial leverage. Similarly a
firm having a low operating leverage will gain profit by having a low operating leverage provided
it has enough profitable opportunities for the employment of borrowed funds. Low operating
leverage and high financial leverage is considered to be an ideal situation for the maximization
of the profits with minimum risk. A firm should therefore, make all possible efforts to combine
the operating and financial leverage to maximize the risk and minimize the risk.
7.4 Examples
Following information is taken from the records of a limited company:
Installed capacity : 1000 units
Operating capacity : 800 units
Selling price per unit : Rs.10

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Variable cost per unit : Rs.7
Calculate operating leverage under the following situations:
Fixed cost:
Situation A – Rs.800
Situation B – Rs.1, 200
Situation C – Rs.1,500
Particulars Situation Situation Situation

A B C
Rs. Rs. Rs.
Sales 8000 8000 8000
Less: Variable cost 5600 5600 5600
Contribution ( C) 2400 2400 2400
Less: Fixed Cost (F) 800 1200 1500
Operating Profit (OP) 1600 1200 900
Operating leverage (C / OP) 2400 2400 2400
1600 1200 900
1.5 2 2.67
A 10 per cent increase in sales would be accompanied by an increase in operating profits

of 15% in situation A, 20% in situation B and 26.7% in situation C. Situation C is of high operating
leverage since the operating profit will increase by one 2½ time (26.7% for every 10% increase
in Sales). This is high risk situation too because a small decrease in sales will result in more
decrease in profits.
2. A company has sales of Rs. 5,00,000, variable costs of Rs. 3,00,000, fixed costs of Rs.
1,00,000 and long-term loans of Rs. 4,00,000 at 10% rate of interest. Calculate the composite
leverage:
Contribution
(i) Operating Leverage 
Earnings before interest and tax
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Rs . 2 ,00 ,000
 2
Rs. 1,00 ,000
Sales - Variable Cost - Fixed Cost

(ii) Financial Leverage 
Sales - Variable cost - Fixed Cost - Interest
Rs. 5,00,000 - Rs. 3,00,000 - Rs. 1,00,000

Rs. 5,00,000 - Rs. 3,00,000 - Rs. 1,00,000 - Rs. 40,000
1,00,000 5
 
60,000 3
(iii) Composite Leverage = Operating Leverage X Financial Leverage
2 5 10
  
1 3 3
7.5 Summary
Leverage is an increased means for accomplishing some purposes. Leverages are
classified into operating leverage, Finanacial Leverage and composite Leverage. The
computation of different Leverages is also discussed in this lesson.
7.6 Keywords
Composite Leverage
Operating Leverage
Financial Leverage

1. Define leverage. Explain its types. Discuss its significance.
2. Explain the concept of operating leverage with suitable examples.
3. Explain the concept of financial leverage with suitable examples.
4. Explain the concept of combined leverage with suitable examples.
5. Explain the significance of operating and financial leverage.
6. Explain how the various leverages are computed?
7. Explain the three different types of leverages elaborately.

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LESSON - 8
CAPITAL STRUCTURE
Learning Objectives
 Define capital structure
 Explain the patterns of capital structure
 Discuss the factors affecting the capital structure
 Describe the various capital structure theories
Structure
8.1 Introduction
8.2 Patterns of Capital Structure
8.3 Factors affecting Capital Structure
8.4 Optimum Capital Structure
8.5 Capital Structure Theories
8.5.1 Net income (NI) Approach
8.5.2 Net Operating Income (NOI) Approach
8.5.3 Modigiliani- Miller Approach
8.5.4 Traditional Approach
8.6 Summary
8.7 Keywords
8.1 Introduction
Capital structure is the permanent financing of the company represented primarily by
long-term debt and shareholder’s funds but excluding all short-term credit. The term capital
structure differs from financial structure.
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Financial structure refers to the way the firm’s assets are financed. In other words, it
includes both, long-term as well as short-term sourced of funds. Thus a company’s capital
structure is only a part of its financial structure.
8.2 Patterns of Capital Structure

In case of new company, the capital structure may be of any of the following four patterns.
(1) Capital structure with equity shares only.
(2) Capital structure with both equity and preference shares.
(3) Capital structure with equity shares and debentures.
(4) Capital structure with equity shares, preference shares and debentures
8.3 Factors affecting Capital Structure

Capital Structure depends on a number of factors such as,
 The nature of the business,
 Regularity of earnings,
 Conditions of the money market,
 Attitude of the investor,
 Debt-equity mix
There is a basic difference between debt and equity. Debt is a liability on which interest
has to be paid irrespective of the company’s profits. While equity consists of shareholders or
owners funds on which payments of dividend depends upon the company’s profits. A high
proportion of the debt content in the capital structure increases the risk and many lead to
financial insolvency of the company in adverse times.
However, raising funds through debt is cheaper as compared to raising funds through
shares. This is because interest on debt is allowed as an expense for tax purpose. Dividend is
considered to be an appropriation of profits and so payment of dividend does not result in any
tax benefit to the company. This means if a company, which is in 50% tax bracket, pays interest
at 12% on its debentures, the effective cost to it comes only to 6%, while if the amount is raised
by issue of 12% preference shares, the cost of raising the amount would be 12%.
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Thus, raising of funds by borrowing is cheaper resulting in higher availability of profits for
shareholders. This increases the earnings per equity share of the company, which is the basic
objective of a financial manager.
8.4 Optimum Capital Structure

The optimum capital structure may be defined as “ Capital Structure or combination of
debt and equity that leads to the maximum value of the firm. Optimal capital structure maximizes
the value of the firm and hence the wealth of its owners and minimizes the company’s cost of
capital. The following considerations should be kept in mind while maximizing the value of the
firm in achieving the goal of optimum capital structure.
(i) It is the return on investment is higher than the fixed cost of funds, the company
should prefer to raise funds having affixed cost, such as debentures, loans and
preference share capital. It will increase earnings per share and market value of the
firm. Thus company should make maximum possible use for leverage.
(ii) When debt is used as a source of finance, the firm saves a considerable amount in
payment of tax as interest is allowed as a deductible expense in computation of tax.
Hence the effective cost of debt is reduced called tax leverage. A company should
take advantage of tax leverage.
(iii) The firm should avoid undue financial risk attached with the use of increased debt
financing. If the shareholders perceive high risk in using further debt-capital, it will
reduce the market price of shares.
(iv) The capital structure should be flexible.
A firm should try to maintain an optimum capital structure with a view to maintain financial
stability. This optimum capital structure is obtained when the market value per equity share is
the maximum. It may, therefore, be defined as that relationship of debt and equity securities
which maximizes the value of a company’s share in the stock exchange. In case a company
borrows and this borrowing helps in increasing the value of the company’s shares in the stock
exchanges, it can be said that the borrowing has helped the company in moving towards its
optimum capital structure.
In case, the borrowing results in fall in market value of the company equity shares, it can
be said that the borrowing has moved the company away from its optimum capital structure.
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The objective of the term should therefore be to select a financing or debt equity mix, which will
lead to maximum value of the firm.
According to Ezra Soloman: “Optimum leverage can be defined as that mix of debt and
equity, which will maximize the market value of a company i.e., the aggregate value of the
claims, and ownership interests represented on the credit interests represented on the credit
side of the balance sheet. Further the advantages of having an optimum, financial structure if
such an optimum does exist, is two-fold; it minimizes the company’s cost of capital which in turn
increases it ability to find new wealth-creating investment opportunities. Also by increasing the
firm’s opportunity to engage in future wealth-creating investment it increases the economy rate
of investment and growth”.
Considerations
The following considerations will be greatly helpful for a finance manager in achieving his
goal of optimum capital structure.
(1) He should take advantage of favourable financial leverage. In other words if the ROI
is higher than the fixed cost of funds, he may prefer raising funds having a fixed cost to increase
the return of equity shareholders.
(2) He should take advantage of the leverage offered by the corporate taxes. A high
corporate income tax also provides some a form of leverage with respect to capital structure
management. The higher cost of equity financing can be avoided by use of debt, which in
effect provides a form of income tax leverage to the equity shareholders.
(3) He should avoid a perceived high risk capital structure. This is because if the equity
shareholders perceive an excessive amount of debt in the capital structure of the company, the
price of the equity shares will drop. The finance manager should not therefore issue debentures
or bonds whether risky or not, if the investors perceive an excessive risk and therefore it is likely
to depress the market prices of equity shares.
8.5 Capital Structure Theories

In order to achieve the goal of identifying an optimum debt-equity mix, it is necessary for
the finance manager to be conversant with the basic theories underlying the capital structure
of corporate enterprises. There are the four major theories approaches explaining the relationship
between capital structures cost of capital and value of the firm.
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1. Net Income (NI) Approach,
2. Net Operating income (NOI) approach,
3. Modigilani-Miller (MM) approach,
4. Traditional approach.
Assumptions
The following are the assumptions in order to present the analysis in a simple and intelligible
manner: -
(i) The firm employs only the two types of the capital-debt and equity. There are also no
preference shares.
(ii) There are no corporate taxes. This assumption has been removed later.
(iii) The firm pays 100% of its earning as dividend. Thus, there are no retained earnings.
(iv) The firm’s total assets are given and do not change .In other words the investment
decision are to assumed to be constant.
(v) The firm’s total financing remains constant. The firm can change its capital structure
either by redeeming the debentures by issue of share or by raising more debt and reduce the
equity share capital.
(vi) The Operating Earning (EBIT) are not expected to grow.
(vii) The business risk remains constant and is independent of capital structure and financial
risks.
(viii) All investor have the same subjective probability distribution of the future expected
operating earnings (EBIT) for a given firm.
(ix) The firm has a perpetual life.
8.5.1 Net Income (NI) Approach
According to this approach, capital structures decision is relevant to the valuation of the
firm. In other words a change in the capital structure causes a corresponding change in the
over all cost of the capital as well as the total value of the firm.
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Higher debt content in the capital structure (i.e. high financial leverage) will result in the
overall or weighted average cost of the capital. This will cause increase in the value of the firm
and consequently increase in the value of equity share of the company. Reverse will happen in
a converse situation.
Assumptions
(i) There are no corporate taxes.
(ii) The cost of the debt is less than cost of equity or equity capitalization rate.
(iii) The debt content does not change the risk perception of the investors.
Value of the firm:
The value of the firm on the basis of NI approach can be ascertained as follows:
V=S+B
Where:-
V = Value of firm;
S = Market value of equity;
B = Market value of debt.
Market value of Equity can be ascertained as follow
S = NI / ke
Where: S = Market value of equity
NI = Earnings available for equity shareholders;
Ke = Equity capitalization Rate.
8.5.2 Net Operating Income (NOI) Approach
This is just opposite of the Net income approach. According to this approach the market
value of firm is not at all affected by the capital structure changes .The market value of the firm
is ascertained by the capitalizing the net operating income at the overall cost of capital (k),
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which is considered to be constant .The market value of equity is ascertained by deducting the
market value of the debt from the market value of the firm.
Assumptions
(i) Over cost of capital (k) remains constant for all degrees of debt equity mix or leverage.
(ii) The market capitalizes the value of the firm as a whole and therefore, the split between
debt and equity is not relevant.
(iii) The use of debt having low cost increases the risk of equity shareholders, this, results
in increase in equity capitalization rate. Thus, the advantage of debt is set off exactly by increase
in the equity capitalization rate.
(iv) There are no corporate taxes.
Value of the firm
According to the NOI approach, the value of a firm can be determined by the following
equation:
V = EBIT/k
Where V = value of the firm,
K = overall cost of capital,
EBIT = earnings before interest and tax.
Value of equity: The value of equity (s) is a residual value, which is determined by
deducing the total value of debt (b) from the total value of the firm (v) thus, the value of equity
(s) can be determined by the following equation.
S=V-B
Where:
S = value of equity
V = value of firm
B = value of debt
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Optimum Capital Structure
According to net operating income (NOI) approach, the total value of the firm remains
constant irrespective of the debt-equity mix or the degree of leverage. The market price of
equity shares will, therefore, also not change on account of change in debt-equity mix. Hence,
there is nothing like optimum capital structure. Any capital structure will be optimum according
to this approach.
In those cases where corporate taxes are presumed, theoretically there will be optimum
capital structure when there is 100% debt content. This is because with every increase in debt
content declines and the value of the firm goes up. However due to legal and other provisions,
there has to be a minimum equity. This means that optimum capital structure will be at a level
where there can be maximum possible debt content in the capital structure.
8.5.3 Modigiliani-Miller Approach
The Modigiliani-Miller approach is similar to the net operating income (NOI) approach. In
other words, according to this approach, the value of a firm is independent of its capital structure.
However, there is a basic difference between the two. The NOI approach is purely conceptual.
It does not provide operational justification for irrelevance of the capital structure in the valuation
of the firm. While MM approach supports the NOI approach provides justification for the
independence of the total valuation and cost of capital of the firm from its capital structure. In
other words, MM approach maintains that the overall cost of capital does not change in the debt
equity mix or capital structure of the firm.
Basic Propositions
The following are the three basic propositions of the MM approach.
1. The overall cost of capital (k) and the value of the firm (V) are independent of the capital
structure. In other words k and V are constant for all levels of debt-equity mix. The total
market value of the firm is given by capitalizing the expected net operating income (NOI)
by the rate appropriate for that risk class.
2. The cost of equity is equal to capitalization rate of a pure equity stream plus a premium
for the financial risk. The financial risk increases with more debt content in the capital
structure. As a result, ke increases in a manner to off set exactly the use of a less
expensive source of funds represented by debt.
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3. The cut-off rate for investment purposes is completely independent of the way in which
an investment is financed.
Assumptions
(i) Capital markets are perfect. This means
(a) Investors are free to buy and sell securities.
(b) The investors can borrow without restriction on the same terms on which
the firm can borrow;
(c) The investors are well informed;
(d) The investors behave rationally; and
(e) There are no transaction costs.
(ii) The firms can be classified into homogeneous risk classes all firms within the same
class will have the same degree of business risk.
(iii) All investors have the same expectation of a firms net operating income (EBIT) with
which to evaluate the value of any firm.
(iv) The dividend payout ratio is 100%. In other words, there are no retained earnings.
(v) There are no corporate taxes. However, this assumption has been removed later.
“MM hypothesis based on the idea that no matter how you divide up the capital structure
of a firm among debt, equity and other claims, there is a conservation of investment value”.
That is, because the total investment value if corporation depends upon its underlying
profitability and risk. It is invariant with respect to relative changes in the firm’s financial
capitalization. So, regardless of the financing mix, the total value of the firm remains the same.
Arbitrage Process
The arbitrage process is the operational justification of MM hypothesis. The term “Arbitrage’
refers to an act of buying an asset or security in one market having lower price and selling it in
another market at a higher price. The consequence of such action is that the market price of
the securities of the two firms exactly similar in all respects except in their capital structures
cannot for long remain different in different markets. Thus, arbitrage process restores equilibrium
in value of securities.
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Limitations of MM Hypothesis
1. Rates of interest are not the same for the individuals and the firms
The assumption made under the MM hypothesis that the firms and individual can borrow
and lend at the same rate of interest does not hold good in actual practice. This is because
firms have the higher credit standing as compared to the individuals on account of firms holding
substantial fixed assets.
2. Homemade leverage is not perfect substitute for corporate leverage
The risk to which an investor is exposed is not identical when the investor is exposed is
not identical when the investor himself borrows. As a matter of fact, the risk exposure to the
investor is greater in the former case as compared to the latter. When the firms borrows, the
liability of the investor is limited only to the extent of his proportionate share holding, in case the
company is forced to go for its liquidation.
3. Transaction costs involved
Buying and selling of securities involves transaction costs. It would therefore become
necessary for investor to invest a larger amount in the shares of the unlevered / levered firms
than his prevent investment to earn the same return.
4. Institutional restrictions
The switching option form unlevered to levered firm and vice-versa is not available to All
investors particularly, institutional investors life insurance corporation of India, unit trust of India,
Commercial banks etc. Thus, the institutional restrictions stand in the way of smooth operation
of the arbitrage process.
5. Corporate taxes frustrate MM hypothesis
On account of corporate taxes, it is a known fact that the cost of borrowing funds to the
firm is less than the contractual rate of interest. As a result, the total return to the shareholders
of an unleveled firm is always less than that of the levered firm,. Thus, the total market value of
levered firm tends to exceed that of the unlevered firm on account of this very reason.
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Corporate taxes
The MM hypothesis that the value of a firm and its cost of capital will remain constant with
leverage does not hold good when there are corporate taxes. Since corporate axes do exist, in
1963 MM agreed that the value of the firm will increase or the cost of capital will decline, if
corporate taxes are introduced in the exercise. This is because interest is a deductible expense
for tax purposes and therefore the effective cost if debt is less than the contractual rate of
interest. A levered firm should have, therefore, a greater market value as compared to an
unlevered firm. The value of the levered firm would exceed that of the unlevered firm by an
amount equal to the levered firm’s debt multiplied by the tax rate.
This can be put in the form of the following form aula:
VL = Vu + Bi
Where
VL = value of levered firm;
Vu = value of an unlevered firm;
B = amount o9f debt; and
T = tax rate
The market value of an unlevered firm will be equal to the market value of its shares.
Vu = S
Where
Vu = market value of an unlevered firm
S = market value of equity;
Profits available for equity shareholde rs

S
Equity capitaliza tion rate
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In other words, the value of Vu can be determined by the following equation.
Vu = (1-t) EBT / Ke
Where;
EBT = earnings before tax
T = tax rate.
Ke = equity capitalization rate.
Since in case of unlevered firm there is no debt content, earning before tax (EBT) means
earning before interest and tax (EBIT).
8.5.4 Traditional Approach
The net income approach and net operating income approach represent two extremes.
According to NI approach the debt content in the capital structure affects both the overall cost
capital and total valuation of the firm while NOI approach suggests that capital structure is
totally irrelevant so far as total valuation of the firm is concerned.
1. The traditional approach is similar to NI approach to the extent that it accepts that the
capital structure or leverage of the firm affects the cost of capital and its valuation. However,
it does not subscribe to the NI approach that the value of the will necessarily increase with
all degree of leverages.
2. It subscribes to NOI approach that beyond a certain degree of leverage, the overall cost
of capital increases resulting in decrease in the total value of the firm. However, it differs
from NOI approach in the sense that the overall cost of capital will not remain constant for
all degree of leverage.
The essence of the traditional approach lies in the fact that a firm through judicious use of
debt-equity mix can increase its total value and thereby reduce its overall cost of capital. This
is because debt is relatively a cheaper source of funds as compared to raising money through
shares because of tax advantage. However, beyond a point raising of funds through debt may
become a financial risk and would result in a higher equity capitalization rate. Thus, up to a
point, the content of debt in the capital structure will favorably affect the value of the firm. At this
level of debt equity mix, the capital structure will be optimum and the overall cost of capital will
be the least.
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8.6 Summary
Capital structure is the permanent financing of the company represented primarily by
long-term debt and shareholder’s funds but excluding all short-term credit. The factors affecting
Capital structure are explained briefly. There are four theories of Capital structure. They are net
income approach, net operating income approach, MM approach and traditional approval.
8.7 Keywords
Capital Structure
Net Income Approach
Net operating Income Approach
Modigilani-Miller Approach
Traditional Approach

1. Explain the term “ Point of indifference”.
2. Differentiate ‘Capitalisation’ and ‘Capital Structure’.
3. What is Optimum Capital Structure?
4. What do you understand by capital structure of a corporation? Discuss the qualities,

which a sound capital structure should possess?
5. Critically examine the Net Income and Net Operating Income approaches to capital
structure.
6. What do you understand by a Balanced Capital Structure? Why should a company

aim at balanced capital structure?
7. Explain “Arbitrage Process” under MM approach.
8. Explain EBIT-EPS approach for determining capital structure of a company

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LESSON - 9
FEATURES OF CAPITAL STRUCTURE
Learning Objectives
After completing this leson, you must be able to
 Explain the features of an appropriate capital structure
 Discuss the factors that determine the capital structure
 Describe EBIT-EPS analysis
Structure
9.1 Introduction
9.2 Features of appropriate Capital Structure
9.3 Factors determining Capital Structure
9.4 EBIT-EPS analysis
9.5 Examples
9.6 Summary
9.7 Keywords
9.1 Introduction
In the previous lesson, the theories of capital structure are explained. In this lesson, the
features of an appropriate capital structure will be dealt with.
9.2 Features of an appropriate Capital Structure

1. Profitability
The capital structure of the company should be most profitable, the most profitable capital
structure is one that tend sot minimize cost of financing and maximize earning per equity share.
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2. Solvency
The pattern of capital structure should be so devised as to ensure that the firm does not
run the risk of becoming insolvent. Excess use of debt threatens the solvency of the company.
The debt content should not therefore be such that it increases risk beyond manageable limits.
3. Flexibility
The capital structure should be such that it can be easily maneuvered to meet the
requirements of changing conditions. Moreover, it should also be possible for the company to
provide funds whenever need to finance its profitable activities.
4. Conservatism
The capital structure should be conservative in the sense that the debt content in the total
capital structure does not exceed the limit which the company can bear. In other words, it
should be such as is commensurate with the company ability to generate future cash flows.
5. Control
The capital structure should be so devised that it involves minimum risk of loss of control
of the company.
9.3 Factors determining Capital Structure

1. Financial Leverage (or) Trading on Equity
The use of long term fixed interest bearing debt and preference share capital along with
equity share capital is called financial leverage or trading on equity. The use of long-term debt
increases, magnifies the earnings per share if the firm yields a return higher than the cost of
debt. The earnings per share also increase with use of preference share capital but due to the
fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is
much more. However the leverage can operate adversely also if the rate of interest on long-
term loans is more than the expected rate of earnings of the firm. Therefore it needs caution to
plan the capital structure of a firm.
2. Growth and Stability
The Capital Structure of a firm is highly influenced by the growth and stability of its sale.
If the sales of a firm are expected to remain fairly stable it can raise a higher lever of debt.
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Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments
of interest repayment of debt. Similarly the rate of growth in sales also affects the capital
structure decision. Usually greater the rate of growth of sales, greater can be the use of debt in
the financing of firm.
3. Cost of Capital
Cost of Capital refers to the minimum return expected by its suppliers. The capital Structure
should provide for the minimum cost of capital. The main sources of finance for a firm are
equity, preference share capital and debt capital. The return expected by the suppliers of capital
depends upon the risk they have to undertake. Usually, debt is cheaper source of finance
compared to preference and equity capital due to i) Fixed rate of interest on debt ii) legal
obligation to pay interest iii) repayment of loan and priority in payment at the time of winding up
of the company.
4. Cash flow ability to service debt

A Firm shall be able to generate larger and stable cha inflows can employ more debt in its
capital structure as compared to the one, which has unstable and lesser ability to generate
cash inflows. Debt financing implies burden of fixed charge due to the fixed payment of interest
and the principal. Whenever a firm wants to raise additional funds. It should estimate the future
cha inflows to ensure the coverage of fixed charges.
5. Nature of enterprise
The nature of enterprise also to a great extent affects the capital structure of the company.
Business enterprises which have stability in their earning or which enjoy monopoly regarding
their products may go for debentures or preference shares since they will have adequate profits
to meet the recurring cost of interest/fixed dividend.
6. Size of the company
Companies, which are of small size, have to rely considerably upon the owner’s funds for
financing. Such companies find it difficult to obtain long-term debt., large companies are
generally considered to be less risky by the investors and therefore they can issue different
types of securities and collect their funds from difficult sources. They are in a better bargaining
position and can get funds form the sources of their choice.
7. Retaining control
The capital structure of a company is also affected by the extent to which the promoter’s
management of the company desires to maintain control over the affairs of the company. The
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preference shareholders and debenture holders have not much say in the management of the
company. It is the equity shareholders who select the team of managerial personnel. It is
necessary for the promoters to own majority of the equity share capital in order to exercise
effective control over the affairs of the company. The promoters or the existing management
are not interested in losing their grip over the affairs of the company and at the same time, they
need extra funds.
8. Purpose of financing
The purpose of financing also to some extent affects the capital structure of the company.
In case funds are required for some directly productive purposes, for example, purchase of
new machinery, the company can afford to raise the funds by issue of debenture. This is
because the company will have the capacity to pay interest on debentures out of the profits so
earned.
9. Requirement of investors
Different types of securities are to be issued for different classes of investors. Equity
shares are best suited for bold or venturesome investors. Debentures are suited for investors
who are very cautious while preference shares are suitable for investors who are not very
cautious. In order to collect funds form different categories of investors, it will be appropriate
for the companies to issue different categories of securities.
10.Period of finance
The period for which finance is required also affects the determination of capital structure
of companies. In case, funds are required, say for 3 to 10years, it will be appropriate to raise
them by issue of debentures rather than by issue of shares. This is because in case issue of
shares raises the funds, their repayment after 8 to 10 years will be subject to legal complications.
11. Capital Market conditions
Capital market conditions do not remain the same forever. Some times there may be
depression while at other times there may be boom in the market. The choice of the securities
is also influenced by the market conditions. If the share market is depressed the company
should not issue equity shares and investors would prefer the company should not issue equity
shares. It is advisable to issue equity shares in the boom period.
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12. Asset structure
The liquidity and the composition of assets should also be kept in mind while selecting the
capital structure. If fixed assets constitute a major portion of the total assets of the company. It
may be possible for the company to raise more of long-term debts.
13. Costs of floatation
The Cost of floating a debt is generally less than the cost of floating equity and hence it
may persuade the management to raise debt financing. The costs of floating as a percentage
of total funds decrease with the increase n size of the issue.
14.Government policy
Government policy is also an important factor in planning the company capital structure.
For example a change in the lending policy of financial institutions may mean a complete change
in the financial pattern. Similarly, by virtue of the capital issues control act, 1947 and the rules
made there under, the controller of capital issues cal also considerably affects the capital issue
policies of various companies.
15. Legal requirements

The promoters of the company have also to keep in view the legal requirements while
deciding about the capital structure of the company. This is particularly true in case of bank9ing
companies, which are not allowed to issue any other type of security for raising funds except
equity share capital on account of the banking regulation act.
16. Corporate Tax Rate
High rate of corporate taxes on profits compel the companies to prefer debt financing,
because interest is allowed to be deducted while computing taxable profits. On the other hand,
dividend on shares is into an allowable expense for that purpose.
9.4 EBIT-EPS analysis

EBIT refers to a company’s earnings before interest and taxes. EPS stands for earnings
per share, which is the profit the company generates including the impact of interest and tax
obligations. EPS is particularly helpful to investors because it measures profits on a per share
basis.
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EBIT/EPS ANALYSIS
 It design various alternatives of debt, equity and preference shares in order to
maximize the EPS at a given level of EBIT.
 It examines how different capital structures affect earnings available to shareholders

(Earning Per Share).
The EBIT-EPS approach to capital structure is a tool businesses use to determine the
best ratio of debt and equity that should be used to finance the business’ assets and operations.
At its core, the EBIT-EPS approach is a way to mathematically project how a balance sheet’s
structure will impact a company’s earnings.
The basic concept of the EBIT-EPS approach

To understand how the EBIT-EPS method works, first we must understand the two primary
metrics involved, EBIT and EPS.
EBIT refers to a company’s earnings before interest and taxes. This metric strips out the
impact of interest and taxes, showing an investor or manager how a company is performing
excluding the impacts of the balance sheet’s composition. In terms of EBIT, it doesn’t matter if
a a company is overloaded with debt or has no loans at all. EBIT will be the same either way.
EPS stands for earnings per share, which is the profit the company generates including
the impact of interest and tax obligations. EPS is particularly helpful to investors because it
measures profits on a per share basis. If a company’s total profit is soaring but its profit per
share is declining, that’s a bad thing for the investor owning a fixed number of shares. EPS
captures this dynamic in a simple, easy to understand way.
The ratio between these two metrics can show investors and management how the bottom
line results, the company’s EPS, relates to its performance independent of its capital structure,
its EBIT.
For example, let’s say a company wants to maintain stable EPS but is considering taking
out a new loan to grow its balance sheet. In order for EPS to remain stable, the company’s EBIT
must also increase at least as much as the new interest expense from the debt. If EBIT increases
the same as the next interest expense, then EPS should remain stable, assuming no change in
taxes.
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9.5 Examples
1. A company’s capital structure consists of the following:
Equity shares of Rs.100 each Rs.20 lakhs
Retained earnings Rs.10 lakhs
9% Preference shares Rs.12 lakhs
7% debentures Rs.8 lakhs
Total Rs.50 lakhs
The company earns 12% on its capital.the income-tax rate is 50%. The company requires
a sum of Rs.25 lakhs to finance its expansion programme for which the following alternatives
are available to it:
(i) Issue of 20,000 equity shares at a premium of Rs.25 per share.
(ii) Issue of 10% preference shares
(iii) Issue of 8% Debentures
It is estimated that the P/E ratios in the case of equity , preference and debenture financing
would be 21.4, 17 and 15 respectively. Which of the three financing alternatives would you
recommend and why?
Evaluation of Various Financing Alternatives
Alternavite Alternative Alternative

(i) (ii) (iii)
(Equity (10% (8%
Shares) Preference Debebtures)
Shares)
(Rs.) (Rs.) (Rs.)
Earnings Before Interest & Tax (EBIT) 9,00,000 9,00,000 9,00,000

[12% n Rs.75 lakhs]
Less: Interest on Old Debentures at 7% 56,000 56,000 56,000
8,44,000 8,44,000 8,44,000
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Interest on New Debentures at 8% - - -

Earnings Before Tax After Interest 8,44,000 8,44,000 6,44,000
Less: Tax at 50% 4,22,000 4,22,000 3,22,000
4,22,000 4,22,000 3,22,000
Less: Preference Dividend on Existing 1,08,000 1,08,000 1,08,000
Shares at 9%
3,14,000 3,14,000 2,14,000
Preference Dividend on New Shares at 10% - - -
Earnings for Equity Shareholders (a) 3,14,000 64,000 2,14,000
Number of Equity Shares (b) 40,000 20,000 20,000
Earnings Per Share (c ) = [ a + b ] 7.85 3.2 10.7
Price / Earning Ratio (d) 21.4 17 15.7
Market Price per Share ( c x d ) 167.99 54.4 167.99
2. X company Ltd is considering three different plans to finance its total project cost of
Rs.100 lakhs. They are
1. Plan A : Equity (Rs.100 per share) – 50 lakhs

Debt (8% Debentures) – 50 lakhs
2. Plan B : Equity (Rs.100 per share) – 34 lakhs

3. Plan C : Equity (Rs.100 per share) – 25 lakhs

Sales for the first three years of operations are estimated at Rs.100 lakhs, Rs.125 lakhs
and Rs.150 lakhs and a 10% profit before interest and taxes is forecasted to be achieved.
Corporate taxation to be taken at 50%. Compute earnings per share in each of the alternative
plans of financing for the three years.
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9.5 Summary
An appropriate capital structure is determined by many factors. They are profitability,
solvency, flexibility, conservation and control. The factors determining capital structure is also
discussed in this lesson. Finally EBIT-EPS analyses has been described
9.6 Keywords
Conservations, EBIT, EPS, Flexibility, Solvency

1. What are the features of capital structure? Explain.
2. Discuss the factors that determine the capital structure
3. Illustrate EBIT-EPS analysis with an example.

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LESSON - 10
DIVIDEND AND DIVIDEND POLICY
Learning Objectives
 Define dividend
 Classify types of dividend
 Discuss the sources available for dividends
 Explain the determinants of dividend policy.
Structure
10.1 Introduction
10.2 Classification of Dividends
10.3 Types of Dividend Policy
10.4 Theories related to Dividend Policies
10.4.1 Modigliani and Miller’s approach
10.4.2 Walter’s Approach
10.5 Factors affecting Dividend Policy
10.6 Summary
10.7 Keywords
10.1 Introduction
The term dividend refers to that part of the profits of a company, which is distributed
amongst its shareholders. It may be defined as the return that a shareholder gets from the
company, out of its profits, on his shareholdings. According to the Institute of Chartered
accountants of India, dividend is “a distribution to shareholder out of profits or reserves available
for this purpose”.
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The term dividend policy refers o the policy concerning quantum of profits to be distributed
as dividend. The concept of dividend policy implies that companies through their Board of
Directors evolve a pattern of dividend payments, which has a bearing on future action.
10.2 Classification of Dividends

Dividends can be classified into different categories depending upon the form in which
they are paid. The various forms of dividends are as follows:
(1) Cash Dividend
Payment of dividend in cash is called cash dividend and this results in outflow of funds
from the firm.
(2) Bond Dividend
If the company does not have sufficient funds to pay dividend in cash it may issue bonds
for the amount due to the shareholders by way of dividends. The purpose of bond dividend is to
postpone the payment of dividend in cash.
(3) Property Dividend
In this case, the dividend is paid in the form of assets other than cash. This may be in the
form of assets, which are not required by the company or tin the form of company’s products.
(4) Stock dividend
The company issues its own shares to the existing shareholders in lieu or in addition to
cash dividend. Payment of stock dividend is known as “Issue of bonus shares”.
10.3 Types of Dividend Policy

There are five types of dividend policies. They are regular, stable, irregular, residual and
no dividend policy.
1. Regular Dividend Policy
A regular dividend policy offers the following advantages.
a. It establishes a profitable record of the company.
b. It creates confidence amongst the shareholders.

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c. It aids in long-term financing and renders financing easier.
d. It stabilizes the market value of shares.
e. The ordinary shareholders view dividends as a source of funds to

meet their day-today living expenses.
f. If profits are not distributed regularly and are retained, the shareholders
may have to pay a higher rate of tax in the year when accumulated profits
are distributed.
However, it must be remembered that regular dividends can be maintained only by

companies of long standing and stable earnings. A company should establish the regular dividend
at a lower rate as compared to the average earnings of the company.
2. Stable Dividend Policy
The term ‘stability of dividends’ means consistency or lack of variability in the stream of
dividend payments. In more precise terms, it means payment of certain minimum amount of
dividend regularly. A stable dividend policy may be established in any of the following three
forms.
Constant dividend per share: Some companies follow a policy of paying fixed dividend
per share irrespective of the level of earnings year after year. Such firms, usually, create a
‘Reserve for Dividend Equalisation’ to enable them to pay the fixed dividend even in the year
when the earnings are not sufficient or when there are losses. A policy of constant dividend per
share is most suitable to concerns whose earnings are expected to remain stable over a number
of years.
2. Irregular Dividend Policy
Some companies follow irregular dividend payments on account of the following:
a. Uncertainty of earnings.
b. Unsuccessful business operations.
c. Lack of liquid resources.
d. Fear of adverse effects of regular dividends on the financial standing of the company.
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4. No Dividend Policy
A company may follow a policy of paying no dividends presently because of its unfavourable
working capital position or on account of requirements of funds for future expansion and growth.
5. Residual Dividend Policy
When new equity is raised floatation costs are involved. This makes new equity costlier
than retained earnings. Under the Residual approach, dividends are paid out of profits after
making provision for money required to meet upcoming capital expenditure commitments.
10.4 Theories related to Dividend Policies

10.4.1 Modigilani and Miller’s approach
This comes under the Irrelevance concept of dividend. According to them, dividend policy
has no effect on the share prices of a company and therefore, of no consequence. They have
suggested that the price of shares of a firm is determined by its earning potentiality and investment
policy and never by the pattern of income distribution.
For eg., If a company having investment opportunities, distributes all its earnings among
its shareholders, it will have to raise the capital from outside. This will result in increasing the
number of shares resulting in the fall in the future Earning per share. Thus, whatever a shareholder
has gained as a result of increased dividends will be neutralized completely on account of fall in
the value of shares due to decline in the expected earning per share.
Assumptions of MM Hypothesis
MM hypothesis is based on the following assumptions:
(i) Capital markets are perfect.
(ii) Investors behave rationally. Information is freely available to them and there are no
transaction and floatation costs.
(iii) There are either no taxes or there are no differences in the tax rates applicable to
capital gains and dividends.
(iv) The firm has a fixed investment policy.

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(v) Risk or uncertainty does not exist.
According to MM hypothesis, the market value of a share in the beginning of the period is
equal to the present value of dividends paid at the end of the period plus the market price of the
share at the end of the period.
This can be put in the form of the following equation:
D1  P1
Po =
(1  Ke)
Where Po = Prevailing market price of a share.
Ke = Cost of equity capital.
D1 = Dividend to be received at the end of the period one.
P1 = Market Price of a share at the end of the period one.
From the above equation, the following equation can be derived for determining the value
of P1.
P1 = Po (1 + Ke) – D1
Criticism of MM hypothesis
(i) Tax: MM hypothesis assumes that taxes do not exist, is far from reality.
(ii) Floatation costs: A firm has always to pay floatation cost in term of underwriting fee
and broker’s commission whenever it wants to raise funds from outside.
(iii)Transaction costs: The shareholder has to pay brokerage fee, etc, when he wants to
sell the shares.
(iv)Discount rate: The assumption under MM hypothesis that a single discount rate can
be used for discounting cash inflows at different time periods is not correct. Uncertainty increases
with the length of the time period.
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10.4.2 Walter’s Approach
This comes under the relevance concept of dividend.
Relevance concept:
A firm’s dividend policy has a very strong effect on the firm’s position in the stock market.
Higher dividends increase the value of stock while low dividends decrease their value. This is
because dividends communicate information to the investors about the firm’s profitability.
According to Prof.James E. Walter’s approach, the dividend policy always affects the
value of the enterprise. The finance manager can, therefore use it to maximize the wealth of the
equity shareholders. Walter has also given a mathematical model to prove this point.
Prof. Walter’s model is based on the relationship between the firm’s
(i) Return on investment or internal rate of return (i.e.)
(ii) Cost of Capital or required rate of return. (i.e., k)
According to Prof.Walter, if r > k, i.e., the firm can earn a higher return than what the
shareholders can earn on their investments, the firm should retain the earnings. Such firms are
known as growth firms, and in their case the optimum dividend policy would be to plough back
the entire earnings. In their case the dividend payment ratio (D/P ratio) would, therefore, be
zero. This would maximize the market value of their shares.
In case of firm, which does not have profitable investment opportunities (i.e., r, k), the
optimum dividend policy would be to distribute the entire earnings as dividend. The shareholders
will stand to gain because they can use the dividends so received by them in channels, which
can give them higher return. Thus, 100% payout ratio in their case would result in maximizing
the value of he equity shares.
In case of firms, where r = k, it does not matter whether the firm retains or distributes
earnings. In their case the value of the firm’s shares would not fluctuate with change in the
dividend rates. There is, therefore, no optimum dividend policy for such firms.
Assumptions
(i) The firm does the entire financing through retained earnings. It does not use external
source of funds such as debt or new equity capital.
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(ii) The firm’s business risk does not change with additional investment. It implies the
firm’s internal rate of return (i.e., r) and cost of capital (i.e., k) remains constant.
(iii) In the beginning earning per share (i.e. E) and dividend (i.e., D) per share remain
constant. It my be noted that the values of ‘E’ and ‘D’ may be changed in the model
for determining the results, but any given values of ‘E’ and ‘D’ are assumed to
remain constant in determining a given value.
(iv) The firm has a very long life.
Mathematical Formula
Prof. Walter has suggested the following formula for determining the market value of a
share:
Dr
E  D 
P Ke
Ke
Where P = Market price of an equity share
D = Dividend per share
R = Internal rate of return
E = Earning per share
Ke = Cost of equity capital
Criticism
(i) Walter’s assumption that financial requirements of a firm are met only by retained
earnings and not by external financing, is seldom true in real situations.
(ii) The assumption that the firm’s internal rate of return (i.e.,r) will remain constant
does not hold good.
(iii) The assumption that ‘k’ will also remain constant does not hold good.
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10.5 Factors Affecting Dividend Policy

The factors affecting the dividend policy are both external as well as internal.
External Factors
1. General state of economy
In case of depressions, uncertain economic and business conditions, the management

may like to retain the whole or part of the retained earnings to build up reserves to absorb
shocks in the future. In periods of prosperity the management may not be liberal in dividend
payments though the earning power of a company warrants it because of availability of larger
profitable investment opportunities.
2. State of capital market
In case a firm has an easy access to the capital markets either because it is financially
strong or because favourable conditions prevail in the market, it can follow a liberal dividend
policy. However, if the firm has no easy access to capital market because either of weak financial
position or because of unfavourable conditions in the capital market, it is likely to adopt a more
conservative dividend policy.
3. Legal restrictions
A firm may also legally restricted form declaring and paying dividends. For e.g., the
Companies Act, 1956 has put several restrictions regarding payments and declaration of
dividends. Some of these restrictions are as follows:
(i) Dividends can only be paid out of
(a) The current profits of the company,
(b) The past accumulated profits or
(c) Money provided by the Central or State Government for the payment of dividends
is pursuance of the guarantee given by the Government.
(ii) A company is not entitled to pay dividends unless
(a) It has provided for present as well as all arrears of depreciation

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(b) A certain p[percentage of net profits of that year as prescribed by the Central
Government not exceeding 10%, has been transferred to the reserves of the
company.
(iii) Past accumulated profits can be used for declaration of dividends only as per the rules
framed by the Central Government in this behalf.
Similarly, the Indian Income tax Act also lays down certain restrictions payment of dividends.
The management takes into consideration all the legal restrictions before taking the dividend
decision.
4. Contractual restrictions
Lenders of the firm generally put restrictions on dividend payments to protect their interests
in periods when the firm is experiencing liquidity or profitability problems. For eg.it may be
provided in a loan agreement that the firm shall not declare any dividend so long the liquidity
ratio is less than 1: 1 or the firm will not pay dividend of more than 12% so long the firm does not
clear the loan.
5. Tax Policy
The tax policy followed by the Government also affects the dividend policy. For e.g., the
Government may give tax incentives to companies retaining larger share of their earnings. In
such a case the management may be inclined to retain a large amount of the firm’s earnings.
Internal Factors
The following are the internal factors, which affect the dividend policy of the firm:
1. Desire Of The Shareholders
Shareholders of a firm expect two forms of return from their investment in a firm:
(i) Capital gains: the shareholders expect an increase in the market value of the equity
shares held by them over a period. Capital gain refers to the profit resulting from the sale
of capital investment i.e., the equity shares in case of shareholders. For.eg if a shareholder
purchases a share for Rs.40 and later on sells it for Rs.60 the amount of capital gain is a
sum of Rs.20.
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(ii) Dividends: The shareholders also expect a regular return on their investment from the
firm. In most cases, the shareholder’s desire to get dividends takes priority over the desire
to earn capital gains because of the following reasons:
 Reduction of uncertainty: Capital gains or a future distribution of earnings involves

more uncertainty than a distribution of current earnings.
 Indication of strength: The declaration and payment of cash dividend carries

information content that the firm is reasonably strong and healthy.
 Need for current income: Many shareholders require income from the investment
to pay for their current living expenses. Such shareholders are generally reluctant
to sell their shares to earn capital gain.
2. Financial Needs of The Company
The financial needs of the company may be in direct conflict with the desire of the
shareholders to receive large dividends. However, a prudent management has to give weightage
to the financial needs of the company rather than the desire of the shareholders. In order to
maximize the shareholder’s wealth, it is advisable to retain the earnings in the business only
when the company has better profitable investment opportunities as compared to the
shareholders. However, the directors must retain some earnings, whether or not profitable
investment opportunity exists, to maintain the company as a sound and solvent enterprise.
3. Nature of Earnings
A firm having stable income can afford to have a higher dividend pay out ratio as compared
to a firm, which does not have such stability in its earnings.
4. Desire to Control
Dividend policy is also influenced by the desire of shareholders or the management to

retain control over the company.
5. Liquidity Position
The payment of dividends results in cash outflow from the firm. A firm may have adequate
earnings but it may not have sufficient cash to pay dividends. It is, therefore, important for the
management to take into account the cash position and overall liquidity position of the firm
before and after the payment of dividends while taking the dividend decision. A firm may not,
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therefore in a position to pay dividends in cash or at a higher rate because of insufficient cash
resources. Such a problem is generally faced by growing firms which need constant funds for
financing their expansion activities.
10.6 Summary
The term dividend refers to that part of the profits of a company, which is distributed
amongst its shareholders. It may be defined as the return that a shareholder gets from the
company, out of its profits, on his shareholdings. The classifications of dividends is discussed.
The theories related to dividends are also explained in this lesson.
10.7 Keywords
Bond Dividend
Cash Dividend
Property Dividend
Stock Dividend

1. Explain EBIT-EPS approach for determining capital structure of a company.
2. Define the terms “Dividend” and “Dividend policy”.
3. Write short notes on the classification of dividends.
4. What are the determinants of the dividend policy of a corporate enterprise?
5. Explain Walter’s approach of dividend policy in detail.
6. What is the MM approach of irrelevance concept of dividends? Under what

assumptions do the conclusions hold good?
7. Explain the shortcomings of the dividend Theories.

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LESSON - 11
WORKING CAPITAL MANAGEMENT
Learning Objectives
 Explain the concepts of Working Capital Management
 Discuss the importance and determinants of Working Capital.
Structure
11.1 Introduction
11.2 Need for Working Capital
11.3 Operating Cycle
11.4 Types of Working Capital
11.5 Adequacy of Working Capital
11.6 Excess or Inadequate Working Capital
11.7 Working Capital Financing
11.8 Management of Working Capital
11.9 Techniques for Assessment of Working Capital Requirement
11.10 Sources of Working Capital
11.11 Approaches for Determining the Financing Mix
11.12 Various Committees On Bank Finance In India
11.13 Summary
11.14 Keywords

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11.1 Introduction
The capital requirement of a business can be divided into two main categories
(1) Fixed capital requirements and
(2) Working capital requirements.
There are two concepts of working capital
(i) Gross Working Capital
It refers to the firm’s investment in total current or circulating assets.
(ii) Net Working Capital
The term net working capital has been defined in two different ways:
(1) It is the excess of current assets over current liabilities.
(2) It is that portion of firm’s current assets which is financed by long-term funds.
For example, a business requires investments in current assets such as cash, accounts
receivable and short-term investments, etc to the extent of Rs15, 000. A part of this requirement
can be financed by the firm by purchasing on credit or postponing certain payments or, in other
words, by creation of current liabilities such as accounts payable, outstanding expenses, etc.
11.2 Need for Working Capital

The basic objective of financial management is to maximize the shareholders wealth.
The amount of such profit largely depends upon the magnitude of sales. However, sales do not
convert into cash instantaneously. There is always a time gap between the sale of goods and
receipt of cash. Working capital is required for this period in order to sustain the sales activity.
11.3 Operating Cycle

The time gap between the sales and their actual realization in cash is technically termed
as operating cycle of the business. In case of a manufacturing company, cycle is the length of
time necessary to complete the following cycle of events:
(1) Conversion of cash into raw materials;
(2) Conversion of raw materials into work-in-progress

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(3) Conversion of work-in-process into finished goods;
(4) Conversion of finished goods into accounts receivable, and
(5) Conversion of accounts receivable into cash.
This cycle will be repeated again and again.
The operation cycle of manufacturing business can be shown as in the following chart.
Operating Cycle of a Manufacturing Business
In the case of a trading firm the Operating cycle will include the length of time required to
convert
(1) Cash into inventories,
(2) Inventories into accounts receivable and accounts
(3) Accounts receivable into cash.
11.4 Types of Working Capital

Working capital can be divided into two categories on the basis of time:
1. Permanent working capital;
2. Temporary or variable working capital.
1. Permanent Working Capital
This refers to that minimum amount of investment in all current assets which is required,
at all times to carry out minimum level of business activities. In other words, it represents the
current assets required on a continuing basis over the entire year. Tandon committee has referred
to this type of working capital as core current assets.
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The following are the characteristics of this type of working capital.
1. Amount of permanent working capital remains in the business in one form or another.
This is particularly important from the point of view of financing. The suppliers of such
working capital should not accept its return during the lifetime of the firm.
2. It also grows with the size of the business; greater is the amount of such working capital
and vice versa.
Permanent working capital is permanently needed for the business and therefore it should
be financed out of long-term funds. This is the reason why the current ratio has to be substantially
more than 1.
2. Temporary Working Capital
The amount of such working capital keeps on fluctuating from time to time on the
basis of business activities. In other words, it represents additional current assets required at
different times during the operating year. For example, extra inventory has to be maintained to
support sales during peak sales period. Similarly, receivable also increase and must be financed
during period of high sales. On the other hand investment in inventories, receivables, etc., will
decreases in periods of depression.
Suppliers of temporary working capital can expect its return during off-season when the
firm does not require it. Hence, temporary working capital is generally financed from short-
term sources of finance such as bank credit.
11.5 Adequacy of Working Capital

A firm must have adequate working capital as much as needed by the firm. It should
neither be excessive nor inadequate. Both situations are dangerous. Excessive working capital
means the firm has idle funds, which earn no profits for the firm. Inadequate working capital
means the firm does not have sufficient funds for running its operations, which ultimately result
in production interruptions ring down the profitability.
1. There is a direct relationship between risk and profitability –higher is the risk, higher
is the profitability; while lower is the risk, lower is the profitability.
2. Current assets are less profitable than fixed assets.
3. Short-term funds are less expensive than long-term funds.

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Advantages of adequate working capital
Working capital is the life blood and nerve centre of a business. Just as circulation of
blood is essential in the human body for maintaining life, working capital is very essential to
maintain the smooth running of a business. No business can run successfully without an adequate
amount of working capital. The main advantages of maintaining adequate amount of working
capital are as follows:
1. Solvency of the business: Adequate working capital helps in maintaining solvency of

the business by providing uninterrupted flow of production.
2. Goodwill: Sufficient working capital enables a business concern to make prompt

payments and hence helps in creating and maintaining goodwill.
3. Easy loans: A concern having adequate working capital, high solvency and good credit
standing can arrange loans from banks and other on easy and favourable terms.
4. Cash discounts: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures regular supply of
raw materials and continuous production.
6. Regular payment of salaries, wages and other day-to-day commitments: A company

which has ample working capital can make regular payment of salaries, wages and other day-
to-day commitments which raises the morale of its employees, increases their efficiency, reduces
wastages and costs and enhances production and profits.
7. Exploitation of favourable market conditions: Only concerns with adequate working

capital can exploit favourable market conditions such as purchasing its requirements in bulk
when the prices are lower and by holding its inventories for higher prices.
8. Ability to face crisis: Adequate working capital enables a concern to face business
crisis in emergencies such as depression because during such periods, generally, there’s much
pressure on working capital.
9. Quick and regular return on investments: Every Investor wants a quick and regular
return on his investments. Sufficiency of working capital enables a concern to pay quick and
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regular dividends to its investors as there may not be much pressure to plough back profits.
This gains the confidence of its investors and creates a favourably market to raise additional
funds i.e., the future.
10. High morale: Adequacy of working capital creates an environment of security,

confidence,high morale and creates overall efficiency in a business
11.6 Excess or Inadequate Working Capital

Every business concern should have adequate working capital to run its business
operations. It should have neither redundant or excess working capital nor inadequate or shortage
of working capital. Both excess as well as short working capital positions are bad for any business.
However, out of the two, it is the inadequacy of working capital which is more dangerous from
the point of view of the firm.
Disadvantages of Redundant or Excessive Working Capital
1. Excessive Working Capital means ideal funds which earn no profits for the business
and hence the business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.
3. Excessive working capital implies excessive debtors and defective credit policy which
may cause higher incidence of bad debts.
4. It may result into overall inefficiency in the organization.
5. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
6. Due to low rate of return on investments, the value of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.
Dangers of Inadequate Working Capital
1. A concern which has inadequate working capital cannot pay its short-term liabilities in
time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
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2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3. It becomes difficult for the firm to exploit favourable market conditions and undertake
profitable projects due to lack of working capital.
4. The firm cannot pay day-to-day expenses of its operations and its creates
inefficiencies,increases costs and reduces the profits of the business.
5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of

liquid funds.
6. The rate of return on investments also falls with the shortage of working capital.
11.7 Working Capital Financing

Accruals
The major accrual items are wages and taxes. These are simply what the firm owes to its
employees and to the government
Trade Credit
Trade credit represents the credit extended by the supplier of goods and services. It is
spontaneous source of finance in the sense that it arises in the normal transactions of the
firm without specific negotiations, provided the firm is considered creditworthy by its supplier. It
is an important source of finance representing 25% to 50% of short-term financing.
Working Capital Advance by Commercial Banks
Working capital advance by commercial banks represents the most important source for
financing current assets.
Short-term Loans from Financial Institutions
The Life Insurance Corporation of India and the General Insurance Corporation of India
provide short-term loans to manufacturing companies with an excellent track record.
Rights Debentures for Working Capital
Public limited companies can issue “Rights” debentures to their shareholders with the
object of augmenting the long-term resources of the company for working capital requirements.
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The key guidelines applicable to such debentures are as follows:
i. The amount of the debenture issue should not exceed (a) 20% of the gross current
assets, loans, and advances minus the long-term funds presently available for financing working
capital, or (b) 20% of the paid-up share capital, including preference capital and free reserves,
whichever is the lower of the two.
ii. The debt. -equity ratio, including the proposed debenture issue, should not exceed 1:1.
iii. The debentures shall first be offered to the existing Indian resident shareholders of the
company on a pro rata basis.
Commercial Paper
Commercial paper represents short-term unsecured promissory notes issued by firms

which enjoy a fairly high credit rating. Generally, large firms with considerable financial strength
are able to issue commercial paper. The important features of commercial paper are as follows:
i. The maturity period of commercial paper usually ranges from 90 days to 360 days.
ii. Commercial paper is sold at a discount from its face value and redeemed at its face
value. Hence the implicit interest rate is a function of the size of the discount and the period of
maturity.
iii. Commercial paper is directly placed with investors who intend holding it till its maturity.
Hence there is no well developed secondary market for commercial paper.
Factoring
Factoring, as a fund based financial service, provides resources to finance receivables

as well as facilitates the collection of receivables. It is another method of raising short-term
finance through account receivable credit offered by commercial banks and factors. A commercial
bank may provide finance by discounting the bills or invoices of its customers. Thus, a firm gets
immediate payment for sales made on credit. A factor is a financial institution which offers
services relating to management and financing of debts arising out of credit sales. Factoring is
becoming popular all over the world on account of various services offered by the institutions
engaged in it. Factors render services varying from bill discounting facilities offered by commercial
banks to a total take over of administration of credit sales including maintenance of sales ledger,
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collection of accounts receivables, credit control and protection from bad debts, provision of
finance and rendering of advisory services to their clients. Factoring may be on a recourse
basis, where the risk of bad debts is borne by the client, or on a non-recourse basis, where the
risk of credit is borne by the factor.
11.8 Management of Working Capital

The term working capital generally stands for excess of current assets over current liabilities.
Working capital management refers to all aspects of the administration of both current assets
and current liabilities. In other words, working capital management is concerned with the problems
that arise in attempting to manage the current assets, the current liabilities, and the
interrelationships that exist between them.
The basic objective of working capital management is to manage the firms current assets
and current liabilities in such a way that the satisfactory level of working capital is maintained it
is neither inadequate nor excessive. The current assets should be sufficient to cover current
liabilities in order to maintain a reasonable safety margin.
Moreover, different components of working capital are to be properly balanced. In the

absence of such a situation, the financial position in respect of the firm’s liquidity may not be
satisfactory in spite of satisfactory liquidity ratio. For example if the proportion of inventories is
very high in the total current assets because of slow moving or obsolete inventory, this cannot
provide the cushion of liquidity. Similarly, if the proportion of the accounts receivable is very high
in the total current assets on accounts of the firm’s inability to recover money from its debtors,
the firm’s liquidity ratio will be deceptive. Similarly, if a firm is maintaining higher cash and bank
balances, it also means that the firm is not making profitable use of its resources.
11.9 Techniques For Assessment of Working Capital

Requirement
Following are the various techniques used for the assessment of firm’s working capital
requirements.
Estimation of Working Capital Required
Since working capital is the excess of current assets over current liabilities an assessment
of the working capital requirements can be made by estimating the amount of different
constituents of working capital inventories accounts receivable. Cash, accounts payable etc.
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Percent of Sales Method
This is a traditional and simple method of estimating working capital requirements.

According to this method on the basis of past experience between sales and working capital
requirements, a ratio can be determined for estimating the working capital requirements in
future. For example, if the past experience show that working capital has been 30% of sales,
and it is estimated that the sales for the next year would amount to Rs One lac, the amount of
working capital requirements can be assessed as Rs30,000. The basic criticism of this method
that it presumes a linear relationship between sales and working capital. This is not true in all
cases and method is not universally acceptable.
Operating Cycle Approach
According to this approach, the requirement of working capital depends upon the operating
cycle of the business.The operating cycle begins with the acquisition of raw materials and ends
with the collection of receivables. It may be broadly classified into the following four stages viz
1. Raw materials and stores storage stage;
2. Work-in-process stage;
3. Finished goods inventory stage; and
4. Receivables collection stag.
The duration of the operating cycle for estimating working capital requirements is equivalent
to the sum of the durations of each of these stages less the credit period allowed by the suppliers
of the firm.Symbolically the duration of the working capital cycle can be put as follows:
O=R+W+F+D-C
Where,
O = Duration of operating cycle
R = raw materials and stores storage period,
W = Work in process period,
F = finished stock storage period.

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D = debtors collection period
C = creditors payment period.
Each of the components of the operating cycle can be calculated as follows.
Average stock of raw materials and stores

R
Average raw materials and stores consumptio n per day
Average work - in - Process inventory

W
Average cost of production per day
Average finished stock inventory

F
Average cost of goods sold per day
Average book debts

D
Average credit sales per day
Average trade creditors

C
Average credit purchases per day
After computing the period of one operating cycle, the total number of operating cycles
that can be completed during a year can be computed by dividing 365 days with the number of
operating days in a cycle. The total operating expenditure in the year when divided by the
number of operating cycles in a year will give the average amount of the working capital
requirements.
Example
From the following information, extracted from the books of manufacturing company
compute the operating cycle in days and the amount of working capital required:
Period covered - 365 days
Average period of credit allowed by the supplies - 15 days
Particulars Rs. in ‘000
Average total of Debtor outstanding 750

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Raw material consumption 6,400
Total Production cost 15,000
Total Cost of Sales 15,500
Sales for the year 25,000
Value of average stock maintained:
Raw material 520
Work-in progress 550
Finished goods 300
Solution:
R = Raw materials held in stock = Average stock of raw materials per day/average
consumption per day = (520 x 365) / 6400 = 30 days
Less: average credit period granted by suppliers = 15 days / 15 days
W = Work-in-progress = Average Work-in-progress maintained/average cost of

production per day = 550x365 /15,000 = 13 days
F = Finished goods held in stock = Average Finished goods maintained / Average cost
of sales per day = 300x365/15,500 =7 days
Credit period allowed to debtors = Average total of outstanding debtors /Average credit
sales per day =750x365/25,000 = 11 days
Total operating cycle = 46 days
Total operating cycles in a year = 365/46 = 8
Amount of working capital required = Total operating cost / Number of operating cycles in
a year = 15,500/8 = Rs.1938 per day
11.10 Sources of Working Capital

The working capital requirements should be met both from short-term as well as long-
term sources of funds. It will be appropriate to meet at least 2\3 of the permanent working
capital requirements from long-term sources and only for the period needed.
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The financing of working capital through short-term sources of funds has the benefits
of lower cost and establishing close relationship with the banks.
Financing of working capital from long-term resources provides the following benefits
1. It reduces risk, since the need to repay loans at frequent intervals in eliminated.
2. It increases liquidity, since the firm has not to worry about the payment of these funds
in the near future.
The finance manager has to make use of both long-term and short-term sources of funds
in a way that the overall coast of working capital is the lowest and the funds are available on
time and for the period they are really needed.
11.11 Approaches for Determining the Financing Mix

There are three basic approaches for determining the working capital financing mix.
1. The Hedging approach
According, to this approach, the maturity of source of funds should match the nature of
assets to be financed. The approach is therefore also termed as matching approach. It divides
the requirements of total working capital funds into two categories
(a) Permanent working capital funds required for purchase of core current assets. Such
funds do not vary over time.
(b) Temporary or seasonal working capital funds which fluctuate over time.
The permanent working capital requirements should be financed by long-term funds while
the seasonal working capital requirements should be financed out of short-term funds.
2. Conservative approach
According to this approach all requirements of funds should be met from long-term sources.
The short-term sources should be used only for emergency requirements. The conservative
approach is less risky but more costly as compared to the hedging approach. In other words
conservative approach is low profit-low risk while hedging approach results in high profit-high
risk.
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3. Trade-off between hedging and conservative approaches
The hedging and conservative approaches are both on two extremes. Neither of them
can therefore help in efficient working capital management. A trade-off between these two can
give satisfactory results. The level of such trade-off between these two can give satisfactory
results. The average working capital so obtained may be financed by long-term funds and the
balance by short-term funds.
For example if during the quarter ending 31st march 1990 the minimum working capital
required is estimated at Rs. 10,000 while the maximum at Rs. 15,000 the average level comes
to Rs. 12,500 [i.e., (10,000+15,000)+2].
The firm should therefore finance Rs.12, 500 from long-term sources while any extra
capital required any time during the period, from short-term sources(i.e., current liabilities)
11.12 Various Committees on Bank Finance in India

Year Chairman Issue covered
1929 B N Mitra Central Banking Functions and Agr. Finance
1944 DR Gadgil Agricultural finance
1945 RS Saria Agr Finance & Coop Societies
1949 Sri Purshottam Dass Agr Finance & Coop Societies
1954 AD Gorwala Study of rural finance
1968 Dehejia Financial requirement of trade & industry
1970 Chatalier Finance to small scale industry
1970 BD Thakar Job criteria approach in bank loans
1971 RK Talwar Enactments at state level regarding

agriculture finance
1974 P.L.Tandon Maximum Permissible Bank Finance (MPBF)
1975 Varshney Revised method for loans of Rs.2 lac or more
1976 CE Kamathv Multi-institutional approach in Agr finance

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1978 Baldev Singh Simplification of loan procedures

and documentation relating to agricultural
and allied activities
1978 Tambe Composite term loan to SSIs
1979 Chore committee Cash credit system of banks
1980 K S Krishaswami Role of banks in priority sector advances and 20

point programmes
1982 Puri Uniformity of loan application
1983 Tiwari Indl sickness and rehabilitation of sick units
1989 SC Kalyansundaram Introduction of factoring services
1991 M Narasimha Financial sector reforms
1992 S.S.Marathe Urban co-operative banks
1992 AC Shah NBFCs
1992 Nadkarni SS Trading in public sector bonds
1993 PR Nayak Institutional credit to SS SSIs
1993 Jilani R Credit delivery system
1998 M Narsimham Financial Sector reforms
1998 S L Kapoor Institutional credit to SSIs
1998 R H Khan Harmonization of role of FIs & Banks
1998 L C Gupta Financial derivatives
Recommendation and Directives have Stemmed from the following

Groups
I. Dehejia Committee
(1) Borrower must decide how much would borrow from bank.
(2) Bank credit should be treated as first source of finance
(3) Amount of credit extended is based on amount of securities.
II. Tandon committee

(1) Norms of current asset.
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(2) Maximum permissible bank finance.

(3) Emphasis on loan system.
(4) Periodic information and reporting system.
III. Chore committee

(1) The banks should obtain quarterly statements from borrowers.
(2) Periodical review of loan
(3) Separate credit limits for peak and non peak level.
(4) Bank should discourage sanction of temporary limits.
11.13 Summary
Working capital is the life blood and nerve centre of a business. Just as circulation of
blood is essential in the human body for maintaining life, working capital is very essential to
maintain the smooth running of a business. No business can run successfully without an adequate
amount of working capital. The need for working capital is explained. The types of working
capital are also discussed in this lesson.
11.14 Keywords
Operating Cycle
Working Capital

1. Working capital is the lifeblood of any business.” Comment.
2. Draw an Operating Cycle of working capital for a manufacturing company. Brief.
3. Define the term working capital. State the different types of working capital.
4. Discuss the various committees that has contributed to working capital financing in
India.
5. State the significance of working capital. Also state the advantages of adequate
working capital and disadvantages of redundant working capital
6. Discuss the principles, needs and determinants of working capital to a manufacturing

firm.
7. Discuss the various sources of working capital in detail.

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LESSON - 12
CASH MANAGEMENT
Learning Objectives
 Discuss the motives for holding cash
 List out objectives and strategies of Cash Management.
 Explain the various cash management problems
 Describe the cash management problems
Structure
12.1 Introduction
12.2 Motives for holding cash
12.3 Objectives of Cash Management
12.4 Cash management-Basic problems
12.4.1 Controlling level of cash
12.4.2 Controlling inflows of cash
12.4.3 Control over cash outflows
12.4.4 Investing surplus cash
12.5 Cash Management Models
12.5.1 Baumol model
12.5.2 Miller Orr Model
12.6 Summary
12.7 Keywords

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12.1 Introduction
The term ‘cash’ with reference to cash management is used in two senses. In a narrower
sense it includes coins, currency notes, cheques, bank drafts, held by a firm with it and the
demand deposits held by it in banks.
In a broader sense it also includes “near cash assets” such as marketable securities and
time deposits with banks. Such securities or deposits can immediately be sold or converted into
cash if the circumstances require. The term cash management is generally used for management
of both cash and near-cash assets.
12.2 Motives for Holding Cash

The following are the motives for holding cash in a company.
1. Transaction motive: A firm enters into a variety of business transactions resulting in both
inflows and outflows. In order to meet the business obligations in such situations, it is
necessary to maintain adequate cash balance. Thus, the firms with the motive of meeting
routine business payments keep cash balance.
2. Precautionary motive: A firm keeps cash balance to meet unexpected cash needs arising
out of unexpected contingencies such as floods, strikes, presentment of bills for payment
earlier than the expected date, unexpected slowing down of collection of accounts
receivable, sharp increase in the prices of raw materials etc. The more is the possibility of
such contingencies, more is the amount of cash kept by the firm for meeting them.
3. Speculative motive: A firm also keeps cash balance to take advantage of unexpected
opportunities, typically outside the normal course of the business. Such motive is therefore,
of purely a speculative nature. For example, a firm may buy securities when the prices fall
and sell it in conditions of financial crunch.
4. Compensation motive: Banks provide certain services to their clients free of charge.
They therefore, usually require clients to keep minimum cash balance with them, which
help them to earn interest and thus compensate them for the free services so provided.
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12.3 Objectives of Cash Management

There are two basic objectives of cash management:
(1) To meet the cash disbursement needs as per the payment schedule.
(2) To minimize the amount locked up as cash balances.
Both the objectives are mutually contradictory and therefore, it is a challenging task for
the finance manager to reconcile them and to have the best in this process.
(1) Meeting cash disbursement: The first basic objective of cash management is to
meet the payments schedule. The firm should have sufficient cash to meet the various
requirements of the firm at different periods of time. The firm has to make payments for purchase
of raw materials, wages, taxes, purchase of assets etc. The business activity may be stopped
if the payment schedule is not maintained. Cash , has therefore been aptly described as the “oil
to lubricate the ever turning wheels of the business, without it the process grinds to stop”.
(2) Minimizing the funds locked up as cash balances: The second basic objective of
cash management is to minimize the funds locked up as cash balances. In the process of
minimizing the cash balances, the financial manager is confronted with two conflicting aspects.
A higher cash balance ensures proper payment with all its advantages. But this will result in a
large balance of cash remaining idle. Low level of cash balance may result in failure of the firm
to meet the payment schedule. The finance manager should therefore, try to have an optimum
amount of cash balance keeping in view both the objectives.
12.4 Cash management-Basic problems

Cash management involves the following basic problems:
 Controlling level of cash;
 Controlling inflows of cash;
 Controlling outflows of cash; and
 Optimum investment of surplus cash.
12.4.1 Controlling Level of Cash
One of the basic objectives of cash management is to minimize the level of cash balance
with the firm. This objective is achieved by means of the following:
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(a) Preparing Cash budget
Cash budget or cash forecast is the most significant device for planning and controlling
the use of cash. It involves a projection of future cash receipts and cash disbursements of the
firm over various intervals of time. It reveals the timings and amount of expected cash inflows
and outflows over a period. This helps to determine the future cash needs of the firm, plan for
financing of these needs and exercise control over the cash and liquidity of the firm.
(b) Providing for unpredictable discrepancies
Cash budget predicts discrepancies between cash inflows and outflows on the basis of
normal business activities. It does not take into account the discrepancies between cash inflows
and outflows on account of unforeseen circumstances such as strikes, recession, floods etc.
Therefore, a certain minimum amount of cash balance has to be kept for meeting the unforeseen
contingencies. Such amount is fixed based on past experience.
(c) Consideration of short costs
The term short cost refers to the cost incurred as a result of shortage of cash. Such cost
may take any one of the following forms:
 The failure of the firm to meet its obligation in time may result in legal action by the
firm’s creditors against the firm.
 Borrowings may have to be resorted to high rates of interest.
(d) Availability of other sources of funds
A firm can avoid holding unnecessary balance of cash for contingencies in case it has to
pay a slightly higher rate of interest than that on a long-term debt.
12.4.2 Controlling Inflows Of Cash
After preparing the cash budget, the finance manager has to ensure to control the deviation
between projected cash inflows and projected cash outflows. The finance manager has to
devise proper techniques which help not only in prevention of diversion of cash receipts but
also in speeding up collection of cash. Speedier collection of cash can be made possible by
adopting any one of the following methods:
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(a) Concentration banking
It is a system of decentralizing the collections of account receivables in case of large

firms having their business spread over a large area. According tot his system, a large number
of collection centers are established by the firm in different areas and the firm opens its bank
account in local banks in different areas where it has its collection centers. The collection canters
are required to collect cheques from their customers and deposit them in the local bank account.
Instructions are given in the local collection centers to transfer funds over a certain limit daily
telegraphically to the bank at the head office. This facilitates fast movement of funds.
(b) Lock-box System
It is a further step in speeding up collection of cash. In case of concentration banking,

cheques are received by collection centers who, after processing deposit them in the local bank
accounts. Thus, there is a time gap between actual receipt of cheques by a collection center
and its actual depositing in the local bank account. Lock-box system has been devised to
eliminate delay on account of this time gap. According to this system, the firm hires a post-
office box and instructs its customer to mail their remittances to the box. The firm’s local box is
given authority to pick the remittances directly from the local box. The bank picks up the mail
several times a day and deposits the cheques in the firm’s account. Standing instructions are
given to the local banks to transfer funds to the Head office bank when they exceed a particular
limit.
12.4.3 Control Over Cash Outflows
An effective control over cash outflows or disbursements also helps a firm in conserving
cash and reducing financial requirements. However, there is a basic difference between the
underlying objective of exercising control over cash inflows and cash outflows. In case of the
former, the objective is the maximum acceleration of collections while in the case of latter, it is
to slow down the disbursements as much as possible. The combination of fast collections and
slow disbursements will result in maximum availability of funds.
A firm can control the outflows of cash if the following considerations are kept in view:
(1) Centralized system of disbursements should be followed as compared to

decentralized system in case of collections. All payments should be made from a
single control account.
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(2) Payments should be made on the due dates, neither before nor after.
(3) The firm must use the technique of “playing float” for maximizing the availability of
funds. The term ‘float’ means the amount tied up in cheques that have not been
presented for payment. There is always a time lag between issue of cheque by the
firm and its actual presentation. As a result of this a firm’s actual balance at bank
may be more than the balance shown by its books. This difference is called “payment
in float”. The longer the “float period” greater is the benefit to the firm.
12.4.4 Investing Surplus Cash
Following are the two basic problems regarding the investment of surplus cash:
(a) Determination of the amount of surplus cash
(b) Determination of the channels of investment
(a) Determination of the amount of surplus cash: Surplus cash is the cash in excess of the
firm’s normal ash requirements. While determining the amount of surplus cash, the finance
manager has to take into account the minimum cash balance that the firm must keep to avoid
risk or cost of running out of funds. Such minimum level may be termed as “Safety level of
cash”.
 Determining Safety level of cash: The financial manager determines the safety level of
cash separately both for normal periods and peak periods. In both the cases, he has to
decide about the following to basic factors:
o Desired days of cash: It means the number of days for which cash balance
should be sufficient to cover payments.
o Average daily cash outflows: This means the average amount of disbursements
which will have to be made daily.
During normal periods
Safety level of cash = Desired days of cash x Average daily cash outflows
During peak periods
Safety level of cash = Desired days of cash at the busiest period X

Average of highest daily cash outflows.
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 Determining channels of investment: The finance manager can determine the amount
of surplus cash, by comparing the actual amount of cash available with the safety or
minimum level of cash. Such surplus cash may be either of a temporary or a permanent
nature. Temporary cash surplus consists of funds which are available for investment on
short-term basis (< 6 months), since they are required to meet regular obligations such
as taxes, dividends etc.
Permanent cash surplus consists of funds which are kept by the firm to avail of some
unforeseen profitable opportunity of expansion or acquisition of some asset. Such funds are
available for investment for a period ranging from 6 months to a year.
Criteria for investment:
 Security
 Liquidity
 Yield
 Maturity
A firm can divide the surplus cash into three categories:
 Surplus cash, which is to be made available for meeting unforeseen disbursements.
 Surplus cash, which is to be made available on certain definite dates for making specific
payments like tax, dividends etc.
 Surplus cash, which is a sort of general, reserve and not required to meet any payment.
12.5 Cash Management Models

Several types of cash management models have recently been designed to help in
determining optimum cash balance.
12.5.1 Baumol model
William.J.Baumol suggested this model. According to this model, optimum cash level is
that level of cash where the carrying costs and transaction costs are the minimum.
Carrying costs: This refers to the cost of holding cash, namely, the interest foregone, on
marketable securities. They may also be termed as opportunity costs of keeping cash balance.
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The basic objective of the Baumol model is to determine the minimum cost amount of cash
conversion and the lost opportunity cost.It is a model that provides for cost efficient transactional
balances and assumes that the demand for cash can be predicated with certainty and determines
the optimal conversion size.
Transaction costs: This refers to the cost involved in getting the securities converted
into cash. This happens when the firm falls short of cash and has to sell the securities resulting
in clerical, brokerage, registration and other costs.
There is an inverse relationship between the two costs. When one increases, the other
decreases. Hence, optimum cash level will be at that point where these costs are equal.
The formula for determining optimum cash balance can be put as follows:
Total conversion cost per period can be calculated with the help of the following formula:
T = TB/C
where,
T = Total transaction cash needs for the period
b = Cost per conversion
C = Value of marketable securities
Where,
i = Interest rate earned
C/2 = Average cash balance
Optimal cash conversion can be calculated with the help of the following formula;
Where,
C = Optimal conversion amount
b = Cost of conversion into cash per lot or transaction

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T = Projected cash requirement
I = Interest rate earned
There are two limitations of the optimum cash model given above:
(i) Cash payments are assumed to be steady over the period of time specified. When the
cash payment becomes lumpy, it may be appropriate to reduce the period for which the
calculations are made so that expenditures during the period are relatively steady.
(ii) Cash payments are seldom predictable. Hence, the model may not give 100% correct
results.
12.5.2 Miller Orr Model
Baumol model is not suitable in those circumstances when the demand for cash is not
steady and cannot be known in advance. Miller Orr model helps in determining the optimum
level of cash in such circumstances. It deals with cash management problem under the
assumption of random cash flows by laying down control limits for cash balances. These limits
consist of an upper limit (h), Lower limit (o) and return point (z). When cash balance reaches
the upper limit, a transfer of cash equal to “h – z” is effected to marketable securities. When it
touches the lower limit, a transfer equal to “z – o” from marketable securities to cash is made.
No transaction between cash and marketable securities to cash is made during the period
when the cash balance stays between these high and low limits.
The model is illustrated in the form of the following chart:

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The above chart shows that when cash balance reaches the upper limit, an amount equal
to “h – z” is invested in the marketable securities and cash balance comes down to ‘z’ level.
When cash balance touches the lower limit, marketable securities of the value “z – 0” are sold
and the cash balance again goes up to ‘z’ level.
The optimal value for d is computed as 3z.
Average cash balance (approx.) = (z + d) / 3.
As long as the cash balance stays within the limits, no transaction occurs. The various
factors in this model are fixed costs of a securities transaction (F) which is assumed to be the
same for buying and selling, the daily interest rate on marketable securities (I) and variance of
the daily net cash flows, represented by ó2. This model assumes that the cash flows are random.
The control limits in this model are d dollars as an upper limit and zero dollars at the lower limit.
When the cash balance reaches the upper level, d less z rupees of securities are bought, and
the new balance becomes z rupees. When the cash balance equals zero, z dollars of securities
are sold and the new balance again reaches z. According to this model, the optimal cash
balance z is computed as follows:
Where: F = fixed cost associated with a security transaction
 2 = Variance of daily net cash flows

I = Interest rate per day on marketable securities
With these control limits set, the Miller-Orr Model of cash management minimizes the
total costs of cash management. Since the method assumes that cash flows are random, the
average cash balance cannot be exactly determined in advance.
In general, the cash model gives the financial manager a benchmark for judging the
optimum cash balance. It does not have to be used as a precise rule governing his behavior.
The model merely suggests what would be the optimal balance under a set of assumptions.
The actual balance may be more or less if the assumption do not hold good entirely.
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12.6 Summary
Cash Management is very vital in any business. The objectives of cash management are
listed out. Basic problems in cash management are explained. The cash management models
are discussed.
12.7 Keywords
Cash
Surplus Cash
Baumol Model
Muller Orr Model

1. Explain in detail the cash management models proposed by Baumol and Miller Orr
with their merits and demerits
2. What are the basic objectives of cash management and various basic problems in
the cash management? Explain.
3. What is management of cash?
4. Explain the motives of holding cash.
5. Explain the problems in cash management.
6. Discuss the principles of cash management
7. How is optimum cash balance maintained?

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Model Question Paper

BBA Degree Examination
Second Year – Third Semester
Paper - V
FINANACIAL MANAGEMENT
Time : 3 Hours Maximum : 75 Marks
SECTION - A
Answer any TEN of the following in 50 words each (10 x 2 = 20 Marks)
1. Whar are the objectives of Financial Management ?
2. What is Profit ?
3. What are equity shares ?
4. What are debentures ?
5. What is time value of money ?
6. What are average costs ?
7. What is financial leverage ?
8. What is capital structure ?
9. What is EBIT-EPS Analysis ?
10. What is working capital ?
11. What are inventories ?
12. What is operating cycle ?
SECTION - B
Answer any FIVE of the following in 250 words each ( 5 x 5 = 25 Marks)
13. Discuss the scope of Financial Management.
14. What are the types of Preference Shares ? Explain.
15. Discuss the concepts of risk and return.

131
16. What is the rate of return on a security that costs Rs.1, 000 and returns Rs.2,000 after 5
years?
17. Explain the factors affecting capital structure.
18. Discuss the types of Working Capital.
19. Discuss the principles of Cash Management.
SECTION - C
Answer any THREE questions in about 500 words each (3 x 10 = 30 Marks)
20. Explain the functions of Finance Management.
21. A Company has to choose one of the following two actually exclusive machine. Both the
machines have to be depreciated. Calculate NPV.
Cash Inflows
Year Machine X Machine Y

0 -20,000 -20,000
1 5,500 6,200
2 6,200 8,800
3 7,800 4,300
4 4,500 3,700
5 3,000 2,000
22. Five banks offer nominal rates of 6% on deposits; but A pays interest annually, B pays
semiannually, C pays quarterly, D pays monthly, and E pays daily. Suppose you don’t
have the Rs.5,000 but need it at the end of 1 year. You plan to make a series of deposits-
annually for A, semiannually for B, quarterly for C, monthly for D, and daily for E-with
payments beginning today. How large must the payments be to each bank?
23. Explain the Modigilani - Muller Approach in detail.
24. Discuss the types of Inventory Control.

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SUBA201

INSTITUTE OF DISTANCE EDUCATION

It is with a great pleasure to welcome you as a student of Institute of Distance

With best wishes from mind and heart,

COORDINATION AND EDITING

© UNIVERSITY OF MADRAS, CHENNAI 600 005.

Meaning, objectives and Importance of Finance – Sources of finance – Functions of financial

Dividend policies – Factors affecting dividend payment - Company Law provision on

1. Financial Management - I.M. Pandey

2. Financial Management – Prasanna Chandra

3. Financial Management – S.N. Maheswari

4. Financial Management – Y. Khan and Jain

Sl.No. Title Page

4 Time Value of Money and Mathematics of Finance 36

6 Computation of Cost of Capital 50

9 Features of Capital Structure 83

10 Dividend and Dividend Policy 92

11 Working Capital Management 103

12 Cash Management 119

After completing this lesson, you must be able to

 Provide the meaning of business finance and financial management

 Explain the nature and scope of financial management

 Discuss the importance and objectives of financial decision making

1.2 Meaning and Definitions

1.3 Nature of Financial Management

1.4 Scope of Financial Management

1.5 Importance of Financial Management

1.6 Objectives of Financial Management

1.9 Review Questions

1.2 Meaning and Definitions

Financial management is concerned with the efficient use of an important economic

“Financial management is the operational activity of a business that is responsible for

1.3 Nature of Financial Management

 Its function is different from accounting function.

 It is Helpful in decisions of top management.

 It is applicable to all types of concerns.

 It is related with different disciplines like economics, accounting, law, information,

 It needs financial planning, control and follow-up.

1.4 Scope of Financial Management

1. Estimating financial requirements: Estimate short-term and long-term financial

3. Selecting a Source of Finance: Selecting appropriate source of finance from various

4. Selecting a pattern of Investment: It is concerned with the use of funds. The

5. Proper cash management: Assess various cash needs at different times

6. Implementing Financial Controls: Involves the use of various financial control

7. Proper Use of Surpluses: A judicial use of surpluses is essential for maintaining

Other areas include

 Increasing the firm’s competitive financial strength in the market;

 Awareness to all the latest developments in the financial markets;

 Interfacing with the capital markets;

 Maximizing the wealth of the shareholders over the long term;

 Repaying lenders on due dates;

 Paying interest on borrowings;

 Ensuring a satisfactory return to all the stake holders;

 Managing funds and treasury operations;

 Collecting on time from debtors and paying to creditors on time;

 Funding day-to-day working capital requirements of business;

 Adhering to the requirements of corporate governance.

As the traditional approach ignored the following aspects, such as

(1) Routine problems,

(2) Non corporate enterprises,

(3) Working capital financing,

(4) Allocation of funds, etc

So the modern approach was formulated.