FMG 301 Corporate Finance

FMG 301
Yashwantrao
Chavan
Maharashtra
Open University
MBA : SECOND YEAR

SEMESTER III
FINANCE GROUP
Corporate Finance
Authors : Dr. Satish Kumar, Dr. Latika Ajbani
Unit 1 : Introduction to Corporate Finance 01

Unit 2 : Long Term Sources of Finance 19
Unit 3 : Short Term Sources of Finance 33
Unit 4 : Valuation: Basic Concepts 43
Unit 5 : Valuation of Shares and Bonds 59
Unit 6 : Risk and Return: an Overview 75
Unit 7 : Portfolio Theory 87
Unit 8 : Assets Pricing 99
Unit 9 : Capital Budgeting Decision- I 109
Unit 10 : Capital Budgeting Decision- II 135
Unit 11 : The Cost of Capital 153
Unit 12 : Capital Structure Decision 175
Unit13 : Dividend Decision 201
Unit 14 : Working Capital Management 227
Unit 15 : Inventory Management 253
Unit 16 : Cash Management 269
Unit 17 : Receivable Management 287
Unit 18 : Derivatives and Risk Management 299
Unit 19 : Merger and Acquisition 311
YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
VICE-CHANCELLOR : Prof. E. Vayunandan
DIRECTOR, SCHOOL OF COMMERCE & MANAGEMENT : Dr. Pandit Palande
NATIONAL ADVISORY BOARD
Dr. Pandit Palande Prof. Devanath Tirupati, Dr. Surendra Patole
Former Vice Chancellor Dean Academics, Assistant Professor,
Director, School of Commerce Indian Institute of Management (IIM) School of Commerce &
& Management, Bangalore. Management,
Yashwantrao Chavan Maharashtra Yashwantrao Chavan Maharashtra
Open University, Nashik Open University, Nashik
Prof. Sudhir. K. Jain Prof. Karuna Jain, Dr. Latika Ajitkumar Ajbani
Former Vice Chancellor Director, Assistant Professor,
Professor & Former Head N I T I E, Vihar Lake, School of Commerce &
Dept. of Management Studies Mumbai Management,
Indian Institute of Technology (IIT) Yashwantrao Chavan Maharashtra
Delhi Open University, Nashik
Prof. Vinay. K. Nangia

Professor & Former Head
Department of Business Studies,
Indian Institute of Technology (IIT)
Roorkee
Authors Editor
Dr. Satish Kumar Dr. Latika Ajitkumar Ajbani Dr. Deepak Verma
Assistant Professor Assistant Professor Assistant Professor
Department of Management Studies School of Commerce & Department of Management Studies
Malaviya National Institute Management Malaviya National Institute of
of Technology, Jaipur Y. C. M. Open University, Nashik Technology, Jaipur
Instructional Technology Editing & Programme Co-ordinator

Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Yashwantrao Chavan Maharashtra
Open University, Nashik
Production
Shri. Anand Yadav
Manager, Print Production Centre, Y. C. M. Open University, Nashik- 422 222
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
(First edition developed under DEB development grant)
q First Publication : October 2016 q Reprint : Oct. 17 q Publication No. 2175
q Cover Design : Shri. Avinash Bharne
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q Publisher : Dr. Dinesh Bhonde, Registrar, Y. C. M. Open University, Nashik- 422 222
ISBN : 978-81-8055-395-0
FMG 301
Introduction
In every business, manager has to take verity of decisions starting from buying raw
materials, assembling a workforce and finally producing and selling finished products. Every
business decision has certain financial implications. Specifically, business decision which in-
volves money can be termed as corporate finance decisions. Every business has scarce
resources thus need to be utilized optimally. The primary goal of corporate finance is to
maximize a company’s value. All businesses have to invest their resources wisely, find the
right kind and mix of financing to fund investments, and return cash to the owners if there are
not enough good investments.
In line with the above statement, this book is written to combine theory of corporate
finance with practical applications. This book begins with the explanation of fundamental
concept related to time value of money, risk and return and valuation of various securities. In
subsequent units methods of capital budgeting, theories of capital structure, dividend policy,
working capital management, cash management receivable management and inventory man-
agement are discussed. The book contains a comprehensive treatment of topics. Concepts
are made clear in simple language for better understanding of students. This book is divided
in to 19 units and each unit includes the summary, key terms, review question and
exercises in the end. This book is specifically designed to cater the need of management
students. It is hoped that this book will facilitate a better understanding of subject matter
among readers.
Dr. Satish Kumar

Dr. Latika Ajitkumar Ajbani
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
All rights reserved. No part of this publication which is material protected by this copyright
notice may be reproduced or transmitted or utilized or stored in any form or by any means
now known or hereinafter invented, electronic, digital or mechanical, including photocopy-
ing, scanning, recording or by any information storage or retrieval system, without prior
written permission from the Publisher.
The information contained in this book has been obtained by authors from sources believed
to be reliable and are correct to the best of their knowledge. However, the publisher and its
authors shall in no event be liable for any errors, omissions or damage arising out of use of
this information and specially disclaim any implied warranties or merchantability or fitness
for any particular use.
Message from the Vice-Chancellor
Dear Students,
Greetings!!!
I offer cordial welcome to all of you for the Master’s degree programme of
Yashwantrao Chavan Maharashtra Open University.
As a post graduate student, you must have autonomy to learn, have information
and knowledge regarding different dimensions in the field of Commerce & Manage-
ment and at the same time intellectual development is necessary for application of
knowledge wisely. The process of learning includes appropriate thinking, understand-
ing important points, describing these points on the basis of experience and observa-
tion, explaining them to others by speaking or writing about them. The science of
Education today accepts the principle that it is possible to achieve excellence and
knowledge in this regard.
The syllabus of this course has been structured in this book in such a way, to
give you autonomy to study easily without stirring from home. During the counseling
sessions, scheduled at your respective study centre, all your doubts will be clarified
about the course and you will get guidance from some experienced and expert
professors. This guidance will not only be based on lectures, but it will also include
various techniques such as question-answers, doubt clarification. We expect your
active participation in the contact sessions at the study centre. Our emphasis is on
‘self study’. If a student learns how to study, he will become independent in learning
throughout life. This course book has been written with the objective of helping in
self-study and giving you autonomy to learn at your convenience.
During this academic year, you have to give assignments and complete the
Project work wherever required. You have to opt for specialization as per
programme structure. You will get experience and joy in personally doing above
activities. This will enable you to assess your own progress and thereby achieve a
larger educational objective.
We wish that you will enjoy the courses of Yashwantrao Chavan Maharashtra
Open University, emerge successful and very soon become a knowledgeable and
honorable Master’s degree holder of this university.
Best Wishes!
- Vice-Chancellor
Corporate Finance
SYLLABUS
UNIT 1 : INTRODUCTION TO CORPORATE FINANCE

• Meaning of Corporate Finance
• Scope and Importance of Corporate Finance
• Goals of Financial Management
• Role of Finance Manager
• The Agency Problem
• Organization of Finance Functions
UNIT 2 : LONG TERM SOURCES OF FINANCE

• Long Term Financing Needs of a Business
• Long Term Financing
• Advantages of Long Term Financing
• Sources of Long Term Finance
• External Sources of Finance
• Internal Sources of Finance
UNIT 3 : SHORT TERM SOURCES OF FINANCE

• Introduction to Short Term Financing
• Advantages of Short Term Finance
• Sources of Short Term Finance
UNIT 4 : VALUATION: BASIC CONCEPTS

• Concept of Time Value of Money
• Techniques of Time Value of Money
• Compounding Techniques/Future Value Techniques
• Discounting/Present Value Techniques
• Amortization Schedule
UNIT 5 : VALUATION OF SHARES AND BONDS

• Concept of Valuation
• Equity Valuation
• Techniques of Equity Valuation
• Dividend Discount Techniques
• Relative Valuation Techniques
• Bond Valuation
UNIT 6 : RISK AND RETURN: AN OVERVIEW
• Concept of Security Return
• Measurement of Single Security Return
• Concept of Security risk
• Measurement of single security return
• Risk and Return Trade off
UNIT 7 : PORTFOLIO THEORY

• Markowitz Model or Mean Variances Analysis
• Portfolio Risk and Return under Markowitz Model
• Diversification and Portfolio Risk
• Markowitz Optimal Portfolio
UNIT 8 : ASSETS PRICING

• Capital Assets Pricing Model (CAPM)
• Assumptions of CAPM
• Inputs for CAPM
• Security Market Line
• Capital Market Line
• Single Index Model
• Arbitrage Pricing Theory
UNIT 9 : CAPITAL BUDGETING DECISION- I

• Meaning of Capital Budgeting
• Importance of Capital Budgeting
• Capital Investment Projects
• Estimation and Evaluation of Cash Flows
• Capital Budgeting Decision Techniques
UNIT 10 : CAPITAL BUDGETING DECISION- II

• Capital Rationing
• Capital Budgeting Under Risk and Uncertainty
• Capital Budgeting Practices in Indian Companies
UNIT 11 : THE COST OF CAPITAL

• Concept of Cost of Capital
• Significance of Cost of Capital
• Concept of Opportunity Cost of Capital
• Cost of Debt
• Cost of Preference Capital
• Cost of Equity Capital
• Cost of Retained Earnings
• Weighted Average Cost of Capital (WACC)
UNIT 12 : CAPITAL STRUCTURE DECISION

• Meaning of Financing Decision
• Source of Long Term Finance
• Equity Financing
• Debt Financing
• Concept of Leverage
• Operating Leverage
• Financial Leverage
• Combined Leverage
• Capital Structure
• Determinants of Capital structure
• Capital Structure Theories
• Relevance Theories
• Irrelevance Theories
UNIT 13 : DIVIDEND DECISION

• Meaning of Dividend
• Conflicting Dividend Theories
• Irrelevance Theory of Dividend
• Relevance Theory of Dividend
• Dividend Policy
• Objectives of Dividend Policy
• Factors affecting the Dividend Policy
• Practical Considerations in Dividend Policy
• Dividends Policy Analysis of Indian Companies
• Factors favouring Higher and Lower Dividend
• Forms of Dividends
• Bonus Shares
UNIT 14 : WORKING CAPITAL MANAGEMENT

• Concepts of Working capital
• Gross Working Capital
• Net Working Capital
• Importance of Working capital
• Operating and Cash Conversion Cycle
• Concepts of Working Capital on Basis of Time
• Fixed (Permanent)
• Temporary (Variable)
• Determinants of Working Capital
• Estimation of Working Capital Needs
• Financing of Working Capital
UNIT 15 : INVENTORY MANAGEMENT

• Concept of Inventories
• Costs associated with Inventories
• Motives of holding Inventories
• Inventory Management Techniques
• Economic Order Quantity
• Reorder Level
• Inventory Control Systems
• ABC Analysis
• VED Analysis
• Just-in-Time
UNIT 16 : CASH MANAGEMENT

• Objectives of Cash Management
• Motives for Holding Cash
• Factors affecting the Cash Requirements
• Cash Management Strategies
• Cash Management Techniques
• Cash Management Practices in India
UNIT 17 : RECEIVABLE MANAGEMENT

• Concept of Receivable
• Cost Associated with Receivable
• Receivable Management
• Credit Policy
• Types of Credit Policy
• Optimum Credit Policy
• Credit Standard and Analysis
• Credit Terms
• Collection Policy and Procedures
• Factoring Services
UNIT 18 : DERIVATIVES & RISK MANAGEMENT
• Concept of Risk Management
• Types of financial Risk
• Types of Derivatives Products
• Forward
• Future
• Options
• Swap
• Participants in Derivatives Market
UNIT 19 : MERGER AND ACQUISITION

• Merger & Acquisition in India
• Forms of merger
• Concept of Acquisition
• Difference between merger and Acquisition
• Strategic Rationales for M&A
• Steps in M&A Process
• Due diligence
• Regulatory Framework for M&A
Introduction to Corporate Finance
UNIT 1 : INTRODUCTION TO CORPORATE
FINANCE
Structure NOTES
1.0 Introduction
1.1 Unit Objectives
1.2 Meaning of Corporate Finance
1.3 Scope and Importance of Corporate Finance
1.4 Goals of Financial Management
1.5 Role of Finance Manager
1.6 The Agency Problem
1.7 Organization of Finance Functions
1.8 Key Terms
1.9 Summary
1.10 Questions and Exercises
1.11 Further Readings and References
1.0 Introduction
Finance may be defined as the science or art of managing money. Suppose you
decide to start a firm to make cricket bats. To do this, you hire managers to buy raw
materials, and you assemble a workforce that will produce and sell finished cricket
bats. In the language of finance, you make an investment in assets such as current
assets and fixed assests. The amount of cash you invest in assets must be matched
by an equal amount of cash raised by Financing the business. When you begin to sell
cricket bats, your firm will generate cash. This is the basis of value creation.
Corporate finance is the study of money-related decisions in a business,
which are essentially for a business. Despite its name, corporate finance applies to
all businesses, not just corporations (Investopedia, 2013). The primary goal of
corporate finance is to know how to maximize a company's value by making good
decisions about investment, financing and dividends. In other words, how should
businesses allocate scarce resources to minimize expenses and maximize revenues?
How should companies acquire these resources- through shares or bonds, owner's
capital or bank loans? Finally, what should a company do with its profits? How much
should it reinvest into the company, and how much should it pay out to the business's
Corporate Finance : 1
Introduction to Corporate Finance owners? This unit will explore each of these business decisions in greater depth.
1.1 Unit Objectives

NOTES After studying this unit, you should be able to :
• Explain the meaning, nature of corporate finance.
• Understand the importance of corporate finance.
• Explain the functions of corporate finance.
• Be aware about the goals and objectives of corporate finance.
• Review the changing role of finance managers.
• Discuss agency problems arising from the relationship between
shareholders and managers.
• Illustrate the organization of finance function.
1.2 Meaning of Corporate Finance
Finance is the lifeblood of every business and its management requires

special attention. Corporate finance is that activity of management which is concerned
with the planning, procuring and controlling of the firm's financial resources. The
scope and coverage of financial management have undergone fundamental changes
over the last half a century. During 1930s and 1940s, it was concerned with raising
adequate funds and maintaining liquidity and sound financial structure. It is known
as the 'Traditional Approach' to procurement and utilization of funds required by a
company. As per traditional approach corporate finance was regarded as an art and
science of raising and spending of funds. Provision of money at the time it is wanted
was the main focus of corporate finance or financial management. The traditional
approach emphasized on the acquisition of funds and ignored efficient allocation and
constructive use of funds. Also, in traditional approach no sufficient attention was
given to the management of working capital.
The need for most profitable allocation of capital was recognized during
1950's. During 1960s and 1970s many scholars have introduced various analytical
tools and concepts like funds flow statement, ratio analysis, cost of capital, earning
per share, optimum capital structure, portfolio theory etc. As a result, a broader
concept of finance began to be used. Thus, the modern approach to finance
emphasizes the proper allocation and utilization of funds in addition to their
procurement. Thus, business finance, in the words of Authman and Dongall, may
broadly be defined as "the activity concerned with the planning, raising, controlling
and administering of funds used in the business."
Corporate finance is concerned with the planning and controlling of the Introduction to Corporate Finance
firm's financial resources. It is also referred as financial management and includes
planning, organizing, directing and controlling the financial activities such as
procurement and utilization of funds of the enterprise. Financial management means
applying general management principles to financial resources of the enterprise. Till
1890, it was a branch of economics and as a separate discipline corporate finance NOTES
has recent origin. Corporate finance has been defined differently by different scholars.
A few of the definitions are being reproduced below:-
"Financial Management is an area of financial decision making harmonizing
individual motives and enterprise goals." - Weston and Brigam.
"Financial Management is the application of the planning and control functions
to the finance function." - Howard and Upton.
"Financial Management is that managerial activity which is concerned with
the planning and controlling of the firm's financial resources". -I.M. Pandey
"Financial Management is the operational activity of a business that is
responsible for obtaining and effectively, utilizing the funds necessary for efficient
operations." - Joseph and Massie.
"The activity concerned with the planning, raising, controlling and
administering of funds used in the business. - Authman and Dongall
The planning, directing, monitoring, organizing, and controlling of the monetary
resources of an organization". - Business Dictionary
1.3 Scope and Importance of Corporate Finance
From the above definitions, it is clear that financial management or corporate

finance is that specialised activity which is responsible for obtaining and effectivety
utilizing the funds for the efficient functioning of the business and, therefore, it includes
financial planning, financial administration and financial control. Following points
highlights the importance of corporate finance in a firm:
• For Incorporation of Company : Finance is needed for starting a
company. It is needed for preparing Project Report, Memorandum of Check Your Progress
Association (MOA), Articles of Association (AOA), Prospectus, etc. It 1. What is finance?
is needed for purchasing both fixed assets (land and building, machinery) 2. Why finance is called
and current assets (raw material and other stock etc.). It is also needed life blood for business?
to pay wages, salaries and other expenses. In brief, we cannot start a 3. What is Traditional
company without finance. approach of finance?
• For Smooth Functioning of Business: Finance is needed for 4. Define Corporate
conducting the business smoothly. It is needed as working capital. A finance?
company cannot function smoothly without finance.
Introduction to Corporate Finance • Expansion and Diversification of Business Activities: Expansion
is to increase the size of the company. Diversification means to produce
and sell new products which can be related or unrelated to the existing
business. New machines with latest technologies and techniques are
needed for expansion and diversification. Finance is needed for
NOTES purchasing modern machines and modem technology. So, finance
becomes mandatory for expansion and diversification of a company.
• Meeting Contingencies: The Company has to meet many unforeseen
events. For example sudden fall in sales, loss due to natural calamity,
loss due to court case, loss due to strikes, etc. The company needs
finance to meet these possibilities.
• Research and Development: In today's competitive world, a company
cannot survive without continuous research and development activities.
Company has to go on making changes in its old products as per the
market requirements and also invent new products to sustain in the
industry. Corporate Finance is needed for research and development.
• Motivating Employees: Manager and employees must be continuously
motivated to improve their performance. They must be given financial
incentives, such as bonus, higher salaries, etc. They must also be given
non-financial incentives such as transport facilities, canteen facilities
etc. All this requires finance.
• Government Agencies: There are many government agencies such
as Income Tax authorities, Sales Tax authorities, Registrar of Companies,
Excise authorities, etc. The company has to pay taxes and duties to
these agencies. Finance is needed for paying these taxes and duties.
• Payment to Dividend and Interest: The Company has to pay dividends
to the shareholders on their shareholdings. Also, it has to pay interest to
the debenture/bond holders, banks, etc. and also repay the loans and
bonds amount at maturity. Finance is needed to pay dividends and interest.
• Replacement of Assets: Fixed assets such as land, plant and machinery
are the main assets of the company. They are used for producing goods
and services. However, after some years, these assets become old and
obsolete and hence need to be replaced with new assets. Finance is
needed for replacement of old assets through buying new apssets.
Scope of Corporate Finance

As discussed in the section 1.2, functions of corporate finance is divided into two
broad categories (i) The Traditional Approach and (ii) The Modern Approach. The
modern approach states that corporate finance covers both acquisition of funds as
well as their effective allocation and utilization. The modern approach is an analytical
way of looking at the financial problems of a company. Modern approach includes
(i) What is the total amount of funds a firm should invest (commit)? (ii) What are the Introduction to Corporate Finance
specific assets a firm should acquire? (iii) How to finance the fund required by the
firm? The modern approach to corporate finance is concerned with the answering
of these three important questions that a finance manager face in a firm. Accordingly,
corporate finance in the modern approach can be broken down into following four
decision or functions:- NOTES
1. Investment decisions or Capital budgeting decisions
2. Financing decisions or Capital structure decisions
3. Dividend decisions or Profit allocation decision
4. Liquidity decisions or Working capital management decision
• Investment Decisions: Investment decisions are concerned with the
commitment of financial resources to long- term profitable opportunities. It
refers to the selection of long term assets in which the funds will be invested
by a firm. These decisions include the allocation of financial resources to the
contemplated activities of the firm.
Alternatively, it is also referred as capital budgeting decision and broadly involves
determination of requirement of financial resources. The capital budgeting
decisions provide the planning, coordination and control of the capital expenditure
(long-term expenditure). A capital budgeting decision may be defined as the
firm's decision to invest (cash outflows) its current funds efficiently for a long-
term in the anticipation of cash inflows over a series of years. These long term
assets are those assets that affect the firm's operations beyond the one- year
period. Investment decisions focussed on the desirability of investment in
expansions, acquisitions, modernization & replacement and divestment activities
of a business with a view to create value for its shareholders.
Most organisations face a constraint of capital and have larger number of business
opportunities available for investment. Not all opportunities are equally rewarding
and therefore need to be placed in an order of preferences on the basis of their
risk and return. Investment decisions involves two important aspects (i) the
evaluation of the prospective profitability of new investments, and (ii) the
determination of cut-off rate against which the prospective return of a new
investment could be compared. It is difficult to measure the future benefits of
new investments and therefore these benefits cannot be predicated with certainty.
Since, investment decisions relate to future, risk in investments arises because
of uncertain returns and time period. Therefore, investment decisions should be
evaluated in terms of both expected return and risk. Apart from determination of
cash flow (benefits) from a new project, determination of cut-off rate or required
rate of return (opportunity cost of capital) is a crucial decision. The opportunity
cost of capital is the expected rate of return that an investor could earn by
investing money in financial assets of a firm. However, there are many problems
in computing the correct opportunity cost of capital in real world and the finance
manager should be aware of these problems. Corporate Finance : 5
Introduction to Corporate Finance Investment decisions have following features:
(1) The exchange of certain current funds for future unexpected benefits.
(2) Commitment of large or huge funds.
(3) Irreversible or reversible at significant loss.
(4) Influence the firm's growth in long term.
NOTES
(5) Have affect on the risk of the firm.
In brief, three main elements of capital budgeting or investment decisions are:
(i) the long term assets and their composition, (ii) the risk of the firm (business
risk), and (iii) the concept and calculation of the cost of capital.
• Financing Decisions: Financing decisions are concerned with financing-mix
or capital structure or leverage. Once firm has decided in which assets it want
to invest the next question arise from which sources these assets will be financed.
There are primarily two sources of funds available -equity and debt. Suppliers
of equity capital called shareholders or owner of the firm and they provide
capital with no fixed and assured reward. Shareholders assume risk of getting
no reward at all and therefore also called as residual equity. They have voting
rights on the decision making and control the affairs of the firm. On the other
hand, Debt providers such as bondholders, debenture holders, Banks and other
financial institutions (providers of loan capital) receive fixed return (in form of
interest) quite independent of the performance of the firm.
• Capital structure : Refers to the mix of equity and debt. The financing
decision relates to the choice of the proportion of these sources to finance the
investment requirements of a firm. Since both debt and equity have different
cost of capital, a fiancé manager must strive to obtain the best financing mix
or the optimum capital structure (where market value of the shares is
maximized).
A finance manager has to decide how much debt and equity should be
raised to finance the assets of the firm. One aspect which is important for
determining this mix or proportion is cost of capital of debt and equity funds.
Cost of raising funds using debt is cheaper than equity capital, so use of debt
in the capital structure may increase the return on equity funds (as measured
by ROE and EPS). But it also increases risk because excess use of debt
attract business risk (in the event of recession or declining sales) The changes
in the shareholders' return caused by the changes in the profit is called financial
leverage. In other words, use of fixed charge sources such as debentures,
bonds and loan along with equity to magnify the shareholders' return is called
financial leverage or also termed as Trading on equity.
A proper balance has to be maintain between return and risk. At a given
risk, when the equity shareholders' return is maximized, the market value per
share will be maximized and such capital structure would be considered as
optimum capital structure. After determining the best combination of debt and
equity, finance managers must raise the required amount through the available Introduction to Corporate Finance
sources. In addition to debt-equity mix, Contral, flexibility, legal aspects are
some other important factors that a finance manager should consider in practice
in determining the capital structure of a firm.
• Dividend Decisions: The third major financial decision of corporate finance
NOTES
is dividend decision. Dividend decisions are related to rewarding the owners
of the firm, i.e. the shareholders, for investing their money in the firms. The
dividend is paid to the shareholders from the operating profits of the firm (net
operating profits after taxes), after meeting all the related cost and expenses.
The dividend decision should be analysed considering the financing decision
of a firm. A firm have two alternatives available for dealing the profits. (a)
profits can be distributed to the shareholders in form of dividends or (b) they
can be retained in the business itself also referred as retained earnings or
ploughing back of profits. The proportion of profits distributed as dividend is
also called as dividend- payout ratio and the retained profits is called as retention
ratio. As in case of financing decision (capital structure decision), the dividend
policy should be determined in terms of its impact on shareholders' wealth. If
the shareholders' are indifferent to firm's dividend policy, the finance manager
must determine the optimum - dividend payout. The optimum dividend payout
policy is that level at which the market value of the share is maximum. It is the
duty of the finance manager to analyse the likely effect of dividend payout on
the market value of share and then determine the optimum dividend policy of
the firm.
• Liquidity Decision: For a firm, it is very important to maintain a liquidity
position to avoid insolvency. Firm's profitability, liquidity and risk all are associated
with the investment in current assets. In order to maintain a trade-off (balance)
between profitability and liquidity, it is important to invest sufficient funds in
current assets. But since current assets do not earn anything for business
therefore a proper calculation must be done before investing in current assets.
Current assets should properly be valued and disposed of from time to time
once they become non profitable. Currents assets must be used in times of
liquidity problems and times of insolvency. Therefore, current assets
management which affects a firm's liquidity is yet another important finance
function, in addition to the management of long-term assets. Current assets
should be managed efficiently for safeguarding the firm against the dangers of
illiquidity and insolvency. The profitability- liquidity trade-off requires that the
finance manager should develop sound technique of managing working capital.
It is the dusty of the finance manager to ensure that funds would be available
when needed.
NOTES
Fig.1.1 : Inter-linkage between Investment, Financing and Dividend Decisions
Source: Paramasivan, C. and Subramanian, T (2008) financial management (chapter 1, pp10)
1.4 Goals of Financial Management
To study financial decision making in a firm, we first need to understand the goal of
corporate finance. Such an understanding is important because it leads to an objective
basis for making and evaluating financial decisions taken by a finance manager in a
firm. Assuming that we consider only profit making businesses, the goal of financial
management should be to make money or adding value for its shareholders' (owners).
Check Your Progress
This goal is a little vague, of course, so we examine some different ways of formulating
5. What do you it in order to come up with a more precise definition. Such a definition is important
understand by
because it leads to an objective basis for making and evaluating financial decisions.
acquisition of funds?
6. Important feautres
1.4.1 Profit Maximization
of modern approach
of corporate finance. Profit maximization is probably the most commonly featured business goal, but this
7. What is Investment is not a very precise objective. Do we mean profits this year? If so, then policies
Decision? such as postponing maintenance expense, low inventory, and other short-run, various
8. Define Capital cost-cutting measures will lead to increase in profits. The goal of maximizing profits
Structure? is vague and ambiguous as it is unclear that whether profits refer to "long-run" or
"short-run", or "average" or "net profits", "profits after tax" or "profits before tax".
In the definition of profit maximization, it's unclear exactly what this means.
A famous economist once remarked, in the long run, we're all dead! Also profit
maximization goal doesn't tell us the appropriate trade-off between current and
future profits.
Possible Goals of a firm Introduction to Corporate Finance
If we were to consider possible financial goals, we might come up with some ideas
like the following:
• Survival.
• Avoid financial distress and bankruptcy.
NOTES
• Beat the competition.
• Maximize sales or market share of the firm.
• Minimize costs.
• Maintain steady earnings growth.
Each of these possible goals presents problems for the financial manager.
For instance, firm can easily increase its market share or sales by lowering the
selling price or by relaxing credit terms. Similarly, firm can always cut costs by
lowering the budgetary allocation on research and development. Firma can also
avoid bankruptcy by never borrowing any money from the banks/bondholders or
never taking any risks, and so on. Are these actions in the stockholders' best interests,
it is not very clear to the finance manager? Profit maximization would probably be
the most commonly cited goal, but as discussed above it is also not free from ambiguity.
The hunt of profit normally involves some element of risk, so it isn't really possible to
maximize both safety and profit. What we need, therefore, is a goal that encompasses
both factors.
1.4.2 Wealth Maximisation

The financial manager in a firm makes decisions for the stockholders of the firm. It
follows that the financial manager should act in the shareholders' best interests by
making decisions that increase the value of the stock. The appropriate goal for the
financial manager can thus be stated quite easily: "The goal of financial management
is to maximize the current value per share of the existing stock". Unlike profit, value
is a long-run phenomenon. The value of the firm is the value of the firm's equity. The
goal of maximizing the value of the stock avoids the problems associated with the
profit maximisation objective. There is no ambiguity and there is no short-run versus
long-run issue in the value maximization objective. We explicitly mean that our goal
is to maximize the current stock value.
The wealth or value maximization objective is no doubt a better objective
and shareholders of a firm can measure it in terms of increase in their earning per
share (EPS) or market price of the share (MPS). Because the goal of financial
management is to maximize the value of the stock, financial manager need to learn
how to identify those investments and financing opportunities that increases the
value of the stock. The wealth maximization objective is based on the concept of
cash flows generated by the decision rather than accounting profit. Cash flow is a
precise concept and measuring benefits of an investment opportunity in terms of
cash flow avoids the ambiguity associated.
1.5 Role of Finance Manager
A financial manager needs to know all five basic because they all impact his or her
job. While the manager's primary responsibilities may be raising money or choosing
NOTES investment projects, the manager also needs to know about capital markets and
debt/equity optimal levels, be able to manage risks of the business and governance
of the corporation. Corporate governance is a function because a manager wants to
act in the best interest of its shareholders. New methods of managing risk have
been developed in recent years, and a manager must be aware of these in order to
maximize shareholder value. The function performed by finance manager can be
categorized under the following heads:
• Analysing and evaluating the investment activities: The finance
manager has to evaluate the investment alternatives and decide how to
allocate funds into profitable ventures so that there is safety on investment
and regular returns is possible as per the objectives of the firm.
• Estimation of capital requirements: A finance manager has to make
estimation with regards to capital requirements of the firm. This will depend
upon expected costs and profits and future programmes and policies of a
concern. Estimations have to be made in an adequate manner which increases
earning capacity of firm.
• Determination of capital composition: Once the estimation of capital
requirement has been made, the capital structure has to be decided. This
involves debt-equity analysis. Finance manager need to decide how much
debt and how much equity need to be raised from the market. The choice
of method will depend on the relative merits and demerits of each source
and period of financing.
• Management of surplus: Finance manager has to decide about how to
dispose the net profits of the firm. This can be done in two ways (a) dividend
declaration which includes identifying the rate of dividends and other benefits
like bonus and (b) retained profits - The volume has to be decided which
will depend upon expansion, innovation, and diversification plans of the
company.
• Management of cash : Finance manager has to make decisions with
regards to cash management. A firm require cash for various purposes like
payment of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintenance of inventory,
purchase of raw materials, etc.
• Financial control : The finance manager has not only to plan, procure and
utilize the funds but he also has to exercise control over finances of the
firm. This can be done through many techniques like ratio analysis, financial
statement analysis, financial forecasting, cost, volume and profit control Introduction to Corporate Finance
(CVP), etc.
• Understanding Capital Markets : As we know that share of a public
company are traded on stock exchanges and there is a continuous sale and
purchase of securities. Hence, a clear understanding of capital market is an
NOTES
important function or role of a financial manager. When securities are traded
on stock market there involves a huge amount of risk involved. Therefore a
financial manger understands and calculates the risk involved in this trading
of shares and bonds. The practices of a financial manager directly impact
the operation in capital market and therefore a clear understanding is must
for efficiently discharging its duties. In the globalized environment, financial
markets are integrated and knowledge of domestic capital market is not
enough therefore, a finance manager needs to be aware about the functioning
of world capital markets.
1.6 The Agency Problem and Control of the Corporation

A striking feature of corporate (company) form of business is the separation of
ownership from management. Managers are agents of the owners (shareholders)
and perform their duties and manage day-today affairs of the company. The
relationship between stockholders and management is called an agency relationship.
This relationship exists when someone (the principal) hires another (the agent) to
represent his or her interest. For example, you might hire someone (agent) to sell
your house, the relationship between you and the agent is termed as agency
relationship. It is assumed that manager (agent) will acts in the best interest of the
stakeholders by taking actions that increases the stock value or maximizes the wealth
of shareholders. But in such relationship (agency relationship) there is a possibility
of a conflict of interest between the principal and agent. This conflict of interest is
termed as agency problem. Agency problem is the likelihood that managers may
place their personal goals above of corporate goal.
To understand how management and shareholder interest might differ,
consider that a company is considering a new investment in a pharmaceutical business.
The investment in pharmaceutical business is expected to favourably impact the
share value, but is also relatively risky business for the company. The owner of the
company are willing to commit the funds in pharmaceutical business (with the
expectation that share price will go up), but managers may not because of the
riskiness of pharmaceutical business, there is possibility that the desired return may
not be possible and things will turn out badly and managers job will be lost. If the
managers do not take the investment in pharmaceutical business, then the shareholders
may lose a valuable opportunity. This conflict between shareholder and managers
will rise to an agency cost.
Introduction to Corporate Finance The term agency cost refers to the costs of conflict between shareholders
and management of a company. Agency costs are borne by the shareholders to
prevent/minimise agency problem as to contribute to maximization of shareholders'
wealth. These costs can be direct or indirect. The situation described above
(pharmaceutical business) is one example of indirect agency cost. Direct agency
NOTES costs are of two types. The first type is corporate expenditure that benefits
management but costs the shareholders. Purchase of corporate jet would fall under
this category of direct agency costs. The second type of expenditure includes the
expense to monitor the management actions such as external audit fees etc.
Resolving the Agency Problem

The agency problem can be prevented or minimized by acts of (i) market forces and
(ii) agency cost. Market forces include (a) behaviour of institutional investors and
(b) Threat of hostile takeovers.
(a) Behaviour of Institutional investors : In today's time, institutional
investors like banks, financial institutions, mutual funds, pension funds,
insurance companies hold large block of shares of the company. These
institutional shareholders participate actively in the management of the
company. In the recent years, these investors have started exercising their
voting rights to ensure competent management of the company and thereby
reducing agency cost. From time to time these investor communicate with
the managers, exert pressure on them to act in the best interest of the
shareholders' or owners. By doing so, owner can be benifited and agency
problem can be reduced.
(b) Threat of hostile takeovers : It is the acquisition of the company (target)
by another company (acquirer) that is not supported by the management of
the target company. In the recent years hostile takeover is another force
Check Your Progress
that has threatened the management to perform in the interest of owners.
9. What is liquidity
Hostile takeover generally happens when acquirer is of the view that target
decision?
company is undervalued due to poor management by its managers. The
10. Important features of acquirer will replace the current management of the target company with
modern approach of
new or its own management team. This threat of takeover and losing job
corporate finance.
would motivate the management to act in the best interest of shareholders'
11. What is investment
and maximise the market value of the firm.
Decision?
12. Define Capital On the other hand, agency costs are those costs which are incurred
Structure? by the management to prevent/minimize agency problems and contribute
13. What is profit to the maximization of shareholders' wealth. Agency cost includes (a)
maximisation expenditures which are related with the monitoring the activities of the
objective? management may fall in to audit and control fees. (b) Offering incentives
14. How Wealth plans such as stock options to the managers. Stock options allow managers
maximisation is to purchase the shares of the company at concessional special price. (c)
superior to profit. Offering monetary and non- monetary incentives to managers to act in the
owner's interest. (d) Opportunities costs which arises from the inability of
the managers to respond to the new opportunities available in the market.
1.7 Oraganization of Finance Functions
It is clear from the role of finance managers that the financial decisions in
an organisation are of utmost importance and therefore to perform these functions,
a sound and efficient organisation structure is needed. The organisation of finance NOTES
function means the division and classification of functions relating to finance. Although
in case of corporate form of business, the main responsibility to carry out finance
function rests with the top management yet the top management or Board of Directors
for organisational convenience can delegate its powers to any subordinate executive
which may be called Chief Financial Officer, Director Finance, Chief Financial
Controller, Financial Manager or Vice President of Finance. Since, financing decisions
are quite significant for the existence and survival of the company; it is the duty of
the Board of Directors or top management to perform the finance functions. Another
reason to assign financial duties in the hand of top management are (i) the growth
and expansion of business is affected by financing policies and (ii) the loan payment
capacity of the business depends upon its financial operations.
The organisation of finance function is not similar in all businesses and it
depends on the nature, size, financial system and other characteristics specific to a
firm. For example in a small business (Sole proprietor), owner of the business himself
looks after the functions of finance. Owner is responsible for various functions
including the estimation and arrangement of funds, cash budget preparation and
arrangement of the required funds, inspection of all receipts and payments, credit
policy preparation, collecting debtors etc. No separate officer is appointed for the
finance function in this form of business.
With the increase in the size of business, specialists were appointed for the
finance function and the decentralisation of the finance function started. In a medium
sized firm, the responsibility of the finance function is performed by a financial
controller, finance manager, deputy chairman (finance), finance executive or treasurer.
On the other hand, in a large sized company the finance function has become more
complex and the position of financial manager occupy an important place. Generally,
the person handling the activities related to finance is the member of top management
of the firm. Due to size, it is not possible for a finance manager to perform all the
finance functions alone or to co-ordinate with the various departments. Therefore,
finance and financial control are separated and allocated to two different sub-
departments. For 'finance', treasurer is appointed and for the 'financial control',
financial controller is appointed.
In a corporate form of business, a finance committee is established between
the Board of Directors and Managing Director to look after the financial planning
and financial control. Finance committee comprises of financial Manger,
representatives of the directors and departmental heads of various departments.
Managing Director is the chairman of the finance committee. The main function of
Introduction to Corporate Finance finance committee is to advise the Board of Directors on the financial planning,
financial control and co-ordinate the activities of various departments. The figure1.2
depicts the organisation of finance functions in a corporate form of business.
NOTES
Treasurer
Mgt.
Figure 1.2: Organization of Finance Functions

The main function performed by Treasurer includes, (i) procurement of essential
funds (ii) maintaining banking relationship, (iii) cash management (iv) credit
management, (v) dividend distribution, (vi) pension, management etc. On the other
hand, Financial, controller is responsible for (i) general accounting, (ii) cost accounting,
(iii) auditing, (iv) budgeting, planning and controlling etc.
1.8 Key Terms

• Finance: It is defined as the science or art of managing money.
• Business finance: It is the activity concerned with the planning, raising,
controlling and administering of funds used in the business.
• Investment decisions: Concerned with the commitment of financial
resources to long- term profitable opportunities.
• Financing decisions: Financing decisions are concerned with financing-
mix or capital structure or leverage.
• Dividend decisions: Concerned with the how much profits should be
paid as dividend and how much is retained for future investment.
• Working capital: Amount of money required for day to day operations Introduction to Corporate Finance
of business is called working capital.
• Wealth maximisation: The goal of financial management which is
concerned with maximizing the current value per share of the existing
stock
NOTES
• Earnings per share (EPS): is the Net Income (profit) of a company
divided by the number of outstanding shares.
• Cost, volume and profit control (CVP) : The cost-volume-profit study
is the manner of how to evolve the total revenues, the total costs and
operating profit, as changes occur in volume production, sale price, the
unit variable cost and / or fixed costs of a product.
• Agency cost : This conflict between shareholder and managers in a
company.
• Hostile takeovers : The acquisition of one company (called the target
company) by another (called the acquirer) that is accomplished not by
coming to an agreement with the target company's management, but by
going directly to the company's shareholders.
• Agency costs : Those costs which are incurred by the management to
prevent/minimize agency problems and contribute to the maximization
of shareholders' wealth.
• Institutional investor: A non-bank person or organization that trades
securities in bulk.
1.9 Summary
• Corporate finance is that activity of management which is concerned
with the planning, procuring and controlling of the firm's financial
resources. The scope and coverage of financial management have
undergone fundamental changes over the last half a century.
• During 1930s and 1940s, it was concerned of raising adequate funds
and maintaining liquidity and sound financial structure. It is known as the
'Traditional Approach' to procurement and utilization of funds required
by a company. As per traditional approach corporate finance was
regarded as an art and science of raising and spending of funds.
• The need for most profitable allocation of capital was recognized during
1950's. During 1960s and 1970s many scholars have introduced various
analytical tools and concepts like funds flow statement, ratio analysis,
cost of capital, earning per share, optimum capital structure, portfolio
theory etc. As a result, a broader concept of finance began to be used.
Thus, the modern approach to finance emphasizes the proper allocation
and utilization of funds in addition to their procurement.
Introduction to Corporate Finance • Corporate finance is concerned with the planning and controlling of the
firm's financial resources. It is also referred as financial management
and includes planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise.
• Corporate finance in the modern approach can be broken down into
NOTES four decision or functions: (i) Investment decisions or Capital Budgeting
decisions (ii) Financing decisions or Capital structure decisions (iii)
Dividend decisions or Profit allocation decision and (iv) Liquidity decisions
or Working capital management decision.
• The goal of maximizing profits is vague and ambiguous as it is unclear
that whether profits refer to "long-run" or "short-run", or "average" or
"net profits", "profits after tax" or "profits before tax".
• The wealth or value maximization objective is no doubt a better objective
and shareholders of a firm can measure it in terms of increase in their
earning per share (EPS) or market price of the share (MPS). Because
the goal of financial management is to maximize the value of the stock,
financial manager need to learn how to identify those investments and
financing opportunities that increases the value of the stock.
• The relationship between managers and shareholders in a company is
called Agency relationship. There is a possibility of a conflict of interest
between the principal and agent. This conflict of interest is termed as
agency problem. Agency problem is the likelihood that managers may
place their personal goals above of corporate goal.
• The agency problem can be prevented or minimized by acts of (i) market
forces and (ii) agency costs. Market forces include (a) behaviour of
institutional investors and (b) Threat of hostile takeovers.
• Agency cost includes (a) expenditures which are related with the
monitoring the activities of the management may fall in to audit and
control fees. (b) Offering incentives plans such as stock options to the
managers. Stock options allow managers to purchase the shares of the
company at concessional special price. (c) Offering monetary and non-
monetary incentives to managers to act in the owner's interest. (d)
Opportunities costs which arises from the inability of the managers to
respond to the new opportunities available in the market.
• The organisation of finance function means the division and classification
of functions relating to finance. Although in case of corporate form of
business, the main responsibility to carry out finance function rests with
the top management yet the top management or Board of Directors for
organisational convenience can delegate its powers to any subordinate
executive which may be called Chief Financial Officer, Director Finance,
Chief Financial Controller, Financial Manager or Vice President of
Corporate Finance : 16 Finance.
• Due to large size, it is not possible for a finance manager to perform all Introduction to Corporate Finance
the finance functions alone or to co-ordinate with the various departments.
Therefore, finance and financial control are separated and allocated to
two different sub-departments. For 'finance', treasurer is appointed and
for the 'financial control', financial controller is appointed.
NOTES
1.10 Questions and Excercises

1. Define Finance and Financial Management. How finance is different
from Accounting and Economics? Discuss with suitable illustrations.
2. What are four major areas of decision making of a Finance Manager?
Elaborate with suitable examples.
3. Recently you have been appointed as Treasury Manager in large sized
manufacturing firms. What are different functions to be performed by
Treasury manager?
4. Discuss how company form of business is different from other forms of
business. Give suitable illustrations.
5. Explain how Organization of Finance Functions is done in trading firm.
6. Taking an example of leading pharmaceutical companies in India, discuss
how goals of the organization are different across companies.
7. What is an Agency cost? How and why it arise? Discuss how it can be
managed in today's competitive business environment.
8. "The profit maximization objective of business is not suitable in current
business situations". Do you agree? Discuss the merits and shortcomings
of profit Maximization goal.
9. Wealth Maximization objective of financial management has attracted
interest of various stakeholders and well accepted among market agents.
Discuss the statement in the light of various advantages of Wealth
Maximization approach over other objectives.
10. Discuss how role of finance manager is changing in the current global
context. Support your answer with suitable illustrations.
Books:
1. Ross, Westerfield & Jaffe, "Fundamental of Corporate Finance", TMH
Publication.
2. Brealey, Myers & Allen, "Principles of Corporate Finance", TMH
Publication.
3. Van Horne and Wachowicz , "Fundamentals of Financial Management",
Pearson Education
4. Chandra, Prasanna, "Financial Management", TMH Publication. Corporate Finance : 17
Introduction to Corporate Finance 5. Khan, M.Y. and Jain, P.K., "Financial Management- Text, Problems and
cases", TMH Publication.
6. Damodaran, A., "Corporate Finance- Theory & Practice", Wiley
Publication
7. Pandey, I.M, "Financial Management", Vikas Publication House Pvt.
NOTES Ltd, New Delhi
Web Resources:
1. Complete Guide To Corporate Finance available at http://
w w w. i n v e s t o p e d i a . c o m / w a l k t h r o u g h / c o r p o r a t e f i n a n c e / 1 /
default.aspx#ixzz2MZ8pcbWW
2. Organization of finance functions, available at: http://www.aimcollege.in/
downloads/Notes/CP_202_FM.PDF
Long Term Sources of
UNIT 2 : LONG TERM SOURCES OF Finance
FINANCE
Structure
NOTES
2.0 Introduction
2.1 Unit Objectives
2.2 Long Term Financing Needs of a Business
2.3 Long Term Financing
2.4 Advantages of Long Term Financing
2.5 Sources of Long Term Finance
2.5.1 External Sources of Finance
2.5.2 Internal Sources of Finance
2.6 Key Terms
2.7 Summary
2.0 Introduction
Finance is the life blood of any business, whether it is small or large. Without adequate
finance, no business can possibly achieve its objectives. Finance is major factor
involved in the success of any organization. The need of finance depends on various
factors like size and the nature of the business. Without adequate finance business
cannot survive in the market. There are various sources to raise the money for the
new and existing project. Bank loans, loans from specialized financial institutions,
raising money from capital market in form of Bonds, debenture or equity shares,
loans from foreign countries are among few alternatives available to the organizations.
Exact suitability of these sources depends on number of factors like nature of business,
amount of finance, credit rating of the firm and purpose of finance etc. The main
objective of this unit is to discuss various alternative sources of financing the long
term business requirements along with their merits and demerits.
2.1 Unit Objectives

After studying this unit, you should be able to -
• Understand the financial need of a business
• Be aware about the different sources of long term finance
• Outline the merit and demerit of long term sources of finance Corporate Finance : 19
Long Term Sources of
Finance
2.2 Long Term Financing Needs of a Business
Finance is needed for all kind of business irrespective of their size and nature of
activities. Financing requirement of a business can be classified into two categories
namely; long term and short term. Long term finance is needed for the acquisition of
NOTES fixed assets like plant, machinery and other long term assets.. The main reasons a
business needs finance are to:
• To start a business: Depending on the type of a business, money is needed
to finance the purchase of assets, materials and employing people. Money is
also needed to cover the running costs. It may be required before the business
generates enough cash from sales to pay for these costs.
• To finance expansions activities : As a business grows in size, it
needs higher capacity and new improved technology to cut product costs
and keep up with competitors. New technology can be relatively expensive
to the business and investment of this type is of long term nature, because
the costs will outweigh the money saved or generated for a considerable
period of time.
• To develop and market new products : In a fast moving markets,
where competitors are constantly updating their products, a business
needs to spend money on developing and marketing new products e.g.
to do marketing research and test new products in "pilot" markets. These
costs are not normally covered by sales of the products for some time (if
at all), so money needs to be raised to pay for the research.
• To enter new markets : When a business seeks to expand, it may look
to sell their products into new markets. These can be new geographical
areas to sell to (e.g. export markets) or new types of customers. This
costs money in terms of research and marketing e.g. advertising
campaigns and setting up retail outlets.
• Takeovers or acquisitions : When a business buys another business,
it will need money to pay for the acquisition as it involves significant
investment. Business need to arrange the money either by borrowing
from banks, financial institutions or raising money from equity shares.
2.3 Long Term Finance

Long term financing is a form of financing that is provided for a period of more than
a year which may extends up to 30 years. Long term financing are provided to those
business entities that face a shortage of capital. This type of financing may be
needed to fund expansion projects, purchase fixed assets, develop a new product,
R&D, Mergers and acquisitions etc. The methods of financing these types of projects
Corporate Finance : 20 will generally be quite complex.
2.3.1 Advantages of long term financing Long Term Sources of
Finance
• Stability: Long-term financing provides businesses with a more stable
debt management instrument than short-term loans. Long-term financing
allows borrowers to have more security when budgeting for costs and
expenses as the time period of financing is fairly long and there is no
NOTES
need to repay back at shorter period.
• Flexibility: There are a wide variety of long-term debt financing options
available to borrowers, such as mortgages, leases, reverse mortgages,
and loan refinancing, which can be fine-tuned to meet the borrower's
needs. This allows more flexibility and control over spending. For example,
a lease is a special type of long-term debt-financing instrument that
allows lessor to benefit from the use of an asset in exchange for rental
payments without having to purchase the asset.
• Linked to company's productivity: Unlike short-term loans, which
are used as a quick source of cash to tide over short-term liquidity
problems, long-term debt financing is used for capital investments. Capital
investments, such a real estate, machinery, vehicles, furniture and leases,
provide real benefits to a company by either increasing its productivity
or expanding its operating capacity. For example, a successful restaurant
can use a mortgage - a classic example of long-term debt financing - to
open a new location and increase its profit potential.
2.4 Sources of Long Term Financing

A business can use a wide range of sources of fund to finance their expansion plan
and long term requirements of business. These sources can broadly be categories
as (a) Internal sources of finance and (b) External sources of finance. Detailed
classification of these sources is presented in the below figure 1.
Long term Sources Check Your Progrece

1. What are various
advantages of Long term
Internal Sources External Sources financing?
2. Why company raise
long- term finance?
1. Equity Shares
1. Retained Profit 2. Preference Shares
2. Sales of Assets 3. Debentures/Bonds
4. Term loan
5. Venture capital
7. Lease financing
Figure 2.1: Various Sources of Long Term Finance

Long Term Sources of 2.4.1. External sources of finance
Finance
1. Equity Shares : Every company has a statutory right to issue shares to raise
funds. Also known as ordinary shares are issued to the owners of a company.
Ordinary share have a nominal or face value. Dividend on these shares is
paid after the fixed rate of dividend has been paid on preference shares, if
NOTES
any amount is left. The rate of dividend on equity shares is not fixed and
depends upon the profits available and the intention of the board to distribute
dividend among shareholders.
In case of winding up of the company, equity capital can be paid back only
after every other claim including the claim of preference shareholders has
been settled. The most outstanding feature of equity capital is that its holders
control the affairs of the company and have an unlimited interest in the
company's profits and assets. Equity shareholders enjoy voting right on all
matters relating to the business of the company and are considered real owners
of the business.
Advantages of equity shares financing
• Permanent Capital: Equity shares are a good source of long-term
finance. A company is not required to pay-back the equity capital during
its life-time and therefore, it is a permanent source of capital for the
business.
• No Fixed Burden: Equity shares are also called residual equity and it
is not mandatory to give dividends to the equity shareholders. Because
the dividend on these shares is subject to availability of profits and the
intention of the board of directors. They may not get the dividend even
when company has profits. Thus they provide a cushion of safety against
unfavourable development.
• Voting rights: Every equity shareholders has the right to vote on every
resolution placed before the general body of shareholders. Voting rights
of each shareholder is in proportion to his or her share of the paid-up
capital of the firm.
• Claim on income and on asset : The shareholders have residual claim
on the income and assets of the firm.
• Credit worthiness : Issuance of equity share capital creates no change
on the assets of the company. A company can raise further finance on
the security of its fixed assets.
2. Preference Shares : Preference shares as those shares which carry
preferential rights as the payment of dividend at a fixed rate and as to
repayment of capital in case of winding up of the company. Thus, both the
preferential rights viz. (a) preference in payment of dividend and (b) preference
in repayment of capital in case of winding up of the company, must attach to
Corporate Finance : 22 preference shares. The rate of dividend on these shares is fixed and the
dividend on these shares must be paid before any dividend is paid to ordinary Long Term Sources of
Finance
shares.
Types of Preference shares
• Cumulative and Non-cumulative Preference shares : Cumulative
preference shares enjoy the right to receive the dividend in arrears for the NOTES
years in which company earned no profits or insufficient profits, in the year
in which company earns profits. In other words, dividend on these shares
will go on accumulating until it is paid in full with arrears, before any dividend
is paid on equity shareholders. In case of non-cumulative preference shares
dividend does not accumulate and therefore, no arrears of dividend will be
paid in the year of profits. If company does not have any profits in a year, no
dividend will be paid to non-cumulative preference shareholders.
• Redeemable and Irredeemable Preference Shares: Redeemable
preference shares can be redeemed on or after a period fixed for
redemption under the terms of issue or after giving a proper notice of
redemption to preference shareholders. The companies Act, however,
impose certain restrictions for the redemption of preference shares.
Irredeemable preference shares are those shares which cannot be
redeemed during the life-time of the company.
• Convertible and Non-convertible preference shares: Where the
preference shareholders are given a right to convert their holding into
ordinary shares, within a specified period of time, such shares as known
as convertible preference shares. The holders of non-convertible
preference shares have no such right of conversion.
• Participating and Non-participating Preference Shares : The holders
of participating preference shares have a right to participate in the surplus
profits of the company remained after paying dividend to the ordinary
shareholders and preference shareholders at a fixed rate. The preference
shares which do not have such right to participate in surplus profits, are
known as non-participating preference shares.
Advantages of Preference shares financing
• Lower cost : The dividend payable on preference shares is fixed that is
usually lower than that payable on equity shares. Thus they help the
company in maximizing the profits available for dividend to equity
shareholders.
• No dilution of control : Preference shareholders have no voting right
on matters not directly affecting their right hence promoters or
management can retain control over the affairs of the company.
• Flexibility in Capital Structure : The Company can maintain flexibility
in its capital structure by issuing redeemable preference shares as they
can be redeemed under terms of issue. Corporate Finance : 23
Long Term Sources of 3. Debentures and Bonds : Debentures and Bonds are a fixed-interest, fixed
Finance
term investment. They are offered by finance and industrial companies which
are referred to as issuers. They usually offer a higher return than is available
from other fixed interest investments. Returns are based on a combination of
official interest rates and loan rates depending on the issuer's lending practices.
NOTES They are not risk free investments.
Types of Debentures
• Registered Debentures: These are the debentures that are registered
with the company. The amount of such debentures is payable only to those
debenture holders whose name appears in the register of the company.
• Bearer Debentures: These are the debentures which are not recorded
in a register of the company. Such debentures are transferable merely by
delivery. Holder of bearer debentures is entitled to get the interest.
• Secured or Mortgage Debentures: These are the debentures that are
secured by a charge on the assets of the company. These are also called
mortgage debentures. The holders of secured debentures have the right to
recover their principal amount with the unpaid amount of interest on such
debentures out of the assets mortgaged by the company.
• Unsecured Debentures: Debentures which do not carry any security
with regard to the principal amount or unpaid interest are unsecured
debentures. These are also called simple debentures.
• Redeemable Debentures : These are the debentures which are issued
for a fixed period. The principal amount of such debentures is paid off to
the holders on the expiry of such period. These debentures can be redeemed
by annual drawings or by purchasing from the open market.
• Non-redeemable Debentures : These are the debentures which are not
redeemed in the life time of the company. Such debentures are paid back
only when the company goes to liquidation.
• Convertible Debentures : These are the debentures that can be
converted into shares of the company on the expiry of pre-decided period.
The terms and conditions of conversion are generally announced at the
time of issue of debentures.
• Non-convertible Debentures : The holders of such debentures cannot
convert their debentures into the shares of the company.
Advantages Debenture Financing
• Benefit of Tax: Issuing of debentures would attract interest expense for
the company. As per normal tax laws, interest is a tax deductible expense.
On the contrary, the dividends paid to equity shareholders are not tax free.
They are paid out of divisible profits i.e. profits remaining after all the
Corporate Finance : 24 expenses and taxes well known as profit after tax (PAT).
• Cheaper Source of Finance : As discussed above, the interest cost Long Term Sources of
Finance
incurred on debentures enjoys a tax shield which indirectly makes the cost
of debenture low as compared to preference and equity shares. For example,
effective cost of a 12% debenture with current tax rate of 30% is 8.4%
{12% * (1-30%)}.
• Dilution of Ownership Control : Debentures don't have any effect on NOTES
the control of the existing shareholders of the company. If the same fund is
raised using equity finance, the control of existing shareholders would dilute
accordingly.
• No Dilution in Share of Profits : Opting for debentures over the equity
as a source of finance saves the profit shares of existing shareholders.
Debenture holders do not share profits of the company except that they
are liable to receive the agreed amount of interest only.
4. Venture capital : The term 'venture capital' represents financial investment in
a highly risky project with the objective of earning a high rate of return. Venture
capital (VC) is financial capital provided to early-stage, high-potential, high risk,
growth start-up companies. The venture capital fund makes money by owning
equity in the companies it invests in, which usually have a novel technology or
business model in high technology industries, such as biotechnology, IT and
software. While the concept of venture capital is very old the recent liberalisation
policy of the government appears to have given a fillip to the venture capital
movement in India. In the real sense, venture capital financing is one of the
most recent entrants in the Indian capital market. Venture capital companies
provide the necessary risk capital to the entrepreneurs so as to meet the
promoters' contribution as required by the financial institutions. In addition to
providing capital, these VCFs (venture capital firms) take an active interest in
guiding the assisted firms.
Features of Venture capital
• High Degrees of Risk : Venture capital represents financial investment
in a highly risky project with the objective of earning a high rate of return.
Check Your Progress
• Equity Participation : Venture capital financing is invariably, an actual or
potential equity participation wherein the objective of venture capitalist is 4. Why company issue
to make capital gain by selling the shares once the firm becomes profitable. equity shares?
5. Compare equity shares
• Long Term Investment : Venture capital financing is a long term
with preference shares.
investment. It generally takes a long period to recover the investment in
6. What are advantages of
securities made by the venture capitalists.
issuing equity shares?
• Participation in Management : In addition to providing capital, venture
7. What is an IPO?
capital funds take an active interest in the management of the assisted
firms. Thus, the approach of venture capital firms is different from that of
a traditional lender or banker. It is also different from that of a ordinary
stock market investor who merely trades in the shares of a company without
participating in their management. It has been rightly said, "venture capital
Long Term Sources of combines the qualities of banker, stock market investor and entrepreneur
Finance
in one".
5. Term Loans : Term loans are provided to the industrial sector by commercial
banks, development financial institutions, state level financial institutions and
investment institutions. Terms loans are secured or unsecured loans obtained
NOTES
by the company. The company has to pay interest on these term loans. The
shareholders do not lose ownership control of the company by obtaining term
loans. Term loans represent long- term debt with a maturity of more than one
year. Term loan is one of the most common methods of financing by companies
in India.
Exhibit 2.1: IDBI Bank Term Loans Scheme

Term loans can be sanctioned for project loan (green field or brown field) or
non-project loan. Project loans are sanctioned for setting up a new unit or for
expansion of existing units whereas Term Loans (Non-project) are extended for
the purpose of acquisition of fixed assets viz., Building, Plant and Machinery
etc.
The Bank provides term loan assistance in both rupee and foreign
currencies for Greenfield projects as also for expansion, diversification and
modernization. Interest rate on rupee term loan is fixed or floating based on
BBR plus a fixed spread, as per creditworthiness of borrower, rating, risk
perception, tenure of loan and other relevant factors. Interest Rate on Foreign
Currency Loan is normally floating rate based on LIBOR plus a fixed spread
according to creditworthiness of borrower, rating, risk perception, tenure of
loan and other relevant factors.
(Source: http://www.idbi.com/term-loan.asp)
Feature of Term Loans

• Term Loan is normally extended for acquisition of Land, Building and
machinery, purchase of vehicles etc. and also along with working capital
finance as composite loans.
• Term Loan is given both for industrial and non-industrial borrowers i.e.
both for projects / activities involved in manufacture/processing/repairing
and business / trading activities etc. The project needs to establish technical
feasibility and economic viability.
• Term loan is extended in different forms such as all rupee loans, foreign
currency loans and Deferred Payment Guarantees (DPG) / acceptance
facilities (other than foreign currency loans obtained from the foreign banks
or branches of Indian Banks abroad without the back-up of DPGs issued
by Banks in India).
• Repayment schedule for term loans would be stipulated based upon Debt
Service Coverage Ratio, cash generation and repayment capacity.
Repayment would be by way of periodic instalments with appropriate
repayment holiday during implementation of the project.
• Rate of interest on term loans depend upon various factors like nature of Long Term Sources of
Finance
the project, quantum of loan, risk rating, repayment period and structure of
the debt.
• Securities for term loans per se would be as per general lending norms of
the banks and also depends on the risk perception of the individual account.
NOTES
6. Lease financing: Lease financing is important method for the companies
who don't have access to capital market. Lease is a contract granting use or
occupation of property during a specified period in exchange for a specified
rent. A lease is a method of obtaining the use of assets for the business
without using debt or equity ?nancing. It is a legal agreement between two
parties that speci?es the terms and conditions for the rental use of a tangible
resource such as a building and equipment. Lease payments are often due
annually. The agreement is usually between the company and a leasing or
?nancing organization and not directly between the company and the
organization providing the assets. When the lease ends, the asset is returned
to the owner, the lease is renewed, or the asset is purchased.
A lease may have an advantage because it does not tie up funds from
purchasing an asset. It is often compared to purchasing an asset with debt
financing where the debt repayment is spread over a period of years. However,
lease payments often come at the beginning of the year where debt payments
come at the end of the year. So, the business may have more time to generate
funds for debt payments, although a down payment is usually required at the
beginning of the loan period. The variables of a lease contract are lessor,
lessee and lease rental. The lessor is actual owner of the asset who permits
the use of the asset to the other party called lessee. The lessee acquires the
right to use the asset on agreed terms on payment of periodic amount. The
lease rental is the periodic amount paid to the lessor by the lessee for using
the asset.
2.4.2 Internal Sources of finance

1. Retained earnings : It is regarded as the most dependable source of long-
term finance. Retained earnings are an easy source of internal financing to
use because they are readily available (provided company have profits).
Retained earnings are the portion of net income (profit after tax) that have
retained in the company and not paid out to the shareholders as dividends.
Instead of paying out retained earnings, shareholders can reinvest them into
the company. In other words, retained earnings refer to the undistributed
profits of companies which are usually kept in the form of general reserve.
The retained profits can be used for expansion and modernization plans by
the companies. The amount of retained earnings is determined by the quantum
of profits, the dividend payout policy followed by the management, the legal
provisions for dividend payment, and the rate of corporate taxes etc. It is an
internal source, which does not involve any cost of floatation and the
uncertainties of external financing. It also strengthens the firm's equity base, Corporate Finance : 27
Long Term Sources of which enables to borrow at better terms and conditions. The main drawbacks
Finance
of this source are (a) it is fully dependent on the accuracy of profits; and (b)
possibility of reckless use of funds by the management.
Advantages of Retained Earnings
• Ready Availability: Being an internal source, these earnings are readily
NOTES
available to the management and directors don't have to ask outsiders
for finance.
• Cheaper than External Equity: Retained earnings are cheaper than
external equity because the floatation costs, brokerage costs,
underwriting commission are other issue expenses are eliminated.
• No Ownership Dilution: Relying on retained earnings eliminates the
fear of ownership dilution and loss of control by the existing
shareholders.
• Positive Connotation: Retained earnings carry positive connotation
as compared to equity issue as far as stock market is concerned.
2. Sale of assets: As firms grow in size they build up various fixed assets.
These assets could be in the form of property, machinery, equipment, other
companies or even logos. In some cases it may be appropriate for a business
to sell off some of these assets to finance other projects. So, sale of assets
is another source of internal finance for financing new projects. Although
convenient method of financing some business requirements but has certain
limitations like not available to all companies, no ready market for buying
the assets of the companies etc.
Check Your Progress 2.5 Key Terms

8. Differentiate between
Bond and Debenture?
• Bond: A debt investment in which an investor lends money to an entity
(corporate or government) that borrows the funds for a defined period
9. What are covertibale
of time at a fixed interest rate. Bonds are used by companies and
debentures?
government to finance a variety of projects and activities.
10.What is Venture Capital?
• Bonus share A bonus share is a free share of stock given to current
11.How venture capital is
shareholders in a company, based upon the number of shares that the
different from Private
equity? shareholder already owns. While the issue of bonus shares increases
the total number of shares issued and owned, it does not change the
value of the company. Although the total number of issued shares
increases, the ratio of number of shares held by each shareholder remains
constant.
• Convertible security: A convertible security is a security that can be
converted into another security. Convertible securities may be convertible
bonds or preferred stocks that pay regular interest and can be converted
Corporate Finance : 28 into shares of common stock.
• Default risk: The event in which companies or individuals will be unable Long Term Sources of
Finance
to make the required payments on their debt obligations. Lenders and
investors are exposed to default risk in virtually all forms of credit
extensions. To mitigate the impact of default risk, lenders often charge
rates of return that correspond the debtor's level of default risk. The
higher the risk, the higher the required return, and vice versa. NOTES
• Dividend: A dividend is a payment made by a corporation to its
shareholders, usually as a distribution of profits. When a corporation
earns a profit or surplus, it can either re-invest it in the business (called
retained earnings), or it can distribute it to shareholders.
• Equity Share: A stock of any company representing an ownership
interest.
• Financial Lease: Long-term, non-cancellable lease contracts are known
as financial leases. The essential point of financial lease agreement is
that it contains a condition whereby the lessor agrees to transfer the title
for the asset at the end of the lease period at a nominal cost. At lease it
must give an option to the lessee to purchase the asset he has used at
the expiry of the lease.
• Foreign Currency Convertible Bond (FCCB) : A type of convertible
bond issued in a currency different than the issuer's domestic currency.
• Hire Purchase : A type of instalment credit under which the hire
purchaser, called the hirer, agrees to take the goods on hire at a stated
rental, which is inclusive of the repayment of principal as well as interest,
with an option to purchase. Under this transaction, the hire purchaser
acquires the property (goods) immediately on signing the hire purchase
agreement but the ownership or title of the same is transferred only
when the last instalment is paid.
• Initial public offering (IPO): An initial public offering (IPO) or stock
market launch is a type of public offering where shares of stock in a
company are sold to the general public, on a securities exchange, for the
first time.
• Maturity period: The period of time for which a financial instrument
remains outstanding. Maturity refers to a finite time period at the end of
which the financial instrument will cease to exist and the principal is
repaid with interest. The term is most commonly used in the context of
fixed income investments, such as bonds and deposits.
• Mortgage loan : A mortgage loan is a loan secured by real property
through the use of a mortgage note which evidences the existence of
the loan and the encumbrance of that realty through the granting of a
mortgage which secures the loan.
Long Term Sources of • Operating Lease: An operating lease stands in contrast to the financial
Finance
lease in almost all aspects. This lease agreement gives to the lessee only
a limited right to use the asset. The lessor is responsible for the upkeep
and maintenance of the asset. The lessee is not given any uplift to
purchase the asset at the end of the lease period. Normally the lease is
NOTES for a short period and even otherwise is revocable at a short notice.
Mines, Computers hardware, trucks and automobiles are found suitable
for operating lease because the rate of obsolescence is very high in this
kind of assets.
2.6 Summary
• Finance is the life blood of any business, whether it is small or large.
Without adequate finance, no business can possibly achieve its objectives.
This is the major factor involved in the success of any organization. The
need of finance depends on various factors like size and the nature of
the business.
• There are several sources to raise the money for the new and existing
project. Bank loans, loans from financial institutions, raising money from
capital market in form of Bonds, debenture or equity shares, loans from
foreign countries are among few alternatives available to the
organizations.
• Suitability of these sources depends on number of factors like nature of
business, amount of finance, financial credibility of firm and purpose of
finance etc.
• Long term financing is a form of financing that is provided for a period
of more than a year which may extends up to 30 years. Long term
financing are provided to those business entities that face a shortage of
capital.
• The main sources of long term finance can broadly divided into: Internal
sources and External sources of finance. Retained earnings and sale of
fixed assets are two important source of internal financing..
• Long term financing may be needed to fund expansion projects, purchase
fixed assets, develop a new product, R&D, Mergers and acquisitions
etc.
• Issuing equity shares, preference shares, debentures &Bonds, raising
term loans, venture capital, leasing are sources of long term finance.
• The term 'venture capital' represents financial investment in a highly
risky project with the objective of earning a high rate of return. Venture
capital (VC) is financial capital provided to early-stage, high-potential,
high risk, growth start-up companies. The venture capital fund makes Long Term Sources of
Finance
money by owning equity in the companies it invests in, which usually
have a novel technology or business model in high technology industries,
such as biotechnology, IT and software.
• Lease financing is important method for the companies who don't have
NOTES
access to capital market. Lease is a contract granting use or occupation
of property during a specified period in exchange for a specified rent. A
lease is a method of obtaining the use of assets for the business without
using debt or equity financing. Lease financing can be of two types;
financial lease and operating lease.

1. List out why company need long term financing from various sources.
2. What are advantages and disadvantages of external financing.
3. "Equity capital is most widely used source of financing long term business
requirements". Elaborate the statement with advantages and
disadvantages of issuing equity shares.
4. Define Term loans. How it is different from Project financing? Discuss
the various features of Term loans.
5. What is venture capital? What are essential characteristics of venture
capital? Discuss how venture capital can be advantageous for financing
a risky business idea.
6. "Retained earnings are cost free source of financing" Do you agree?
Discuss the statement with advantages of using retained earnings as
source of financing.
7. Discuss how lease financing is different from Hire purchase. Elaborate
with suitable examples.

Books:
Publication.
2. Brealey, Myers & Allen, "Principles of Corporate Finance", TMH Publication.
Pearson Education
4. Chandra, Prasanna, "Financial Management", TMH Publication.
5. Khan, M.Y. and Jain, P.K., "Financial Management- Text, Problems and
cases", TMH Publication. Corporate Finance : 31
Long Term Sources of 6. Damodaran, A., "Corporate Finance- Theory & Practice", Wiley Publication
Finance
7. Pandey, I.M, "Financial Management", Vikas Publication House Pvt. Ltd,
New Delhi
8. Kapil, Seeba, "Financial Management", Pearson Publication.
NOTES Web resources:

1. Riley, Jim (2013) "Why businesses need finance", available at: http://
www.tutor2u.net/business/gcse/finance_why_needed.htm
2. Prashnathi (2012), "Sources of Finance - Short term and Long Term",
available at: http://prasanthigovada.blogspot.in/2012/05/sources-of-finance-
short-term-and-long.html
3. FAO Corporate Document Repository, "Sources of finance", available at :
http://www.fao.org/docrep/w4343e/w4343e08.htm
4. Latham, Andrew (2013), "The Advantages of Long-Term Debt Financing",
http://yourbusiness.azcentral.com/advantages-longterm-debt-financing-
9624.html
5. Akarni, Gaurav (2012), "Sources of Fixed Capital or Long Term Finance",
available at: http://kalyan-city.blogspot.com/2012/10/what-are-sources-of-
fixed-capital-long.html
6. Das, Bipin (2012), "The merits and demerits of equity shares as a source of
finance", available at: http://www.publishyourarticles.net/knowledge-hub/
business-studies/the-merits-and-demerits-of-equity-shares-as-a-source-of-
finance.html
7. "Benefits and Disadvantages of Debentures", available at: http://
www.efinancemanagement.com/sources-of-finance/130
Short Term Sources of
UNIT 3: SHORT TERM SOURCES OF FINANCE Financing
Structure
3.0 Introduction
NOTES
3.1 Unit Objectives
3.2 Short Term Financing
3.3 Advantages of Short Term Finance
3.4 Sources of Short Term Finance
3.5 Key Terms
3.6 Summary
3.0 Introduction
Finance is the life blood of any business, whether it is small or large. A firm may
require finance for long-term, medium-term or for short-term period. Short term
finance facilitates the smooth running of business operations by meeting day to day
financial requirements. It is also required to allow flow of cash during the operating
cycle. Operating cycle refers to the time gap between commencement of production
and realization of sales. Financial requirements with regard to short term or working
capital vary from one organization to other. In the previous chapter we have discussed
about the various types of sources for long term financing needs. In this chapter we
will study about the various sources of financing like trade credit, cash credit, overdraft,
and bank loan etc which make money available for a shorter period of time and their
relative merits and demerits.
3.1 Unit Objectives

After studying this unit, you should be able to:
• Understand the short term financial needs of a business
• Be aware about the different sources of short term finance
• Outline the merit and demerit of short term sources of finance
3.2 Short Term Financing

Short Term financing is very important for any organization. It includes the borrowing
and lending of funds for a shorter period of time usually one year or less that. Short
term finance is secured for financing the current assets, for example, inventories. Corporate Finance : 33
Short Term Sources of Short term finance is also known as working capital which is the excess of current
Financing
assets over current liabilities. Current liabilities become due within one year and
indicate the amount of short-term credit being utilized by the business. Short term
financing is essential for maintaining liquidity of a company. Short-term finance
serves following purposes:
NOTES • It facilitates the smooth running of business operations by meeting day
to day financial requirements.
• It enables firms to hold inventory of raw materials and finished product.
• With the availability of short-term finance, business can afford to sell its
goods on credit. Sales are for a certain period and collection of money
from debtors takes time. During this time gap, production continues and
money will be needed to finance various operations of the business.
Short term sources of finance helps in meeting this requirement.
• Short-term finance becomes more essential when it is necessary to
increase the volume of production at a short notice.
• Short-term funds are also required to allow flow of cash during the
operating cycle. Operating cycle refers to the time gap between
commencement of production and realization of sales.
3.3 Advantages of Short Term Financing

• Easier to Obtain: Short term credit can be more easily obtained than
long term credit. A firm with poor credit standing may be unable to
obtain long term funds but it can procure, at least some trade credit from
sellers who are anxious to increase their sales. The short-term creditors,
by granting loans, assume less risk than long term creditors because
there is less chance of substantial change in the financial soundness of
the creditor within a few week's or month's time.
• Lower cost : Short term credit may be obtained with lower cost than
the long term finance because of priority of creditors in general. Because
of the priority given to creditors in the matter of claim to income and to
assets at the time of dissolution, creditors generally became ready to
accept a relatively low interest.
• Flexibility : Due to seasonal nature of business many firms have a
temporary demand for short term funds to carry more inventories in
order to meet the growing demand of products or services. Short-term
financing is flexible in the sense that the firm is able to secure funds as
they are needed and repay then as soon as the need finishes. Funds may
be needed to meet the daily, weekly or monthly requirements. Such
funds can be advantageously supplied by short term credit. In case long
term credit is secured to finance the daily or weekly or seasonal variations,
it would become inflexible because long term funds cannot be repaid as Short Term Sources of
Financing
soon as the need for funds vanishes.
• No dilution of ownership : Obtaining funds form short term creditors
prevents the inclusion of more owners through the procurement of
owner's funds (for example equity shares). This results in maintaining
NOTES
the position of control by the existing owners. Suppliers of short term
credit have no voice in the operations of the business; therefore there is
no danger of dilution of ownership.
• Availability : In many cases, particularly for small enterprises short
term credit is the only source available. It may not be possible for a
small firm to obtain long term funds because of poor credit standing.
Long-term credit is not generally granted without adequate margin of
protection which the small firms may not be able to provide with. The
small business has then recourse to short term funds.
• Tax Savings : The cost of short term funds are deductible for income
tax purposes while the dividend paid to the owners is not deductible.
Thus a substantial tax-savings may result from the use of short-term
funds.
• Convenience : Short Term credit can be more conveniently secured
than the other types of funds. It is more convenient to pay labour weekly
or employees monthly than every day
3.4 Sources of Short Term Financing

1. Trade credit : It is one of the important and commonly used methods of
financing short term business requirements. Trade credit refers to credit that
a customer gets from suppliers of goods in normal course of business. Usually
business enterprises buy supplies on a 30 to 90 days credit. This means that
the goods are delivered immediately but payments are not made until the
expiry of period of credit. This type of credit does not make the funds
available in cash but it facilitates purchases without making immediate
payment. This is cost free source of financing. In India, trade credit contributes
to about one-third of short term financing. The amount of days for which a
Check Your Progress
credit is given is determined by the company allowing the credit, and is
agreed upon by both the company allowing the credit and the company 1. Define short term
receiving it. With the extension of the payment date, the company receiving financing.
the credit essentially could sell the goods and use the net proceeds to pay 2. What is Working Capital?
back the suppliers of goods. Theoretically, four main factors are determined
3. What is various use of
the length of credit allowed.
short term finance?
• The economic nature of the product : products with a high sales
turnover are sold on short credit terms. If the seller is relying on a low
Short Term Sources of profit margin and a high sales turnover, he cannot afford to offer
Financing
customers a long time to pay.
• The financial circumstances of the seller : if the seller's liquidity
position is weak he will find it difficult to allow very much credit and will
prefer an early cash settlement. If the credit term is used as part of
NOTES
sales promotion then, he may allow more credit days and use other
means for improving liquidity position.
• The financial position of the buyer : If the buyer is in weak liquidity
position he may take long time to settle the balance. The seller may not
be will to trade with such customers, but where competition is stiff
there is no choice other than accepting such risk and improve on sales
levels.
• Cash discounts: when cash discounts are taken into account, the cost
of capital can be surprisingly high. The higher the cash discount being
offered the smaller is the period of trade discount likely to be taken.
2. Commercial Paper (CP) : An unsecured, short-term debt instrument issued
by a creditworthy corporation, typically for the financing of accounts
receivable, inventories and meeting short-term liabilities. Maturities on
commercial paper vary from 3 to 6 months. Commercial paper is usually
issued in large denominations (minimum amount is INR0.5 million).
Commercial paper is issued at a discount, reflecting prevailing market interest
rates. Commercial paper is not backed by any form of collateral, so only
firms with high-quality debt ratings will easily find buyers without having to
offer a substantial discount (higher cost) for the debt issue. In India,
commercial paper was introduced in 1990 with a view to enabling highly
rated corporate borrowers to diversify their sources of short-term borrowings
and to provide an additional instrument to investors. Subsequently, primary
dealers and all-India financial institutions were also permitted to issue CP to
enable them to meet their short-term funding requirements for their operations.
In India, a corporate would be eligible to issue CP provided -
• The tangible net worth of the company, as per the latest audited balance
sheet, is not less than Rs. 4 crore.
• Company has been sanctioned working capital limit by bank/s or all-
India financial institution/s; and
• The borrowal account of the company is classified as a Standard Asset
by the financing banks institutions.
3. Inter Corporate Deposits (ICD): An ICD is an unsecured loan given by
one corporate to another. This market allows corporate with surplus funds to
lend to other corporate. Also in India, the better-rated corporate can borrow
from the banking system and lend in this market. As the cost of funds for a
corporate is much higher than that for a bank, the rates in this market are Short Term Sources of
Financing
higher than those in the other markets. Also, as ICDs are unsecured, the risk
inherent is high and the risk premium is also built into the rates. The tenor of
ICD may range from 1 day to 1 year, but the most common tenor of borrowing
is for 90 days. In India, RBI permits Primary Dealers to accept Inter- Corporate
Deposits up to fifty percent of their Net Worth and that also for a period of NOTES
not less than 7 days. Primary Dealers cannot lend in the ICD market.
Exhibit 3.1: Inter Corporate Deposits Scheme at SBI DFHI Ltd.
SBI DFHI Ltd. has a scheme, SBI DFHI Money, through which Corporates can
place ICDs with us. We take Inter Corporate Deposits based on the on-going
rates of CBLO and Call Rates in the Money Market. If you are a corporate with
short term surplus funds, we can help you earn good returns. Place Rs. 5 crores
and above with us for periods starting from a minimum of 7 days in the form of
Inter Corporate Deposits (ICD) and earn high returns. ICD’s placed with us will
enable you to earn interest on very short term floats with zero risk to your
funds.
(Source:https://sbidfhi.com/education-details.aspx?id=18)
4. Letter of Credit (L/C) : This is a document that a financial institution(Bank)

or similar party issues to a seller of goods or services which provides that the
issuer will pay the seller for goods or services the seller delivers to a third-
party buyer. Letter of credit is an indirect form of working capital financing
and banks assume only the risk, the credit being provided by the supplier
himself. A letter of credit is issued by a bank on behalf of its customer to the
seller. As per this document, the bank agrees to honour drafts drawn on it for
the supplies made to the customer if the seller fulfils the condition laid down
in the letter of credit.
5. Factoring : With rising competition many businesses are finding themselves
in shortage of cash due to the demanding terms of their customers. However,
there is an alternative financial solution called factoring that allows your
business to be more competitive while improving your cash flow, credit rating,
and supplier discounts. Factoring is a financial transaction in which a business
sells its accounts receivable (i.e., invoices) to a third party (called a factor) at
a discount. Under factoring agreement, the business owner sells his
receivables in the form of invoice to the factor, which makes an advance of
70-85% of the purchase price of the receivable amount. A factor is a financial
institution which offers services relating to management and financing of
debts arising from credit sales. Factoring provides resources to finance
receivables as well as facilitates the collection of receivables. Factoring can
improve the profit and offer a company a whole range of benefits, such as:
Short Term Sources of
Financing
Exhibit 3.2: Recourse and Non- Rescourse Factoring,
In recourse factoring the factor turns to the client (seller), if the receivables
become bad, i.e. if the customer does not pay on maturity. The risk of bad
receivables remains with the client, and the factor does not assume any risk
associated with the receivables. The factor provides the service of receivables
NOTES collection, but does not cover the risk of the buyer failing to pay the debt. The
factor can recover the funds from the seller (client) in the case of such default.
The seller assumes the risks associated with the credit and the buyer’s
creditworthiness. The factor charges the seller for the management of
receivables and debt collection services, while also charging interest on the
amount advanced to the client (seller).
In non-recourse factoring, the factor assumes the risk of non-payment
by the client’s customers. The factor cannot demand any outstanding amount
from the client (seller). The commission or fees charged for non-recourse
factoring services are higher than for recourse factoring. The factor assumes
the risk of non-payment on maturity and consequently takes an additional fee
called a del -credere commission.
Source:: http://www.cbbh.bapdf.phpid = 680&lang = en

• Improved cash flow by releasing up to 85% of funds against the value of
outstanding invoices
• It gives you access to an ongoing supply of cash that grows as your
sales grow.
• In the case of factoring, you work with a dedicated team of professionals
who will prepare and send out statements, telephone all of your customers,
collect payments for you and maintain professional and detailed accounts
of your transactions
• By making use of a factoring facility firm can benefit from improved
profitability as it can pay suppliers earlier, buy in larger quantities and
take advantage of any volume discounts available
• It is possible to protect your company from bad debts if you decide to
choose non-recourse factoring
• The facility provides flexibility for the business and access to a range of
additional products such as cash flow loans, trade or transactional finance.
RBI Guidelines on Factoring: Following guidelines has been issued by
Reserve Bank of India for regulating factoring services:
• A factor firm requires approval from Reserve Bank of India.
• Bank shall not take directly the business of factoring but can promote
factoring firms. Bank can set up subsidiary to take up the factoring
business.
• A factor should not engage in financing other companies or firms engaged
in factoring.
6. Bank Finance: Banks are the main source of short term (working capital)
Corporate Finance : 38 financing. Commercial banks grant short-term finance to business firms which
are known as bank finance or credit. When bank credit is granted, the borrower Short Term Sources of
gets a right to draw the amount of credit at one time or in instalments as and Financing
when needed. Bank credit may be granted by way of loans, cash credit,
overdraft and discounted bills.
• Working Capital Loan : Working capital loan is one of the most
commonly used sources of financing short term business requirements. NOTES
Almost all banks and financial institutions provide short term loans to
corporate (big or small) to meet their working capital need. When a
certain amount is advanced by a bank repayable after a specified period
(generally up to 1 year), it is known as bank loan. Such advance is credited
to a separate loan account and the borrower has to pay interest on the
whole amount of loan irrespective of the amount of loan actually drawn.
Usually loans are granted against security of assets. All most all leading
commercial banks in India provide working capital loans to corporate.
• Cash Credit : Cash credit is another popular method of bank finance
for working capital requirement. Under cash credit facility, banks allow
the borrower to withdraw money up to a specified limit or sanctioned
credit limit. This sanctioned limit is known as cash credit limit. Initially
this limit is granted for one year. This limit can be extended after review
for another year. Borrower is not required to borrow the entire sanctioned
credit once, rather, he can draw periodically to the extent of business
needs and repay by depositing surplus funds to his cash credit account.
Interest is paid on the amount utilized rather than on the sanctioned credit
limit. Rate of interest varies depending upon the amount of limit. Banks
ask for collateral security for the grant of cash credit. Cash credit is a
most flexible arrangement from the borrower's point of view.
• Overdraft : An overdraft facility is a formal arrangement with a bank
that allows an account holder to draw on funds in excess of the amount
on deposit. This type of financing is most commonly used by businesses
as a way of making their working capital more flexible, although it can Check Your Progress
also be available to individuals. This limit is granted purely on the basis of
4. Who can issue
credit-worthiness of the borrower. Although overdraft amount is repayable commercial papers?
on demand, such facility continues for a long period by annual renewal of
5. What is factoring?
the limits. In overdraft facility, interest is charged on daily balances-on
6. H o w f a c t o r i n g i s
the amount actually withdrawn. There are certain minimum charges that
forfeiting?
bank charge irrespective of the actually withdrawn amount. Rate of
7. Define bill of exchange.
interest in case of overdraft is less than the rate charged under cash
credit. 8. What is a letter of
credit?
• Bill Discounting : a bill discounting is a process that involves effectively
9. What is Bank
selling a bill to a bank or similar entity for an amount that is slightly less overdraft?
than the par value and before the maturity date associated with the bill of
exchange. The debtor tenders payment to the new owner of the discounted
Short Term Sources of bill in the full amount agreed upon originally. This approach allows the
Financing
issuer of the bill to receive cash before the actual due date associated
with the bill, while also allowing the buyer to make a modest profit on the
cash advance extended to the bill's originator.
NOTES
3.5 Key Terms
• Accounts receivable : a record of all short-term (less than 12 months)
expected payments, from customers that have already received the goods/
services but are yet to pay. These types of customers are called debtors
and are generally invoiced by a business.
• Factoring : Factoring is when a factor company buys a business'
outstanding invoices at a discount. The factor company then chases up
the debtors. Factoring is a way to get quick access to cash, but can be
quite expensive compared to traditional financing options.
• Time Deposit: A savings account or certificate of deposit whose funds
are subject to notice (such as 30 days) prior to withdrawal. In the event
of early withdrawal a penalty will normally be incurred.
• Credit rating : A credit rating is an evaluation of the credit worthiness
of a debtor, especially a business (company) or a government, but not
individual consumers. The evaluation is made by a credit rating agency
of the debtor's ability to pay back the debt and the likelihood of default.
• Overdraft : An extension of credit from a lending institution when an
account reaches zero. An overdraft allows the individual to continue
withdrawing money even if the account has no funds in it. Basically the
bank allows people to borrow a set amount of money.
• Letter of credit : A letter from a bank guaranteeing that a buyer's payment
to a seller will be received on time and for the correct amount. In the
event that the buyer is unable to make payment on the purchase, the bank
will be required to cover the full or remaining amount of the purchase.
• Cash Credit : Cash Credit is defined as a short term loan provided by
banks or financial institutions to its customers up to a certain limit. The
customer can withdraw the required amount not exceeding such specified
limit.
3.6 Summary
• Short term finance is any form of investment, which has a maturity
period of less than one year. In business, short term financing loan is
where you get a loan, and you are expected to repay in a period of less
Corporate Finance : 40 than one year.
• Short term financing is required to finance day to day expenses incurred Short Term Sources of
Financing
in the routine operations of a firm. There are various sources of short
term financing such as trade credit, cash credit, overdraft, factoring, bill
discounting, commercial papers etc.
• Bank financing is most important and commonly used method of short
term financing. Commercial banks grant short-term finance to business NOTES
firms which are known as bank finance or credit. Bank credit may be
granted by way of loans, cash credit, overdraft and discounted bills.
• Trade credit is a spontaneous source of finance arising from day to day
business transactions like credit purchase and outstanding expenses.
For many businesses, trade credit is an essential tool for financing growth.
• Factoring is a financial transaction in which a business sells its accounts
receivable (i.e., invoices) to a third party (called a factor) at a discount.
Under factoring agreement, the business owner sells his receivables in
the form of invoice to the factor, which makes an advance of 70-85% of
the purchase price of the receivable amount.
3.7 Question and Exercises

1. Why short-term finance is a necessity for business enterprises?
2. Enumerate the various points of difference between cash credit and
bank overdraft.
3. Explain the various features and advantages of trade credit as a short
term source of finance.
4. What do you mean by bank financing? Explain the various methods of
bank financing.
5. What is factoring? Explain the various advantages of factoring.
6. Differentiate between recourse and non-recourse factoring.
Boosks:
1. Ross, Westerfield & Jaffe, "Fundamental of Corporate Finance",
TMH Publication.
Publication.
3. Van Horne and Wachowicz , "Fundamentals of Financial
Management", Pearson Education
Short Term Sources of 4. Chandra, Prasanna, "Financial Management", TMH Publication.
Financing
5. Khan, M.Y. and Jain, P.K., "Financial Management- Text, Problems
and cases", TMH Publication.
Publication
NOTES
Ltd, New Delhi
8. Kapil, Seeba, "Financial Management", Pearson Publication.
Web resources:
1. Sources of Short-term Finance, available at: http://download.nos.org/
srsec319/319-18.pdf.
2. Definition of Commercial Paper, available at: http://www.investopedia.com/
terms/c/commercialpaper.asp
3. Sharma, Rajini (2012), "Commercial Papers-Advantages and
disadvantages", available at: http://www.careerride.com/fa-commercial-
papers-advantages-disadvantages.aspx
4. Prashnathi (2012), "Sources of Finance - Short term and Long Term",
available at: http://prasanthigovada.blogspot.in/2012/05/sources-of-
finance-short-term-and-long.html
5. FAO Corporate Document Repository, "Sources of finance", available
at : http://www.fao.org/docrep/w4343e/w4343e08.htm
Valuation : Basic Concepts
UNIT 4: VALUATION : BASIC CONCEPTS
Structure
4.0 Introduction
NOTES
4.1 Unit Objectives
4.2 Concept of Time Value of Money
4.3 Techniques of Time Value of Money
4.3.1 Compounding Techniques/Future Value Techniques
4.3.2 Discounting/Present Value Techniques
4.4 Amortization Schedule
4.5 Key Terms
4.6 Summary
4.0 Introduction
Most important financial decisions such as the purchase of fixed assets or procurement
of funds, affect the firm's cash flows in different time periods. For example, if
machinery is purchased, it will require an immediate cash outlay and will generate
cash flows during many (up to the expected life of machine) future periods. Similarly,
if the firm borrows funds say by issuing bonds, it receives cash today and commits
an obligation to pay interest and repay principal in future periods. The firm may also
raise funds by issuing equity shares or through bank loans. The firm's cash balance
will increase at the time when shares are issued, but as the firm pays dividends in
future, outflow of cash will occur. Sound decision-making requires that the cash
flows which a firm is expected to give up over the period should be logically
comparable. In fact, the absolute cash flows which differ in timing and risk are not
directly comparable. Cash flows become logically comparable when they are
appropriately adjusted for their differences in timing and risk. The importance of the
time value of money and risk is integral in financial decision-making. The main
objective of this unit is to explore the concept of time value of money, understanding
what gives money its time value, how the value of money changes with time and
how to calculate the time value of money.
4.1 Unit Objectives
After studying this unit, you should be able to :
• Understand the concept of time value of money
• Know why money has time value
NOTES
• Discuss the concepts of simple interest and compound interest.
• Learn the methods of calculating present and future values
• Understand the concept and calculation of annuity and perpetuity
• Calculate the amortization schedule of a loan payment
• Recognize the importance of time value of money in the financial decision
making.
4.2 Concept of Time Value of Money

One of the most fundamental concepts in finance is that money has "time value."
That is to say that money in hand today is worth more than money that is expected
to be received in the future. It is because money today helps an individual to buy
whatever he want today. If an individual behaves rationally, he would not value the
opportunity to receive a specific amount of money now equally with the opportunity
to have the same amount at some future date. Individuals normally value the
opportunity to receive money now higher than waiting for one or more periods to
receive the same amount. This is called time preference for money. Time preference
of money is an individual's preference for ownership of a given amount of money
now, rather than the same amount at some future time. This reflects an important
principle that the value of money is time dependent. Following are four important
reasons for the time preference of money:
1. Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash
is in our control as payments to parties are made by us. There is no certainty
for future cash inflows. As an individual or firm is not certain about future cash
receipts, it prefers receiving cash now. Following this, Rs 1 now is certain,
whereas Rs 1 receivable tomorrow is less certain. This principle is also refereed
Check Your Progress as bird- in- the- hand.
1. Why money have time 2. Inflation: In an inflationary economy, the money received today has more purchasing
value? power than the money to be received in future. In other words, a rupee today
2. What is Time preference represents a greater real purchasing power than a rupee at later period.
of money?
3. Consumption: Individuals generally prefer current consumption to future
Simple interest and
consumption. Thus, individuals give more value to the received money today as
Compound interest. compared to be received in future.
4. Investment opportunities: An investor can profitably employ a rupee received
today to give him a higher value to be received tomorrow or after a certain
Corporate Finance : 44 period of time. For example, an investor can deposit Rs 1000/- in the Bank and
can earn 8% return after a fixed period say one year. Thus, Rs 1000 today Valuation : Basic Concepts
(present value) will become Rs 1080 (future value) after one year. Due to
above reasons, time value of money is a vital consideration in making financial
decision.
EXAMPLE 4.1:
NOTES
A project needs an initial investment of Rs. 1, 00,000. It is expected to give a
return of Rs 20,000 per annum at the end of each year, for six years. The
project thus involves a cash outflow of Rs 1, 00,000 in the ‘zero year’ and
cash inflows of Rs 20,000 per year, for six years. In order to decide, whether
to accept or reject the project, it is necessary that the present value of cash
inflows received annually for six years is ascertained and compared with the
initial investment of Rs 1,00,000. The firm will accept the project only when the
Present Value of cash inflows at the desired rate of interest exceeds the initial
investment or at least equals the initial investment of Rs 1, 00,000.
4.3 Techniques of Time Value of Money

The preceding discussion has revealed that in order to have logical and meaningful
comparisons between cash flows that result in different time periods it is necessary
to convert the sums of money to a common point in time. There are two approaches
for adjusting time value of money. These are :
1. Compounding Techniques/Future Value Techniques
2. Discounting/Present Value Techniques
4.3.1 Compounding Techniques/Future Value Techniques

Compounding techniques are used to calculate the future value of present cash
flows. This concept is based on the principle of compound interest. Under this principle,
the interest earned on the initial principal amount becomes a part of the principal at
the end of the compounding period.
EXAMPLE 4.2 : Suppose you invest Rs 1000 for three years in a saving account
that pays 10 per cent interest per year. If you let your interest income be reinvested,
your investment will grow as follows:
First year Principal at the beginning 1,000
Interest for the year (Rs 1,000 × 0.10) 100
Principal at the end of First year 1,100
Second year Principal at the beginning 1,100
Interest for the year (Rs.1, 100 × 0.10) 110
Principal at the end 1,210
Third year Principal at the beginning 1210
Interest for the year (Rs.1210 × 0.10) 121
Principal at the end 1,331 Corporate Finance : 45
4.3.1.1 Calculation of Future Value
To know the future value of a sum, the principle of compounding is used. Essentially,
practical problem related to present value calculation can be categories as follow
(a) Future Value of a Single Amount
NOTES (b) Future Value of a Series of Payment
(c) Future Value of an Annuity
(a) Future Value of a Single Amount: The Future value (FV) of an investment with
compound interest i earned in a given period of n number of year can be calculated
using the compound interest principle. A generalized procedure for calculating the
future value of a single amount compounded annually is as follows :
FVn = PV (1 + r)n
Where,
FVn = Future value of the initial flow n year hence
PV = Initial cash flow
r = Annual rate of Interest
n = number of years
By considering the above example 2, we get the same result.
FVn = PV (1 + r)n
= 1,000 (1.10)3
FVn = 1331
In order to solve the future value problems, we consult a future value interest factor
(FVIF) table. The table shows the future value factor for certain combinations of
periods and interest rates. To simplify calculations, this expression has been evaluated
for various combinations of 'r' and 'n'. Exhibit 4.1 presents the sample of one such
table showing the future value factor for certain combinations of periods and interest
rates.
Exhibit 4.1 : Future Value Interest Factor (FVIF) Table
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
Example 4.3 : If you deposit Rs. 50,000 in a bank which is paying a 10 per cent
rate of interest on a five-year time deposit, how much would the deposit grow at the
Corporate Finance : 46 end of five years?
Solution Valuation : Basic Concepts
Using the formula for calculating the future value of a single amount compounded
annually, we can solve as follows:-
FVn = PV (1 + r) n
or NOTES
FVn = PV(FVIF10%,5 yrs)
FVn = 50000 (1.10)5
= 50000 × 1.611
= Rs 80550
Multiple Compounding Periods : Interest can be compounded monthly,
quarterly and half-yearly. If compounding is quarterly, annual interest rate is
to be divided by 4 and the number of years is to be multiplied by 4. Similarly,
if monthly compounding is to be made, annual interest rate is to be divided
by 12 and number of years is to be multiplied by 12. The formula to calculate
the compound value is
r mn
Fvnn = Pv (1+
FV )
m
Where,
FVn = Future value after 'n' years
PV = Present value of cash flow today
r = Interest rate per annum
m = Number of times compounding is done during a year
n = Number of years for which compounding is done.
Example 4.4
Calculate the compound value when Rs 2,000 is invested for 3 years and the interest
on it is compounded at 20% p.a. semi-annually.
Solution
Given : PV = 2000
n = 3 years
r = 20%
= 2000 (1.10) 6
= 2000 x 2.5937
= 5187.50 Ans.
Valuation : Basic Concepts (b) Future Value of a Series of Payment: So far we have considered only the
future value of a single payment at time zero. In many instance, we may be
interested in the future value of a series of payments made at different time
periods. For example, Mr. A deposit at the end of each year Rs 1,000 Rs. 2,000
Rs.3,000 Rs.4,000 in his saving bank account .The Interest rate is 5% . He
NOTES wishes to find the future value of his deposits at the end of the 4th year. Table 4.2
present the calculation required to determine the sum of money he will have.
Table: 4. 2 Future Value of Series of Payment
Year Amount Number of Compounded Future

deposited year interest factor value
compounded (amount in Rs)
1 1,000 3 1.216 1,216

2 2,000 2 1.158 2,316
3 3,000 1 1.103 3,309
4 4,000 0 1 4,000
TOTAL Rs 10,841
(c) Future Value of an Annuity : An annuity is defined as a series of equal

payments (fixed) or receipts that occur at evenly spaced intervals. Lease and
rental payments are examples. The payments or receipts occur at the end of
each period for an annuity .The Future Value of an Ordinary Annuity (FVoa) is
the value that a stream of expected or promised future payments will grow to
after a given number of periods at a specific compounded interest. The Future
Value of an Annuity could be solved by calculating the future value of each
individual payment in the series using the future value formula and then summing
the results. A more direct formula is:
FVoa = CIFArn*A
Where
A = amount of annuity (fixed payment)
CIFA = compounded interest factor of an annuity for n years at a
interest rate of r
r = rate of interest
n = number of years
Example: 4.5
What amount will accumulate if we deposit Rs.5,000 at the end of each year for the
next 5 years? Assume an interest of 6% compounded annually.
Solution
Given : Valuation : Basic Concepts
A = 5000
n = 5 years
r = 6%
NOTES
Using the formula FVoa = CIFArn*A, we can find the tuture value :
FV = 5.637x5000 = 28,185
Thus, total accumulated amount of 5000 in 5 years with 6 percent interest
rate will be Rs.28,185
4.3.2 Discounting/Present Value Techniques

In the above section, we have discussed how compounding techniques can be used
to adjust the time value of money and helps in determining the future value of an
investment decision. The concept of present value is exactly opposite of that of
compound value (future value). The present value of a future cash inflow or outflow
is the amount of current cash that is of equivalent value to the decision maker. The
present value is always less than or equal to the future value because money has
interest-earning potential. The process of determining present value of a future
payment or receipts or a series of future payments or receipts is called discounting.
Let us illustrate the discounting procedure by using an example.
Example: 4.6
Mr. A has an opportunity to receive Rs. 1060 one year later. He knows that he can
earn 6% interest on his investment. What amount will he be prepared to invest for
this opportunity?
Solution:
To answer this question, we must determine how many rupees Mr. A must invest at
6% today to have Rs. 1060 one year afterwards.
Let us assume that P is this unknown amount and by using following formula
Present value = Future value / (1 + r)n
Where,
r = Rate of Interest
n = Number of years
P = 1060/ (1+.06)1 Check Your Concept
= 1060/1.06
5. What is Future value of
= 1000 cash flow?
Mr. A must invest Rs 1000 today in order to get Rs 1060 after 1 year with 6% 6. What is discount rate?
rate of interest.
7. What is Present value of
future cash flow?
4.3.2.1 Calculation of Present Value
Practical problem related to present value calculation can be categories as follow
(a) Present value of a single cash flow
(b) Present value of a series of cash flows
NOTES (c) Present value of an annuity
(a) Present value of a single cash flow: We will first look at discounting a
single cash flow or amount. The cash flow can be discounted back to a present
value by using a discount rate that accounts for the factors mentioned above
(present consumption preference, risk, and inflation). Conversely, cash flows
in the present can be compounded to arrive at an expected future cash flow.
The present value of a single cash flow can be written as follows:
PV = FVn / (1 + i)n
Where:
PV = the present value (or initial principal)
FVn =future value at the end of n periods
i = the interest rate paid each period
n = the number of periods
Example: 4.7
Suppose X offer to pay you Rs.150, 000 in five years. You determine that you
can invest today in a five-year government note that yields 8.5%. What is the
present value of this offer?
Solution: We can solve our problem using formula :
PV = FVn / (1 + r)n
= Rs. 1, 50,000 / (1 + .085) 5
Note:
• The lower the discount rate, the more valuable are future amounts -- in a low-
inflation economy, the promise of being a millionaire in ten years means
something.
• The higher the discount rate, the less valuable are future amounts -- in a high-
inflation economy, the promise of becoming a millionaire in ten years means
little.
(b) Present Value of a Series of Cash Flows: Till we have considered only the
present value of a single receipt at some future date. In many situations,
especially in capital budgeting decision, we may be interest in the present
value of a series of receipts receiving by a firm at a different time period. For
Corporate Finance : 50 calculating present value of series of cash flow we need to determine the
present value of each future payment and then aggregates them to find the
total present value.
n
C1 C2 C3 Cn Cet
PV = + 2
+ 3
+ = ∑ n
(1 + i ) (1 + i ) (1 + i ) (1 + i ) t = 1 (1 + i )t
n
NOTES
Formula for calculating the Present Valu of a Series of Cash flow:
where,
PV = Present Value of a series of cash flow
C1, C2, C3, Cn = Cash flow in time records, 1,2,3 and n year.
i = rate of Interest for each year
t = number of year extending fram year 1 to n.
The present value interest factor (PVIF) table is used for simplifying the process
of calculating the present value of a serious of cash flow. This table is used to
find the present value per rupee of cash flows based on the number of periods
and rate per period. Once the value per Rupee of cash flows is found, the
actual periodic cash flows can be multiplied by the Rupee amount to find the
present value.
Example : 4.8
Mr. X purchased government bonds in order to temporarily invest funds that are
being held for future plant expansion. The bonds will yield interest of Rs. 10000,
12000, 11000 respectively in first, second and third year. What is the present value of
the stream in interest receipts from the bonds? Assuming a discount rate of 10%
compounded annually.
Solution: As shown from the following calculations the present value of this stream
is Rs 27,188 if we assume a discount rate of 10% compounded annually.
Year PV factor @10% Cash in flow Present value

(Rs)
1 0.909 10,000 9,090
2 0.826 11,000 9,086
3 0.751 12,000 9,012
Total Rs 27188
Valuation : Basic Concepts Table 4.3: Present Value Factor (PVIF) of Rs. 1
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
NOTES
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
Reading Time Value Tables (PVIF)

In a time value of money table, the interest rates are given on the horizontal axis and
the years are given on the vertical axis. Let assume we are interested to know the
present value interest factor (PVIF) at 9 % and 5 years. Following steps will be
required to know the value at required rate and time period:-
i. Open the PVIF table.
ii. On the top horizontal axis, choose the 5 rate of interest rate Colum.
iii. Move through the 9% Colum from top to down.
iv. Locate the year 5 row from the vertical left hand side.
v. The value is 0.650
(c) Present Value of an Annuity: As discussed earlier, an annuity is a series of

equal payments or receipts that occur at evenly spaced intervals. Lease and
rental payments are examples. The payments or receipts occur at the end of
each period. The present value (PV) of an annuity can be calculated by
discounting each periodic payment separately to the starting point and then
adding up all the discounted figures, however, it is more convenient to use the
'one step' formulas given below.
 1 
PV of an Ordinary Annuity = A 1 − n 
 (1 + i ) 
i
Where
i is the interest rate per compounding period;
n is the number of compounding periods; and
A is the fixed periodic payment.
The present value intrest factor of annuity (PVIFA) can be used to simplify the
process of calculating the present value of an annuity. This table is used to find the
present value of per rupee annuity based on the number of periods and rate per
period. Once the value per rupee annuity is found, the actual cash flows of annuity
Corporate Finance : 52 can be multiplied by the per rupee amount to find the present value of an annuity.
Where: Valuation : Basic Concepts
PV of an ordinary Annuity = A x PVIFA in

A = Amount of Annuity
PVIFA in = Present Value factor of an Annuity for year and interest rate i.
NOTES
Example: 4.9
Calculate the present value of an annuity of Rs. 1000 paid at the end of each
year for 5 years. Assuming annual interest rate is 8%.
Solution:
Present Value = 1000 x 3.993
= Rs. 3993
1
Table 4.4: Present Value Factor of an Annuity (PVIFA) of Rs 1
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
4.4 Amortization Schedules

One important use of present value concepts is to know the payment required for an
installment type loan. An important use of loan (installment based) is that it is repaid
in equal periodic payments that include both interest and principal. Such payments
can be monthly, quarterly or annually. Such types of payments are quite popular in
auto loans, mortgage loan, consumer loans and certain business loans. Such periodic
payments are also known as EMI or easy monthly installments. Amortization means
paying off the borrowed sum completely so that in the end of the repayment periods, Check Your Concept
the balance loan amount is zero.
8. What is effective rate of
Amortization payments are a form of annuity, being an equal amount interest?
periodically. The average amount that that must be repaid annually to repay the
9. What is Amortization
interest and principal on a loan at an i rate of interest over n years can be calculated
using capital recovery or amortization factor. schedule?
Example : 4.10 10.How to calculate the EMI

of a loan?
Suppose you borrow Rs 50,000 at 10 percent compounded annual rate of interest to
be repaid at the end of each year for over the next five year. Equal installment 11.What is Annuity?
payments are required at the end of each year. Calculate the annual payment to be
repaid each year.
Valuation : Basic Concepts Solution:
To determine the annual payment R, we can use the following formula.
Present Value = R (PVIFA) i n
Where
R= annual instalment paid
NOTES
PVIFA= Present value interest factor of an annuity
i = rate of interest and,
n=number of year
Value of PVIFA as read from Table 4.4 for Rs. at 10% rate of interest
and 5 years is 3.791. Using this:
50,000 = R x 3.791
R = 50,000/3.791 = Rs 13,189 per annum to be paid for 5 years.
4.5. Key Terms

• Annuity : An annuity is a series of equal cash flows paid at equal time
intervals for a finite number of periods. A lease that calls for payments
of $1000 each month for a year would be referred to as a "12-period,
$1000 annuity." Note that, strictly speaking, in order for a series of cash
flows to be considered an annuity, each cash flow must be identical and
the amount of time between each cash flow must be the same in all
cases. There are two types of annuities that vary only in the timing of
the first cash flow:
• Annuity Due : The first payment is made immediately (at period 0).
• Regular Annuity : The first payment is made one period in the future
(at period 1).
• Compound Interest: This refers to the situation where, in future periods,
interest is earned not only on the original principal amount, but also on
the previously earned interest. This is a very powerful concept that means
money can grow at an exponential rate.
• Compounding Frequency : This refers to how often interest is credited
to the account. Once interest is credited it becomes, in effect, principal.
Note that the compounding frequency and the frequency of cash flows
are not always the same. In that case, the interest rate is typically adjusted
to an effective rate that is of the same periodicity as the cash flows. For
example, if we have quarterly cash flows with monthly compounding,
we would typically convert the monthly rate into an effective quarterly
rate to solve the problem.
• Discount Rate : This is the interest rate that is used to convert between
future values and present values. Note that the process of calculating
present values is often referred to as "discounting" because present values
are generally less than future values. Valuation : Basic Concepts
• Lump Sum : A lump sum is a single cash flow. For example, an

investment that is expected to pay Rs 100 one year from now would
have a "lump sum payment" of Rs 100.
• Perpetuity : Perpetuity is simply a type of annuity that has an infinite
NOTES
life. In other words, it is a "perpetual annuity."
• Simple Interest : A quick method of calculating the interest charge on
a loan. Simple interest is determined by multiplying the interest rate by
the principal by the number of periods.
4.6 Summary
• Most important financial decisions such as the purchase of fixed assets
or procurement of funds, affect the firm's cash flows in different time
periods.
• The importance of the time value of money and risk is integral in financial
decision-making.
• One of the most fundamental concepts in finance is that money has a
"time value." That is to say that money in hand today is worth more than
money that is expected to be received in the future. It is because money
today helps an individual to buy whatever he want today.
• There are two approaches for adjusting time value of money namely,
compounding techniques/Future value techniques and discounting/Present
value techniques. Compounding techniques are used to calculate the
future value of present cash flows. This concept is based on the principle
of compound interest.
• The present value of a future cash inflow or outflow is the amount of
current cash that is of equivalent value to the decision maker. The present
value is always less than or equal to the future value because money has
interest-earning potential.
• An important use of present value concepts is to know the payment
required for an installment type loan. An important use of loan (installment
based) is that it is repaid in equal periodic payments that include both
interest and principal.

1. If you have a choice to earn simple interest on Rs. 10,000 for three
years at 8% or annually compound interest at 7.5% for three years
which one will pay more and by how much?
2. John is considering the purchase of a Property. He can buy the property
Valuation : Basic Concepts today and expects the price to rise to Rs 15,000 at the end of 10 years.
He believes that he should earn an investment yield of 10 percent annually
on this investment. The purchase price for the Property is Rs.7, 000.
Should he buy it?
3. Jim makes a deposit of Rs.12, 000 in a bank account. The deposit is to
NOTES earn interest annually at the rate of 9 percent for seven years. How
much will Jim have on deposit at the end of seven years?
4. Mr. X is evaluating an investment that will provide the following returns
at the end of each of the following years: year 1, Rs.12, 500; year 2,
Rs.10, 000; year 3, Rs.7, 500; year 4, Rs. 5,000; year 5, Rs.2, 500; year
6, Rs 0; and year 7, RS. 12,500. Mr. believes that he should earn an
annual rate of 9 percent on this investment. How much should he pay
for this investment?
5. Exactly 5 years from now Mr X will start receiving a pension of Rs.
5000 a year. The payment will continue for 10 years .calculate how
much pension worth now. Use a rate of Discount at 10%.
6. A court settlement awarded an accident victim four payment of Rs 50,000
to be paid at the end of each of the next four years. Using a discount
rate of 4%, calculate the present value of the annuity.
7. A loan of Rs. 50,000 is due 10 years from today. The borrower wants to
make annual payments at the end of each year into a sinking fund that
will earn interest at an annual rate of 10 percent. What will the annual
payments have to be?
8. An investor can make an investment in a real estate development and
receive an expected cash return of Rs. 45,000 after six years. Based on
a careful study of other investment alternatives, she believes that an 18
percent annual return compounded quarterly is a reasonable return to
earn on this investment. How much should she pay for it today?
9. What amount must you invest today a 6% interest rate compounded
annually so that you can withdraw Rs. 5,000 at the beginning of each
year for the next 5 years?
10. A company has to replace a machine after 21 years for which it deposits
Rs 30,000 every year in the beginning of the year. In all, there are 21
instalments deposited at the rate of 5% p.a. find the future value.
11. If you would like to accumulate Rs. 7,500 over the next 5 years, how
much must you deposit each six months, starting six months from now,
given a 6 percent interest rate and semi-annual compounding?
12. You plan on buying some property in five years from today. To do this
you estimate that you will need Rs 30, 00,000 at that time for the purchase.
You would like to accumulate these funds by making equal annual deposits
in your savings account, which pays 10 % annually. If you make your
first deposit at the end of this year and you would like your account to
reach Rs 30, 00,000 when the final deposit is made, what will be the
Corporate Finance : 56 amount of your deposits?
Books:
Publication. NOTES
Publication.
Pearson Education
Publication
Ltd, New Delhi.
8. Kapil, S. "Financial Management", Pearson Education, New Delhi.
Web resources:
1. Basic Concept of Time Value of Money, available at: http://
www.newagepublishers.com/samplechapter/001945.pdf
2. Present Value of Annuities, available at: http://www.getobjects.com/
Components/Finance/TVM/pva.html
3. Introduction to concept of value and return, available at: http://
www.kkhsou.in/main/EVidya2/management/value_return.html
4. Time Value of Money Practice Problems, available at: http://webs.wichita.edu/
longhofer/Common/TVM/TVM_PracticeProblems_Solutions.pdf
5. Time Value of Money Problems, available at: http://www.me.utexas.edu/
~jensen/ORMM/omie/problems/units/economics/tvm_probs/tvm_f.html
6. Tajirian, A., "Time Value of Money", available at: http://
www.morevalue.com/i-reader/ftp/Ch6.PDF
Valuation of Shares and Bonds
UNIT 5 : VALUATION OF SHARES AND
BONDS
Structure
NOTES
5.0 Introduction
5.1 Unit Objectives
5.2 Concept of Valuation
5.3 Equity Valuation
5.4 Techniques of Equity Valuation
5.4.1. Dividend Discount Techniques
5.4.2. Relative Valuation Techniques
5.5 Bond Valuation
5.6 Key Terms
5.7 Summary
5.8 Questions and Exercise
5.0 Introduction
Knowing what an asset is worth and what determines its value is a pre-requisite for
intelligent decision making. The premise of valuation is that we can make reasonable
estimates of value for most assets and that the same fundamental principles determine
the values of all types of assets i.e. real and financial assets. Some assets are easier
to value than others, the details of valuation vary from asset to asset, and the
uncertainty (as measured by risk) associated with value estimates is different for
different assets, but the core principles remain the same. This introduction lays out
some general insights about the valuation process and outlines the role that valuation
plays in portfolio management, acquisition analysis and in corporate finance. The
main objective of this unit is to understand various methods for the valuation of both
debt and equity securities.
5.1 Unit Objectives

After studying this unit, you should be able to
• Understand the concept of valuation.
• Explain how to value Equity shares
• Explain the methods of Bond valuation
5.2 Concept of Valuation
Investment process invariably requires the valuation of securities in which the
investments are proposed. The value of a security may be compared with the price
of the security to get an idea as weather a particular security is overpriced, under-
NOTES priced or fairly priced. Valuation is the process of determining the intrinsic value of
a financial asset. It is used to measure a company's size and help the investors to
diversity their investments across companies of different sizes and different levels
of risk. A number of concepts of valuation have been used in the literature. Some of
basic concepts associated with valuation are:
1. Book Value (BV) : Book Value of an asset is an accounting concept
based on the historical data given in the balance sheet of the firm. BV of
an asset may either be given in the balance sheet or can be ascertained
on the basis of figures contained in the balance sheet. For example, the
BV of a debenture is the face value itself and is stated in the balance
sheet. The BV of an equity share can be ascertained by dividing the net
worth of the firm by the number of equity shares.
2. Market Value (MV) : MV of an asset is defined as the price for which
the asset can be sold. MV of a financial asset refers to the price prevailing
at the stock exchange (NSE and BSE in case of India). In case a security
is not listed, then its MV may not be available.
3. Going Concern Value (GV) : GV refers to the value of the business
as an operating, performing and running business unit. This is the value
which a prospective buyer of a business may be ready to pay. GV is not
necessarily the MV or BV of the entire asset taken together. GV may
be less than or more than the MV/BV of the total business. Rather, GV
depends upon the ability to generate sales and profit in future. If the GV
is higher than the MV, then the difference between the two represents
the synergies of the combined assets.
4. Liquidation Value (LV) : LV refers to the net difference between the
realizable value of all assets and the sum total of the external liabilities.
This net difference belongs to the owners/shareholders and is known a
LV. The LV is a factor of realizable value of an asset and therefore, is
uncertain. The LV may be zero also and in such a case, the owners/
shareholders do not get anything if the firm is dissolved.
5. Capitalized Value (CV) : CV of a financial asset is defined as the sum
of present value of cash flows from an asset discounted at the required
rate of return. In order to find out the CV, the future expected benefits
are discounted for time value of money. In the valuation of financial
assets, the CV is most relevant concept of valuation and has been used
in this text.
5.3 VALUATION OF EQUITY SHARE
Conceptually, the valuation of the equity share is the most typical because of its
residential ownership character. The equity shareholders receive the residential profit
and also the residual assets in case of liquidation. From the point of view of calculation
also, the valuation of equity share is difficult for (i) the rate of dividend is not given, NOTES
and (ii) unlike rate of interest or rate of preference dividend which remains constant
over the life of the security. The rate of dividend on equity share may be varying
over the years during the life of company. So, the normal valuation model as applied
for the valuation of equity shares use different assumption regarding the company's
future profits, the amount and the timing of the dividends, the required rate of returns,
etc. Different approaches have been developed for the valuation of equity shares.
These different approaches, however, make the following assumptions regarding
the basic characteristics of equity shares.
• Equity share does not have any redemption rate.
• Equity share do not have any given redemption or liquidation value. In
case of liquidation of the company, their claim is residual in nature and
arising in the last (after paying all external liabilities and the preference
shareholders).
• Dividends on equity shares are neither guaranteed nor compulsory.
Further, the rate and the timing of dividend are not specified.
5.4 TECHNIQUES OF EQUITY VALUATION

There are various approaches available for valuation of equity shares. Broadly, the
value of equity share may be found by following either of the two approaches:
A. Income based approaches (Discounted Cash Flow Techniques)
B. Market based approaches (Relative Valuation Techniques)
Dividend Discount Model

Discounted Cash
Flow Techniques
Free Cash Flow Model
Techniques of
Fundamental
Equity Valuation:
Price to Earnings Ratio
Relative Valuation
Techniques
Price book value Ratio
Figure 5.1: Techniques of Foundamental equity Valuation
Valuation of Shares and Bonds 5.4.1 Income Based Approaches (Discounted Cash Flow)
Income based approaches aim to discover value of a firm through its income metrics
like Net profits (PAT), Free Cash Flows or Dividends etc. This approach includes
the following models:-
NOTES 5.4.1.1 Dividend Discount Model

The dividend discount model (DDM) is a method of valuing a company based on the
theory that a stock is worth the discounted sum of all of its future dividend payments.
In other words, it is used to value stocks based on the net present value (NPV) of
the future dividends. Though there is no legal compulsion to pay dividend on equity
shares, still most companies prefer to pay dividends to satisfy the exceptions of i
shareholders. These modes are based on the following assumptions:
• The dividends are paid annually.
• The first dividend is paid after one year from the date of acquisition/
purchase.
• Sale of the equity share, if any, occurs only at the end of a year and at
the ex-dividend terms.
There are many variations of dividend discount models. These are as follows:
(A) Single period valuation models
(B) Multiple period valuation models
(C) Constant growth model
(D) Two stage growth model
(A) Single period valuation models: Let us begin with the case where the
investor expects to hold the equity share for one year only. In this case the
price of Equity share will be:
D1 P1
r r
Check Your Concept

where -
book value and market Po = Current price of equity share
value of share. D1 = Dividend expected a year hence
2. What do you mean by P1 = Price of share expected a year hence
dividend?
r = rate of return required on the equity share
Example 5.1 : HCL's Equity share is expected to provide a dividend of Rs 3 and

fetch a price of Rs. 20 a year hence. What is the price of equity share for now if
Corporate Finance : 62 investors' required rate of return is 12%?
Given =
P1 = 20 Rs.
D1 = 3 Rs.
NOTES
r = 12%
D1 P1
= 20.53 Rs.
(B) Multiple period valuation models: Single period share valuation model is
based on the assumption that the investor is expected to hold the security for
one year than sell it at the end of the year. Since equity share has no maturity
period, investors can hold it for the duration more than one year. In this case
equity share can be valued as:
D1 D2 D t
2
2
r r r r t
where =
Po = Current Price of equity share
D1, D2, D = Dividend expected in 1,2 ......8 years
Note : Above equation represents the valuation model for an infinite
horizon. It can also be applicable to finite horizon based on the inventor's
plan to hold shares for 'n' year. In this case equation will be.
D1 D2 D3 Dn Pn
PO = + + + +
(1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r )n
n
Dt Pn
= ∑ (1 + r )
r =1
t
+
(1 + r )n
where
P0 = current price of equity share :
NOTES
D1, D2, Dn is dividend expected in 1,2 and n years.
Pn = Sales price of equity share at the end on 4th year
r = rate of return required on equity shares.
(C) Constant growth model: This is one of the most popular model given
by Myron J. Gordon This model assume that the dividends will grow
constantly at a rate ,g, every year. If a firm pays a dividend of Do at
present then dividend at the end of year 1 will be D1, i.e., Do (1+g). The
value of share under this model is
n
n
r 2
r r
Applying the formula for the sum of a geometric progression the

above expression simplifier to :
r-g
wher = D1 = Dividend expected a yare hence = Do + (1 + g)

r = required Rate of return by equity share holder
g = costant growth of dividend
Example 5.2 : A share of X limited having a face value of Rs. 100 is expected to
pay a dividend of 12% for the current year and the growth rate of dividends is
estimated to be 3%. If investor has a required rate of return of 16% .Calculate the
value of the equity share:
Solution
Face value = 100
Dividend (do) = 12.10 = 12 x 100 = Rs.12
100
Growth of dividend = 3%
r = 16%
than D1 = Do + (1 + 9) = 12 + (1.03) = 12.36
12.36 12.36
= = = 95.08
r-g 16 -03 0.13
(D) Two stage growth model : The two stage growth model allows for two
NOTES
stages of growth - an initial phase where the growth rate is not a stable growth
rate and a subsequent steady state where the growth rate is stable and is
expected to remain so for the long term. While, in most cases, the growth rate
during the initial phase is higher than the stable growth rate, the model can be
adapted to value companies that are expected to post low or even negative
growth rates for a few years and then revert back to stable growth. The model
is based upon two stages of growth, an extraordinary growth phase that lasts
n years and a stable growth phase that lasts forever afterwards. In this case
the price of Equity share will be
  
1 -  (1 + g ) n    D − (1 + g ) n −1 (1 + g )   1 
Po = D1 1  1
 +  1 1 2
+ n 
  1 + r    (r − g 2 )   (1 + r ) 
  r − g1  
 
where =
D1 = Dividend expected a year hence
r = required rate of return by equity share holder
g1 = extraordinary growth rate applicable for n year
n = period in year for extraordinary growth rate
g2 = Normal growth rate
Example 5.3 : Current dividend on an equity share of HUL Limited is Rs.2. HUL
expected to enjoy an above normal growth rate of 20 % for 6 years. Thereafter, the
growth rate will fall and stabilise at 10%. Equity investors require a return of 15%.
Calculate the value of Equity share of HUL.
Solution : Given :
g1 = 20%
g2 = 10%
n = 6 years
q = 15%
D1 = Do (1 + g1) =
= 2 (1.20) = 2.40
DI = 2.40
Valuation of Shares and Bonds 6
( ))
NOTES
= 13.968 + 56.79
= Rs.70.76
5.4.1.2 Free Cash Flow Discount Model

Although dividends are actual cash flows paid out to stockholders, the discounted
free cash flow (DFCF) models are based on the cash available for distribution but
not necessarily distributed to shareholders. Common equity can be valued either
directly discounting free cash flow to equity (FCFE) or indirectly by calculating the
value of the firm using free cash flow to the firm (FCFF) and then subtracting the
value of non-common stock capital (usually debt and preferred stock) from this
value. This model determines the total value of the firm to all investor-both equity
holders and debt holders. That is, we begin by estimating the firm's enterprise value.
The enterprise value is the value of the firm's underlying business, unencumbered
by debt and separate from any cash or marketable securities. We can interpret the
enterprise value as the net cost of acquiring the firm's equity, taking its cash, and
paying off all debt; in essence, it is equivalent to owning the unlevered business. The
advantage of the discounted free cash flow model is that it allows us to value a firm
without explicitly forecasting its dividends, share repurchases, or its use of debt.
Valuation of Equity : For estimating the value of the equity shares, we compute
the present value (PV) of the firm's total payouts to the equity holders. Likewise, to
estimate a firm's enterprise value, we compute the present value of the free cash
flow (FCF) that the firm has available to pay all investors, both debt and equity
holders. Free cash flow can be calculated as follow:
Free Cash Flow = EBIT * (1 - tax rate) + Depreciation -

Capital Expenditures - Increase in Net Working Capital
Free cash flow measures the cash generated by the firm before making any payments
to debt or equity holders. Thus, just as we determine the value of a project by
Check Your Concept calculating the NPV of the project's free cash flow, so we estimate a firm's current
business value by computing the present value of the firm's free cash flow.
3. Elaborate the various
assumptions of
V0 =PV (Future Free Cash Flow of Firm)
dividend discount
model.
4. What do you mean by Given the enterprise value, we can estimate the share price by using solves for the
free cash flow? value of equity and then divide by the total number of shares outstanding.
P0 = V0 + Cash0 - Debt0/ Shares

5.4.2 Relative Valuation Techniques
Relative valuation is based on the premise that the value of an asset equals to its
market value (MV). To do relative valuation, analysts use the prices of similar or
comparable assets as proxy to estimate the value of an asset and to control possible
differences. Relative valuation is based on two fundamental principles: NOTES
• The intrinsic value of an asset cannot be estimated by any valuation method.

Therefore, it is always equal to what the market is willing to pay for the asset
depending on its unique characteristics.
• Markets are inefficient and assets are not priced perfectly, but because assets
are comparable, errors in pricing can be identified and corrected more easily.
The most common proxies used to standardize market prices are earnings,
book value, revenues and industry-specific variables. Some of the most important
ratios used are as follow :
(A) Price to earnings ratio (P/E) : The price-to-earnings ratio, or P/E

ratio, is an equity valuation multiple. This ratio is probably the most popular
indicator used by investors for valuation of stocks. It is the ratio of a
company's stock price to its earnings per share.
P/E Ratio = Stock Price per/Earning per share

(B) Price to book value ratio : Price-to-book value (P/B) is the ratio of
market price of a company's share price over its book value of equity.
The book value of equity is the value of a company's assets expressed
on the balance sheet. It is calculated as the difference between the book
value of assets and the book value of liabilities. Investors often look at
the relationship between the price they pay for a stock and the book
value of equity (or net worth) as a measure of how over- or undervalued.
The price/book value ratio that emerges can vary widely across industries,
depending again upon the growth potential and the quality of the
investments in each.
P/E Ratio = Stock Price per share /Book Value per share
5.5 Bonds Valuation
Bonds are long term debt securities that are issued by corporations and government
entities. Investors receive periodic interest payments, called coupon payments, until
maturity at which time they receive the face value of the bond and the last coupon
payment. Most bonds pay interest semi-annually. Bonds valuation is the determination
of the fair price of a bond. As with any security or capital investment, the theoretical
fair value of bonds is the present of the stream of cash flows (coupon or interest
Valuation of Shares and Bonds payments) it is expected to generate. Hence, the value of bonds is obtained by
discounting the bond's expected cash flows to the present using an appropriate
discount rate. In practice, this discount rate is often determined by reference to
similar instruments, provided that such instruments exist.
It is relatively easy to determine the present value of bonds since its cash
NOTES
flow and discount rate can be determined with certainty. For the sake of valuation
bonds may be classified into following groups :
(A) Valuation of Bonds with maturity
(B) Valuation of Pure discount Bonds
(C) Valuation of Perpetual Bonds
(A) Valuation of Bond with Maturity : The Government and corporations most
of the time issue bonds with a specified maturity period and coupon rate. In this
case, value of bond is equal to the discounted value of its all future cash inflows.
The discount rate is the interest rate expected by the bond holder or interest
provided by the similar kinds of bonds in the market place. Price of these bonds
can be calculated as follow:
2 n n
Where,
Bo = Present Bond Price
I1, I2, I3, I4 = Interest Payment on 1, 2, 3 and n yearly
Kd = Bond Interest rate (required rate of Return)
Bn = Bond price at the time of maturity after n years
n = maturity period of Bond in years.
Example 5.4 : From the following figures, calculate the present value of Bond.
The par value is Rs.2000 maturity date is 4 years. Annual coupon payments
are of Rs.200 market interest rate is 8%.
Solution : Given
Bn = 2000
n = 4 years
kd = 8%
I = 200
NOTES
= 662.4 + 14.70
= 2132.4
Bond valuation with semi annual interest payment

In practice, many companies pay interest on bond half-yearly. In this case bond
valuation formula can be modified as fallow:
(B) Valuation of Pure Discount Bond

A zero coupon bond, sometimes referred to as a pure discount bond or simply discount
bond is a bond that does not pay coupon payments and instead pays one lump sum at
maturity. The amount paid at maturity is called the face value. The term discount
bond is used to reference how it is sold originally at a discount from its face value
instead of standard pricing with periodic dividend payments as seen otherwise.
The value, and/or original price, of the zero coupon bond is discounted to
present value. A pure discount bond or a zero-coupon bond has a coupon rate of
zero percent. Any compensation to the bondholder comes solely from the difference
between the bond's purchase price and the face value of the bond.
Bn Check Your Concept

B0 = (1-kd)n 5. What is the difference
between share and
bond ?
Kd = Discount Rate
6. Explain Zero coupon
Bn = Maturity Value of Bond after 'n' years bond ?
n = Maturity time in years
Example 5.5 : If a bond of company has a face value of Rs.100, and a maturity of
8 years, and the appropriate (effective annual) discount rate for a given bond is 9%,
calculate the current price of Bond.
given Bn = 100
Valuation of Shares and Bonds n=8
kd = 9%
NOTES
= 100
3.342
= 29.92 Rs.
(C) Valuation of Perpetual Bonds

Perpetual bonds are bonds in which the issuer company does not repay the principal
amount during its life. In other words, such bonds have an indefinite life and thus
have no maturity value. A perpetual bond pays the bondholder a fixed coupon as
long as one holds it. The price for perpetual bonds varies widely according to long-
term interest rates. When interest rates rise, price perpetual bonds fall and vice
versa. Since, in case of perpetual bond there is no maturity, or terminal value, the
value of the bond would simply be the discounted value of infinite stream of interest
flows. The value of the perpetual bond is determined as follows:
where
Bo = Current Bond Price
I = Intrest Payment (Annual)
Kd = discount Rate
Example 6 : Calculate the present value of a bond which pays Rs 200 annual
interest in to perpetuity assuming market yield is equal to 15%.
Solution :
I = 200
kd = 15%
I
Bo =
Kd
B0 =
= 1333.33 Rs.
5.6 Key Terms
• Amortization : Liquidation of a debt through installment payments.
• Capitalization rate (or "cap rate") is the ratio between the net operating
income produced by an asset and its capital cost (the original price paid
to buy the asset) or alternatively its current market value NOTES
• Convertible Security : A security of an issuer (for example - bonds,
debentures, or preferred shares) that may be converted into other
securities of that issuer, in accordance with the terms of the conversion
feature. The conversion usually occurs at the option of the holder of the
securities, but it may occur at the option of the issuer.
• Cost of Capital : The expected rate of return that the market requires
in order to attract funds to a particular investment.
• Coupon : The yield paid by a fixed income security such as bond,
debenture etc.
• Current yield : Annual income (interest or dividends) divided by the
current price of the security. This measure looks at the current price of
a bond instead of its face value and represents the return an investor
would expect if he or she purchased the bond and held it for a year.
• Deep-discount bond : A bond that sells at a significant discount from
par value.
• Default : Failure to pay principal or interest when due. Default can also
occur for failure to meet nonpayment obligations, such as reporting
requirements, or when a material problem occurs for the issuer, such as
a bankruptcy.
• Equity capitalization : It is a method used by investors or potential
investors to project the estimated value of an investment by calculating
the current cash flow in conjunction with any expected risks.
• Equity Risk Premium : a rate of return added to a risk-free rate to
reflect the additional risk of equity instruments over risk free instruments
(a component of the cost of equity capital or equity discount rate).
• Face value : The nominal value of a security stated by the issuer. For
stocks, it is the original cost of the stock shown on the certificate. For
bonds, it is the amount paid to the holder at maturity.
• Term structure of interest rate : The relationship between interest
rates or bond yields and different terms or maturities. It is also known as
yield curve.
• Yield to maturity : Yield to maturity is simply the discount rate at which
the sum of all future cash flows from the bond (coupons and principal) is
equal to the price of the bond.
5.7 Summary
• Knowing the value of any financial assets is very important for the issuing
firm as well as for the investors. As intrinsic values of securities help
them to take proper financial decisions by providing them a point of
NOTES reference for comparison.
• Many concepts like Book value, Market Value, Liquidation value and
capitalization value are use by companies as value indicators based on
different financial decisions.
• Valuation of Bond is different from valuation of Equity and relatively
easier than that of equity due to certainty of interest payments and fixed
maturity.
• Value of equity can either be calculated by using income based approach
or market based approach. Income based approaches are based on the
discounting of probable cash flows of equity shares while market based
approach used market prices.
• Value of bonds with fixed maturity can easily be calculated by discounting
bonds current and capital gains through interest rate expected by the
bond holder or interest provided by the similar kind of Bonds in the
market place.
1. Explain the concept of valuation of securities? Why is the valuation

concept relevant for financial decision making process?
2. Explain in detail the methods of valuing an ordinary share.
3. Consider a bond of 1000 Rs. Face value which pays 7% semi annually
and has 8 years to maturity. The market requires an interest rate of 8%
on bonds of this risk. What is this bond's price?
4. Overland Ltd. has just paid a dividend of Rs.2.25. These dividends are
expected to grow at a rate of 5% in the foreseeable future. The risk of
this company suggests that future cash flows should be discounted at a
rate of 11%. Calculate the present value of the share of overland Ltd.
5. X Ltd, a high technology company, has been growing at the rate of 20

percent per year. You believe that this growth rate will last for two years
and then drop to 8 percent per year thereafter. Total dividends just paid
were 50 cents, and the required return is 15 percent. What should the
share price be today?
6. What would be the maximum an investor should pay for the common
Corporate Finance : 72 stock of a firm that has no growth opportunities but pays a dividend of
Rs.1.36 per year? The next dividend will be paid in exactly 1 year. The Valuation of Shares and Bonds
required rate of return is 12.5%.
7. Y Ltd. has experienced a steady growth of 6 %per year in its annual

dividend. This growth is expected to continue indefinitely. The last dividend
paid was Rs.0.17 per share. Investors require a 12% return on the similar
NOTES
companies. What will be the current price of Y Ltd?
8. A corporate bond with a face value of Rs.1, 000 matures in 4 years and
has a 8% coupon paid at the end of each year. The current price of the
bond is Rs.932. What is the yield to maturity for this bond?
9. Calculate the value of a bond that is expected to mature in 13 years with

a face value of Rs.1, 000. The interest coupon rate 8% and the required
rate of return is 10%. Interest is paid annually.
10. FLB Industries share sold for Rs.1.90 on January 1 and ended the year
at a price of Rs.2.50. In addition, the stock paid dividends of Rs.0.20 per
share. Calculate the dividend yield, capital gain yield, and total rate of
return for the year.
Books:
Publication.
Publication.
Pearson Education
Publication
Ltd, New Delhi.
8. Kapil, S. "Financial Management", Pearson Education, New Delhi.
Web- resources:
1. Concept of Valuation, available at: http://s3.amazonaws.com/
caclubindia/cdn/forum/files/55_valuation_of_securities.pdf
Valuation of Shares and Bonds 2. Fundamentals of equity valuation, available at: http://
www.finaticsonline.com/Freebies/Valuation_Fundamentals_[Finatics].pdf
3. http://ethesis.unifr.ch/theses/downloads.php?file=FroidevauxP.pdf
4. Dividend Discount model for equity valuation, available at: http://
NOTES pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf
5. Relative valuation Techniques for Equity Shares, available at : http:/
/pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch7.pdf
6. Bond Valuation methods, available at : http://134.198.33.115/hussain/
508C03.pdf
Risk and Return : An Overview
UNIT 6 : RISK AND RETURN: AN OVERVIEW
Structure
6.0 Introduction NOTES
6.1 Unit Objectives
6.2 Concept of Security Return
6.3 Measurement of Single Security Return
6.4 Concept of Security Risk
6.6 Risk and Return Trade off
6.7 Key Terms
6.8 Summary
6.0 Introduction
Security investment is a conscious act that involves deployment of money (cash) in
various securities or assets issued by any financial institution or a company with a
view to obtain the target returns over a specified period of time. Investment decisions
are very complex in nature and influenced by various motives. People invest in
various avenues like shares, debentures, real estate and gold etc as per their financial
need. Risk and return are most integral part of any investment. All investment
decisions are mainly guided by risk and return trade-off. To make effective investment
decisions, investors need to understand what causes risk, how it should be measured
and the effect of risk on the rate of return required by investors. This unit aims to
explain the concepts of risk and return.
6.1 Unit Objectives

• Understand the concept of risk and return of securities
• Explain trade off between risk and return
• Calculate and compare risk and return of securities
6.2 Concept of Return

The return is the fundamental motivating force and the principal reward in the
investment process. The return may be defined in terms of (i) realized return, i.e.,
the return which has been earned, and (ii) expected return, i.e., the return which the Corporate Finance : 75
Risk and Return : An Overview investor anticipates to earn over some future investment period. The expected return
is a predicted or estimated return and may or may not occur. The realized returns in
the past allow an investor to estimate cash inflows in terms of dividends, interest,
bonus, capital gains, etc, available to the holder of the investment.
The return can be measured as the total gain or loss to the holder over a
NOTES
given period of time and may be defined as a percentage return on the initial amount
invested. With reference to investment in equity shares, return consists of the dividends
and the capital gains or loss(s) at the time of selling the shares.
The return on an investment consists of two components:
(1) Current Return: The first component of return is the periodic cash
flow (income), such as dividend or interest generated by an investment.
Current return is measured as the periodic income in relation to the
beginning price of the investment.
(2) Capital Return: Capital return is reflected in the price change of
securities between two time periods. It is simply the price appreciation
of a security over a time divided by the initial price of a security.

Return is the primary motive of any investment. A return from any investment can
be calculated simply by subtracting the amount invested from the final amount realised
or expected to be realised. So, the calculation of return may be categorised in terms
of (i) realized return, i.e., the return which has been earned, and (ii) expected return,
i.e., the return which the investor anticipates to earn over some future investment
period.
6.3.1 Realised or Historical Return

Realised return is calculated in terms of regular cash flows and price change
over a period a time. Historical return can be positive, zero and negative also. Following
formula can be used to calculate historical return:
Cash Payment received during the period + Price change over the period
Total return =
Price of the Assest at the beginning
where :
C = Cach Payment received dooing the period
Pe = Price at the end of the period
Pb = Price at the beginning of the period
Example 6.1: Ram purchase 100 share of X limited with a price of 10 Rs. Per Risk and Return : An Overview
share. He received a dividend of Rs.2 per share during the year and sold the share
for Rs.13 per share at the end of the year. Calculate the rate of return earned by
Ram on these shares.
Solution
NOTES
Given :
C = 2 Rs. per share
Be = 13 Rs. Per share
pb = 10 Rs. per share
Total Return (R) =
= 50 %
Where =
E (R) = expected return
Pi = Return of Stock under state i
Pi = Probabiliy that state i occus
n = number of probable state
6.3.2 Expected Return

An expected return from investing in a security over some future holding period is
an estimate of the future outcome of this security. Since, it is an estimate of an
investor's expectations of the future; it can be estimated using probability distribution. Corporate Finance : 77
Risk and Return : An Overview Simply it is the weighted average of all possible returns multiplied by their respective
probabilities. n
E(R)∑ R 1P1
i =1
Where =
NOTES E (R) = expected return
Ri = Return of Stock under state i
Pi = Probability that state i occurs
n = number of probable state of the world.
Example 6.2 : The possible return corresponding to the state of economy and
probability of occurrence of a particular state is given below. Calculate the rate of
return of ABC ltd. security
State Probability of occurrence (Ps) Rate of return (ABC ltd)

Good 30% 20%
Average 50% 15%
Poor 20% -4%
Solution
State Ps Rs Ps * Rs
Good 30% 20% 0.3(0.2)
Average 50% 15% +0.5(0.15)
Poor 20% - 4% +0.2(-0.04)
EMBED Equation3 12.70%
Note : Return discussed so far is nominal returns, or money returns. To convert

nominal returns into real returns, an adjustment has to be made for the factor on
inflation.
Real Return= {(1+nominal return)/ (1+inflation rate)}-1
6.4 Concept of Risk

In finance, risk may be defined as "the chance that an investment's actual return will
be different than expected. It includes the possibility of losing some or all of the
original investment". Risk is an important concept in financial analysis, especially in
terms of how it affects security prices and rates of return. Most investments carry
some amount of risk with them. Investment risk is related to the probability of actually
earning less than the expected return. Risk of any asset can be divided in to systematic
and unsystematic.
6.4.1 Systematic Risk Risk and Return : An Overview
It refers to that portion of variability in return which is caused by the factors affecting
all the firms. It refers to fluctuations in return due to general factors in the market
such as money supply, inflation, economic recessions, interest rate policy of the
government, political factors, credit policy, tax reforms, etc. These are the factors
NOTES
which affect almost all firms in an economy. The effect of these factors is to cause
the prices of all securities to move together. This part of risk arises because every
security has a built in tendency to move in line with fluctuations in the market.
Investor cannot avoid or eliminate this risk even with precautions or diversification.
The systematic risk is also called the non-diversifiable risk or general risk.
6.4.1.1 Components of Systematic Risk
= Market Risk: The market risk refers to variability in return due to change in the
market price of investment. Market risk appears because of reaction of investors to
different events. There are different social, economic, political and firm specific
events which affect the market price of equity shares. Due to one or the other
factor, investors' attitude may change towards equities resulting in the change in
market price. Change in market price causes the return from investment to vary.
This is known as market risk. Market psychology is another factor affecting market
prices. In bull phases, market prices of all shares tend to increase while in bear
phases, the prices tend to decline. In such situations, the market prices are pushed
beyond far out of line with the fundamental value.
= Interest-Rate Risk:The interest rate risk refers to the variability in return caused
by the change in level of interest rates. Such interest rate risk usually appears through
the changes in market price of fixed income securities, i.e., bonds and debentures.
Prices of bonds and debentures have an inverse relationship with the level of interest
rates (Prices of existing securities fall increases with decline in interest rates and
vice-versa).
= Purchasing power or Inflation Risk: The inflation risk refers to the uncertainty
of purchasing power of cash flows to be received out of an investment. It shows the
impact of inflation or deflation on the investment. The inflation risk is related to
interest rate risk because as inflation increases, the interest rates also tend to increase. Check Your Concept
This is due to the fact that the investor wants an additional premium for inflation risk 1. What are the different
(due to decrease in purchasing power of money). An investment involves a sacrifice components of return?
of present consumption for future return. The inflation risk arises because of 2. Differentiate between
uncertainty of purchasing power of the amount to be received from investment in expected and realised
future. return?
3. What do you mean by
6.4.2 Unsystematic Risk financial risk?
It represents the fluctuations in return from an investment due to the factors which
are specific (unique) to the particular company. Since these factors are unique to a
particular company, these must be examined separately for each firm and for each Corporate Finance : 79
Risk and Return : An Overview industry. These factors may also be called firm-specific as these affect one firm
without affecting the other firms. For example, fluctuation in price of crude oil will
affect the petroleum companies but not the textile manufacturing companies. As the
unsystematic risk results from random events that tend to be unique to an industry or
a firm, this risk is random in nature.
NOTES
6.4.2.1 Components of Unsystematic Risk
= Business Risk : Business risk refers to the variability in income of a firm
due to changing operating conditions. Investopedia define business risk "as
the possibility that a company will have lower than anticipated profits, or that
it will experience a loss rather than a profit. Business risk is influenced by
numerous factors, including sales volume, per-unit price, input costs and
competition". For example, if the earning or dividends from a company are
expected to increase say by 6%, however, the actual increase is 10% or
12%.Thus, variation in actual earnings than the expected earnings refers to
business risk.
= Financial Risk: It refers to the degree of leverage or degree of debt financing

used by a firm in the capital structure along with the equity capital. Higher the
degree of debt financing, the greater is the degree of financial risk. Since,
interest payment is a fixed charge on the firm, it can bring burden on firm's
profitability during the recessionary conditions. On the other hand, presence
of interest payment brings more variability in the earning available for equity
shares. This is also known as financial leverage. A firm having lesser or no
risk financing has lesser or no financial risk.
6.5 Measurement of Single Security Risk

The variability of rates of return of a security is known as risk. The variability of
rates of return may be defined as the extent of deviations of individual rates of
return from average rate of return. In practice, no investment should be undertaken
unless the expected rate of return is high enough to compensate the investor for the
perceived risk of the investment. The most commonly used measure of risk in finance
is variance or square root the standard deviation. Another useful measure of risk is
coefficient of Variation (CV), which is the standard deviation divided by the expected
return. Coefficient of variation CV) measure the risk per unit of return, and it provides
a more meaningful basis for comparison when the expected returns on two
alternatives are not the same:
6.5.1 Calculation of Historical Risk

Standard deviation of historical return can be calculated as follow:
n 2
2
∑(R R)
r =1
1
σ =
n −1
σ = σ2
Where :
σ 2 = Varius of Return
NOTES
σ = Standard Deviation of Return
Ri = Return from the security for the period i
R = Asuthmetic Mean of all returns far all the period
n = Number of periods
Example 6.3
Calculate the standard deviation of returns of Alpha ltd. last five years of return are
as follow
Year Rt
2002 15%
2003 20%
2004 10%
2005 10%
2006 5%
Solution
Year Ri R i -R (Ri-R)2
2002 .15 .05 .0025
2003 .20 .10 .01
2004 .01 00 00
2005 .01 00 00
2006 0.5 -.05 .0025
N=5 ΣRi = .05 Σ (Ri-R) = .10 Σ(Ri-R)2 = .015
R = ΣRi/n
R = .1
n 2
∑( R1 R )
σ2 = r =1
n −1
5-1
= .0612 or 6.12% an
NOTES
6.5.2 Calculation of Expected Risk

Expected risk can be calculated by using probability distribution. It is commonly
measured by the variance or standard deviation of expected return. Following steps
are used for the calculation.
= The expected return is subtracted from the return within each state of
nature; this difference is then squared.
= Each squared difference is multiplied by the probability of the state of
nature.
= These weighted squared terms are then summed together.
σ2 = Σ Pi[Ri-E(R)]2
Where
σ2 = Risk (Variance)
Ri = Return for the ith possible outcome
E(R) = Expected return
Pi = Probability associated with 'i' Possible outcome.
Example: 6.4
Calculate the standard deviation of returns on Axis bank stocks. The possible return
corresponding to state of economy and probability of occurrence of a particular
state is given in the table.
State Pi Ri
Good 30% 20%
Average 50% 15%
Poor 20% -4%
Pi Ri
NOTES
6.6 Risk and Return Trade Off
A fundamental investment concept is tradeoff between risk and return of

security. The concept is based on two realities of investments and investment
performance. Firstly, all investments carry some degree of risk - the reality that you
could lose some or all of your money when you buy stocks, bonds, mutual funds or
other investments. Secondly, not only do different types of investments carry different
levels of risk, but the more risk you assume, the greater the investment return you
are likely to achieve. Thus, the simple rule of investment management is that "the
higher the risk, the greater will be the returns".
Figure : 6.1 : Risk and Return trade off

(Source: Basics of Investing, available at: www.assetmanagement.hsbc.com)
Check Your Concept

6.7 Key Terms 4. What are the different
measures of risk?
• Business risk: The risk related to the inability of the firm to hold its
competitive position and maintain stability and growth in earnings.
systematic and
• Discount rate: The interest rate at which future sums or annuities are
unsystematic risk?
discounted back to the present.
• Financial risk: The risk related to the inability of the firm to meet its
debt obligations as they come due. Corporate Finance : 83
Risk and Return : An Overview • Inflation premium: A premium to compensate the investor for the
eroding effect of inflation on the value of the dollar. In the 1980s the
inflation premium was 3 to 4 percent. In the late 1970s it was in excess
of 10 percent.
• Probability distribution: a probability distribution assigns a probability
NOTES to each measurable subset of the possible outcomes of a random
experiment, survey, or procedure of statistical inference.
• Required rate of return: That rate of return investors demand from
an investment (securities) to compensate them for the amount of risk
involved.
• Risk premium: The return in excess of the risk-free rate of return that
an investment is expected to yield. An asset's risk premium is a form of
compensation for investors who tolerate the extra risk - compared to
that of a risk-free asset - in a given investment.
• Risk-free rate of return: Rate of return on an asset that carries no
risk. Treasury bills are often used to represent this measure, although
longer-term government securities have also proved appropriate in some
studies.
6.8 Summary
• Risk is an important concept in financial analysis, especially in terms of
how it affects security prices and rates of return. Most investments
carry some amount of risk with them.
• All investment decisions are mainly guided by risk and return trade-off.
To make effective investment decisions, investors need to understand
what causes risk, how it should be measured and the effect of risk on
the rate of return required by the investors.
• Return on investment includes the regular income in the form of dividend
and interest along with the capital appreciation of the investment.
• Risk is the chance of financial loss. Investment having greater chances
of loss is considered more risky than those with lesser chances of loss.
It can be calculated by measuring the volatility of returns.
• Mainly risk is of two types first, systematic risk, caused the factors
which affect the variability in returns of all the firms. Second,
unsystematic risk caused by the factors which are specific (unique) to
the particular company.

1. What is risk? Define in context of security market. Also distinguish
Corporate Finance : 84 between systematic and unsystematic risk.
2. Briefly explain how interest rate affects the security risk. Risk and Return : An Overview
3. A company is expecting the following scenario of returns the next year.

Find out the expected return.
Possible return % Likelihood Probability %
14 Normally likely 30 NOTES
8 Most likely 50
3 Meagrely likely 18
4 Least likely 2
4. An investor buys a stock for Rs.47 and gets an annual cash dividend of
Rs.2.25. Will he experience a capital gain or a capital loss if he sells the
stock for Rs.51.75 one year later? What is the investor's percentage
return?
5. The returns for two different investments are shown in the following
table.
a. Which of the two investments seems to be more risky? Explain why.
b. What are the standard deviations of returns of each investment?
Year Return on A (in %) Return on B (in %)
2002 5 10
2003 16 14
2004 11 8
2005 1 13
2006 9 9
2007 24 12
6. The table below shows the returns for three alternative investments.
• Determine which of the three investments seems to be most risky.
Which appears to be the safest investment?
• What are the standard deviations of returns of each investment?
Year Return on A Return on B Return on C
2003 8 16 24
2004 8 5 16
2005 8 9 10
2006 8 14 3
2007 8 1 7
7. You are expected to earn a return of 15% on a share. If the inflation rate
is 6%, what is your real rate of return?
Books:
NOTES Publication.
Publication.
Pearson Education
Publication
Ltd, New Delhi.
8. Kapil, S. "Financial Management", Pearson Education.
Web resources:
1. Computation of risk and return, available at:
http://wps.aw.com/wps/media/objects/222/227412/ebook/ch05/
chapter05.pdf
2. Types of risk, available at:
http://kalyan-city.blogspot.com/2012/01/types-of-risk-systematic-and.html
3. Risk and Return Trade-off, available at:
http://www.assetmanagement.hsbc.com/in/mutual-funds/learning-centre/
investment-basic/fin_concepts.html
Portfolio Theory
UNIT 7 : PORTFOLIO THEORY
Structure
7.1 Unit Objectives

7.2 Markowitz Model or Mean Variances Analysis
7.3 Portfolio Risk and Return under Markowitz Model
7.4 Diversification and Portfolio Risk
7.5 Markowitz Optimal Portfolio
7.6 Key Terms
7.7 Summary
7.0 Introduction
Any investment process mainly includes two different but interrelated steps. The
first step is security analysis for assessing risk and return of individual security. The
second step is portfolio construction which involves choosing the best possible
portfolio. The term portfolio refers to combination of financial assets such as stocks,
bonds, and other securities. Portfolio theory provides a standard approach to investor
to make investment decision under risk.
The Modern Portfolio Theory (MPT), a hypothesis put forward by Harry
Markowitz in his paper "Portfolio Selection," (published in 1952 in the Journal of
Finance) is an investment theory based on the idea that risk-averse investors can
construct portfolios to optimize or maximize expected return based on a given level
of risk. MPT was the first formal attempt to quantify the risk of portfolio and
develop a methodology for determining optimal portfolio. Harry Markowitz was the
first person to show quantitatively why and how diversification reduces risk. Portfolio
theory was expanded on in 1958 by James Tobin and again in 1964 by William
Sharpe. In 1990, Markowitz, Sharpe and Merton Miller shared the Nobel Prize for
economics for their development in what is now called modern portfolio theory.
Portfolio Theory
7.1 Unit Objectives
After studying this unit, you should be able to:-
• Explain the modern portfolio theories
NOTES • Understand the concept portfolio diversification

• Calculate and compare risk and return of a portfolio
• Construct an optimal portfolio
7.2 Markowitz Model (Mean-Variance Analysis)

Harry M. Markowitz is credited with introducing new concepts of risk measurement
and their application to the selection of portfolios. He started with the idea of risk
aversion of average investors and their desire to maximise the expected return with
minimum risk. The Markowitz model is thus a theoretical framework for analysis of
risk and return and their inter-relationships. It uses statistical analysis for measurement
of risk and mathematical programming for selection of assets in a portfolio in an
efficient manner. This framework led to the concept of efficient portfolios. An efficient
portfolio is expected to yield the highest return for a given level of risk or lowest risk
for a given level of return. Markowitz Model works to eliminate or minimize the risk
of an individual security by diversifying the portfolio across asset classes. The modern
portfolio theory of Markowitz is based on the following assumptions:
• Investors are rational and behave in a manner as to maximise their utility
with a given level of income or money.
• Investors have free access to fair and correct information on the returns
and risk, thereby no information asymmetry.
• The markets are efficient and absorb the information quickly and
perfectly.
• Investors are risk averse and try to minimise the risk and maximise
return.
• Investors base decisions on expected returns (Mean) and variance or
standard deviation of these returns from the mean.
• Investors prefer higher returns to lower returns for a given level of risk.
7.2.1 Portfolio risk and return under Markowitz model
(A) Portfolio Expected Return

As discussed above, portfolio is a combination of securities. The expected return on
a Portfolio is computed as the weighted average of the expected returns on the
securities which comprise the portfolio. The weights reflect the proportion of the
Corporate Finance : 88 portfolio invested in the stocks. This can be expressed as follows:
Portfolio Theory
Where,
• E[Rp] = the expected return on the portfolio, NOTES
• N = the number of securities in the portfolio,
• wi = the proportion of the portfolio invested in security i, and
• E[Ri] = the expected return on security i.
Example 7.1:
Oliver's portfolio holds security A, which returned 12.0% and security B, which
returned 15.0%. At the beginning of the year 70% was invested in security A and
the remaining 30% was invested in security B. Calculate the return of Oliver's
portfolio over the year.
Solution : Rp = (.6×12%) + (.3×15%) = 12.9%
(B) Portfolio Expected Risk

Risk of an individual security is measured by variance or standard deviation of its
return, the portfolio risk is also measured by variance or standard deviation of its
return from securities comprising portfolio. Although, the expected return on a portfolio
is the weighted average of the expected returns on the individual securities in the
portfolio, portfolio risk is not the weighted average of risks of the individual securities
in the portfolio because the variance/standard deviation of a portfolio reflects not
only the variance/standard deviation of the securities that make up the portfolio but
also how the returns on the securities which comprise the portfolio vary together.
There are two measures for how the returns on a pair of securities vary together
are the covariance and the correlation coefficient.
(1) Covariance: Covariance reflects the degree to which the returns of the two
securities vary or change together. Covariance between the returns on two
securities can be calculated using the following equation:
Where,
(Cov (Ri, R2) = σ12 = Pi (R1i - E (R1)) (R2i - E (R2))
σ12 = the covariance between the returns on security 1 and 2,

N = the number of states,
Pi = the probability of state i,
R1i = the return on security 1 in state i,
E[R1] = the expected return on security 1, Corporate Finance : 89
Portfolio Theory R2i = the return on security 2 in state i, and
E [R2] = the expected return on security 2.
(2) Correlation Coefficient: Correlation Coefficient between the returns on

two securities can be calculated using the following equation:
NOTES
Corr (R1 . R2) = σ12/σ1×σ2
Where
σ12 = the covariance between the returns on stocks 1 and 2,
σ1 = the standard deviation on stock 1, and
σ2 = the standard deviation on stock 2.
Thus, risk of portfolio consisting of two securities is given by the following
formula:
σ2p = w1σ21 + w22 σ22 + 2w1 w2 P12σ1σ2
where :
σ2p = variance of the portfolio
w1, w2 = weight of securities 1 and 2 in the portfolio
σ12 = variance of the return of security 1
σ22 = variance of the return of security 2
σ1 = standard devition of security 1
σ2 = standard devition of security 2
P12 = Co-relation cofficient of secuirty 1 and 2
Example: 7.2
What is the portfolio standard deviation for a two-asset portfolio comprised of the
following two assets if the correlation of their returns is 0.5?
Asset A Asset B
Expected return 10% 20%
Standard Deviation of Expected Returns 5% 20%
Amount Invested 40000 60000
Solution : given
WA = .4
WB = .6
A
= .25
B
= .2
PAB = .5
Portfolio Theory
σAB = W2A 2
+ W2Bσ2B+2WA.WB.PAB
A A B
= (.4)2 x (.05)3 + (.6)2 x (.2)2 + 2 x .4 x .6 x .5 x .2 x .05
NOTES
= 0.0172
= 0.131179 or 13.1149%
7.2.2 Diversification and portfolio risk

Most investor agree that holding two securities is less risky that holding one. This is
called the principal of diversification. The Modern Portfolio Theory (MPT) provides
a rigorous understanding of what diversification is and how it works to improve
investment opportunities. MPT also shows how to create the portfolio that contains
as much diversification as possible. It tells us exactly which risky assets we should
hold and in what proportions. The risk in a portfolio of diverse individual stocks will
be less than the risk inherent in holding any one of the individual stocks (provided the
risks of the various stocks are not directly related). Consider a portfolio that holds
two risky stocks: one that pays off when it rains and another that pays off when it
doesn't rain. A portfolio that contains both assets will always pay off, regardless of
whether it rains or shines. Adding one risky asset to another can reduce the overall
risk of an all-weather portfolio. The MPT states that the risk for individual stock
returns has two components:
7.2.2.1 Systematic risk

It refers to that portion of variability in return which is caused by the factors affecting
all the firms in an economy. In other words, systematic risk means fluctuation in
return due to general factors in the market such as money supply, inflation, economic
recessions, interest rate policy of the government, political factors, credit policy, tax
reforms, etc. These are the factors which affect almost all firms. The effect of
these factors is to cause the prices of all securities to move together. This part of
risk arises because every security has a built in tendency to move in line with
fluctuations in the market. It is very difficult to eliminate and reduce this risk. The
systematic risk is also called the non-diversifiable risk or general risk.
7.2.2.2 Unsystematic risk

The unsystematic risk represents the fluctuations in return from an investment due
to the factors which are specific (unique) to the particular company. Since these
factors are unique to a particular company, these must be examined separately for
each firm and for each industry. These factors may also be called firm-specific as
these affect one firm without affecting the other firms. For example, fluctuation in Corporate Finance : 91
Portfolio Theory price of crude oil will affect the petroleum companies but not the textile manufacturing
companies. As the unsystematic risk results from random events that tend to be
unique to an industry or a firm, this risk is random in nature. This risk is also called
specific risk or diversifiable risk.
For a well diversified portfolio, the risk or average deviation from the mean
NOTES
of each security contributes little to portfolio risk. Instead, it is the difference or
covariance between individual stock's levels of risk that determines overall portfolio
risk. As a result, investors benefit from holding diversified portfolios instead of individual
stocks.
Figure 7.1: Risk-Return Relationship

7.2.3 Construction of Optimal Portfolio
Harry Markowitz generated a number of portfolios within a given amount of money or
wealth and given preferences of investors for risk and return. Individuals vary widely
in their risk tolerance and asset preferences and also their means, expenditures and
investment requirements vary from one to another. Given the preferences, the portfolio
selection is not a simple choice of any security or securities, but a right combination of
securities. Markowitz emphasized that quality of a portfolio will be different from the
Check Your Concept quality of individual assets within it. Thus, the combined risk of two assets taken
separately is not the same risk of two assets together. Markowitz provided the framework
of efficient portfolios. An efficient portfolio is expected to yield the highest return for a
portfolio?
given level of risk or lowest risk for a given level of return.
2. What are the basic
assumptions of Markowitz 7.2.3.1 Markowitz Efficient Frontier
portfolio model? The efficient frontier is a concept in modern portfolio theory introduced by Harry
Markowitz and others. A combination of assets, i.e. a portfolio, is referred to as
"efficient" if it has the best possible expected level of return for its level of risk .s Here, Portfolio Theory
every possible combination of risky assets, without including any holdings of the risk-
free asset, can be plotted in risk-expected return space, and the collection of all such
possible portfolios defines a region in this space. The upward-sloped (positively-sloped)
part of the left boundary of this region, a hyperbola, is then called the "efficient frontier".
The efficient frontier is then the portion of the opportunity set that offers the highest NOTES
expected return for a given level of risk, and lies at the top of the opportunity set or the
feasible set. Figure 7.2 illustrates the concept of Efficient Frontier
Figure 7.2: Efficient Frontier

(Source: https://www.smart401k.com/resource-center/advanced-investing/modern-
portfolio-theory-and-the-efficient-frontier)
7.2.3.2 Risk and Return Indifference Curve

In the previous section, we learned that different investors exhibit different levels of
risk aversion. For each investor the degree of risk aversion translates into certain
utility (satisfaction) that he gets from an investment. As the risk aversion increases,
an investor demands more returns for every unit of increase in risk. When the risk
increases, the investor demands more return based on his utility function, thereby
keeping the level of utility the same. This concept can be explained with the help of
indifference curve. An indifference curve presents the risk-return requirements of
an investor at a certain level of utility. Fighure 7.3 shows three indifference curves
for the same investor.
Portfolio Theory
NOTES
Figure 7.3- Indifference Curves for an Investor

(Source: Utility Indifference Curves for Risk-averse Investors, avilable at: http://
financetrain.com/utility-indifference-curves-for-risk-averse-investors/)
7.2.3.3 Optimal Portfolio

Once the efficient frontier is delineated, the next question is: what is optimal portfolio
for the investors? To determine the portfolio on the efficient frontier, the investor's
risk and return trade off must be known. Each investor will want to hold a portfolio
somewhere on the efficient frontier. Risk-aversive investors will choose the portfolio
that suits their preference for risk. As investors are a diverse group there is no
reason to believe that they will have identical risk preferences. Each investor may
therefore prefer a different point (portfolio) along the efficient frontier.
So the optimal portfolio is found at the point of tangency between the efficient
frontier and utility Indifference Curve. This point represents the highest level of
utility the investor can reach. In the figure 7.4 the feasible set (the dark area), the
efficient set (the borderline between E and S is) and some indifference curves are
shown. The optimal portfolio is marked with O*.
Figure 7.4- Feasible set, the efficient set and Indifference curves
Corporate Finance : 94 (Source: Efficient Set, avilable at: http://www.cs.brandeis.edu/~magnus/stocks/
node4.html)
7.6 Key Terms Portfolio Theory
• Beta: A measure of the volatility, or systematic risk, of a security or a

portfolio in comparison to the market as a whole. Beta is used in the
capital asset pricing model (CAPM), a model that calculates the expected
return of an asset based on its beta and expected market returns. NOTES
• Covariance: A measure of the degree to which returns on two risky
assets move in tandem. A positive covariance means that asset returns
move together. A negative covariance means returns move inversely
• Diversification: Diversification means reducing risk by investing in a

variety of assets. If the asset values do not move up and down in perfect
synchrony, a diversified portfolio will have less risk than the weighted
average risk of its constituent assets, and often less risk than the least
risky of its constituent.
• Efficient frontier: A combination of assets, i.e. a portfolio, is referred

to as "efficient" if it has the best possible expected level of return for its
level of risk.
• Efficient frontier: A set of optimal portfolios that offers the highest

expected return for a defined level of risk or the lowest risk for a given
level of expected return.
• Indifference Curve: A diagram depicting equal levels of utility

(satisfaction) for a consumer faced with various combinations of goods.
7.7 Summary
• The Modern Portfolio Theory (MPT), originally proposed by Harry
Markowitz, was the first formal attempt to quantify the risk of portfolio
and develop a methodology for determining optimal portfolio based on
the idea that risk-averse investors. MPT was the first formal.
• Expected return on portfolio is the weighted average of the expected
returns on the individual securities in the portfolio. But the portfolio,
measured in terms of variance and standard deviation is not the weighted
average of the risks of the individual securities in the portfolio.
• An efficient portfolio is portfolio option which expected to yield the highest
return for a given level of risk or lowest risk for a given level of return..
• Optimum portfolio can be obtained out of different efficient portfolio by
combining the risk preference of individual invested with it.

1. What is a portfolio? How is the portfolio return and risk calculated for a
2 security portfolio?
2. How does diversification reduce the risk of investment?
3. Explain the process developed by Markowitz for obtaining the optimal
portfolio of risky security.
Portfolio Theory
4. You have been asked for your advice in selecting a portfolio of assets
and have been supplied with the following future expected return data.
You have been told that you can create 2 portfolios-one consisting of
assets P and Q and the other consisting of assets P and R-by investing
equal proportions (50%) in each of the 2 component assets.
NOTES
Year Asset P Asset Q Asset R
2009 10% 14% 9%
2010 12 12 12
2011 14 10 15
Calculate the following

(a) Average expected return for each asset over the 3-year period?
(b) Standard deviation of returns for each asset?
(c) Average expected return for each of the two portfolios?
(d) Standard deviation of returns for each portfolio?
(5) Assume you are considering a portfolio containing two assets, A and B.
Asset A will represent 45% of the dollar value of the portfolio, and asset
B will account for the other 55%. The expected returns over next 6
years, 2009-2014, for each of these assets are summarized as follow.
Year Return on A Return on B

2009 13% 20%
2010 13 19
2011 15 15
2012 16 13
2013 16 12
2014 20 11
(a) Calculate the average return and standard deviation of returns for
Assets A and B.
(b) Find the portfolios expected return for EACH of the 6 years.
(c) Calculate the (arithmetic) average expected portfolio return, over the
6-year period.
(d) Calculate the standard deviation of expected portfolio returns, over
the 6-year period.
(6) Calculate the average return of the following portfolio
Investment Avg. Return Amount invested Portfolio Theory
Stocks 15% 100,000

Bonds 5% 50,000
Real estate 10% 250,000
NOTES
7. Suppose you have Rs. 10,000 to invest and you want to invest it in two
securities equally. Your assessment suggests that the probability
distributions of the returns on securities A and B are shown as follow
State of Economy Probability Return on stock A Return on stock B
1 0.2 15% -5
2 0.2 -5% 15%
3 0.2 5% 25%
4 0.2 35% 5%
5 0.2 25% 35%
(a) Calculate the Expected return of security A and B and portfolio.
(b) What is the standard deviation of security A and B

Books:
Publication.

Publication.
Pearson Education


Publication

Ltd, New Delhi.
Web resources:
1. Portfolio risk and return, available at:
Portfolio Theory • http://www.oliversnotes.com/pdfs/PMT_StudyNotes_Extract.pdf
• http://www.chinaacc.com/upload/html/2013/06/27/
lixingcun02485e0c63144e7e8fe217ce88bd5213.pdf
2. Markowitz portfolio theory, available at:
NOTES • http://cgi.di.uoa.gr/~vassilis/aee/MPTTextbook.pdf
3. Numerical Exercise, available at:
• https://sites.google.com/site/investments242/assignments/numerical-
practice-qs
Assets Pricing
UNIT 8 : ASSETS PRICING
Structure
8.1 Unit Objectives
8.2 Capital Assets Pricing Model (CAPM)
8.2.1 Assumptions of CAPM
8.2.2 Inputs for CAPM
8.2.3 Security Market Line
8.2.4 Capital market Line
8.3 Single Index Model
8.4 Arbitrage Pricing Theory
8.5 Key Terms
8.6 Summary
8.0 Introduction
The theory of asset pricing is concerned with explaining the price of financial assets
in an uncertain world. Asset pricing theory tries to determine the prices or values of
claims to uncertain future payments. The aim of these theories is to determine the
fundamental value of an asset. As we know that there is a close relation between
this fundamental value and an appropriate return. Thus the main focus of asset
pricing theories is to determine this appropriate return. A low price implies a high
rate of return, so one can also think of the theory as explaining why some assets pay
higher average returns than others. In this unit, we get familiarized with Sharpe
Index Model and classical asset pricing models, such as CAPM and APT (Arbitrage
Pricing Theory).
8.1 Unit Objectives

• Understand the assumptions and application of CAPM
• Distinguish between security market line and capital market line
• Explain Arbitrage Pricing Theory (APT)
Assets Pricing
8.2 Capital Assets Pricing Model (CAPM)
The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan
Mossin independently, building on the earlier work of Harry Markowitz on
diversification and modern portfolio theory. The CAPM is a model for pricing an
NOTES individual security or a portfolio. The CAPM, in essence, predicts the relationship of
an assets and its expected return. This relationship helps in evaluating various
investments options. The CAPM assumes that investors hold fully diversified
portfolios.
The measure of risk used in the CAPM, which is called 'beta', is therefore
a measure of systematic risk. The minimum level of return required by investors
occurs when the actual return is the same as the expected return, so that there is no
risk at all of the return on the investment being different from the expected return.
This minimum level of return is called the 'risk-free rate of return'
Therefore, the expected rate of return for any security under CAPM is
deflated by the following equation:-
E(Ri) = Rf + âi[ E(Rm) – Rf]

Where:
E (Ri) = Return required on financial asset i
Rf = Risk-free rate of return
â i = Beta value for financial asset i
E (Rm) = Average return on the capital market
8.2.1 Assumptions of CAPM

The CAPM is often criticized as being unrealistic because of the assumptions on
which it is based, so it is important to be aware of these assumptions and the reasons
why they are criticized. The assumptions are as follows:
• Investors hold diversified portfolios: This assumption means that
investors will only require a return for the systematic risk of their portfolios,
since unsystematic risk has been eliminated and can be ignored.
• Single-period transaction horizon: A standardized holding period is
assumed by the CAPM in order to make comparable the returns on
different securities. A return over six months, for example, cannot be
compared to a return over 12 months. A holding period of one year is
usually used.
• Investors can borrow and lend at the risk-free rate of return:
This is an assumption made by portfolio theory from which the CAPM
was developed, and provides a minimum level of return required by
investors.
• Perfect capital market: This assumption means that all securities are Assets Pricing
valued correctly and prices reflect all information.
• Homogeneous expectations: All investors analyse securities in the
same way and share the same economic view of the world. The result is
identical estimates of the probability distribution of future cash flows
from investing in the available securities NOTES
• Rational Investors: All investors are rational mean-variance optimizers.
It means that at a given level of risk they want to maximize their return
and for a given level of return they want to minimize their risk.
8.2.2 Inputs for CAPM

To apply the CAPM, you need to estimate the following factors:
1 Risk free rate of return
.
2 Market risk premium
.
3 Beta
.
1. Risk free rate of return: In theory, the risk-free rate is the minimum rate of
return an investor expects for any investment with zero risk. In practice, however,
the risk-free rate does not exist because even the safest investments carry a very
small amount of risk. However, short-term government debt is a relatively safe
investment and in practice, return on these assets can be used as an acceptable
proxy for the risk-free rate of return under CAPM. The risk-free rate of return is
also not fixed, but will change with changing economic circumstances.
2. Market Risk Premium : Market risk premium is the difference between the
expected return on a market portfolio and the risk-free rate. It results of
investment in risky security rather than risk free security. The market risk premium
can be calculated as follows:
Market Risk Premium = Expected Return of the Market - Risk-Free Rate
3. Beta: Beta is an indirect measure which compares the systematic risk associated
with a company's shares with the systematic risk of the capital market as a whole.
If the beta value of a company's shares is 1, the systematic risk associated with the
shares is the same as the systematic risk of the capital market as a whole. Beta can
also be described as 'an index of responsiveness of the returns on a company's
shares compared to the returns on the market as a whole'. For example, if a share
has a beta value of 1, the return on the share will increase by 10% if the return on
the capital market as a whole increases by 10%. If a share has a beta value of 0.5,
the return on the share will increase by 5% if the return on the capital market
increases by 10%, and so on. Beta values are found by using regression analysis to
compare the returns on a share with the returns on the capital market. Beta can be
calculated as fallow:
Beta= Cov (Ri,Rm)/Variance of Rm

Assets Pricing Where:
Cov (Ri,Rm) = Covariance between individual security and market return
Ri= Individual security return
Rm= Market return
NOTES
8.2.3. Security Market Line (SML)
The security market line (SML) is the line that reflects an investment's risk versus
its return, or the return on a given investment in relation to risk. The measure of risk
used for the security market line is beta. The SML essentially graphs the results
from the capital asset pricing model (CAPM) formula. The x-axis represents the
risk (beta), and the y-axis represents the expected return.
The market risk premium is determined from the slope of the SML. The
relationship between â and required return is plotted on the securities market line
(SML) which shows expected return as a function of â . The intercept is the nominal
risk-free rate available for the market, while the slope is the market premium, E
(Rm) ?Rf. The securities market line can be regarded as representing a single-
factor model of the asset price, where beta is exposure to changes in value of the
Market. The equation of the SML is thus:
E (Ri) = Rf + â i [ E(Rm) - Rf]

Where:
E (Ri) = Return required on financial asset i
Rf = Risk-free rate of return
â i = Beta value for financial asset i
E(Rm) = Average return on the capital marke
Check Your Concept

Figure 8.1: Security Market Line (SML)
1. What is beta?
(Source, Security Market Line, available at: http://en.wikipedia.org/wiki/
2. What do mean by Security_market_line)
market risk premium?

8.2.4 Capital Market Line (CML) Assets Pricing
As discussed in the previous section, adjusting for the risk of an asset using the risk-
free rate, an investor can easily alter his risk profile. Keeping that in mind, in the
context of the capital market line (CML), the market portfolio consists of the
combination of all risky assets and the risk-free asset, using market value of the
NOTES
assets to determine the weights. The CML defined by every combination of the
risk-free asset and the market portfolio. The Mean-Variance criteria as proposed by
Henry Markowitz' did not take into account the risk-free asset.
The CML results from the combination of the market portfolio and the risk-
free asset. All points along the CML have superior risk-return profiles to any portfolio
on the efficient frontier, with the exception of the Market Portfolio, the point on the
efficient frontier to which the CML is the tangent. From a CML perspective, this
portfolio is composed entirely of the risky asset, the market, and has no holding of
the risk free asset, i.e., money is neither invested in, nor borrowed from the money
market account.
Figure 8.2 Capital Market Line (CML)
(Source: Capital market line (CML), available at: http://

financialplanningbodyofknowledge.com/wiki/Capital_market_line_(CML))
For an efficient portfolio, the relationship between risk and return is depicted by the
capital market line (CML). The equation for capital market line is as follow:
λ σi
E (Ri)=Rf +λ
Where:
E(Ri)= Expected rate of return of portfolio (i)
Rf = Risk free rate of return
λ= slope of CML
Assets Pricing σi = standard deviation of portfolio (i)
The slope of CML can be obtained as follow:
λ=E(Rm)-Rf/ σ m
Where:
NOTES
= Slope of capital market line
σm = standard deviation of market returns
8.3 The Single Index Model

The Sharpe Single-Index Model was developed by William Sharpe as a tool for
reducing the number of inputs (estimates) needed for Markowitz portfolio
optimization. The model starts with the observation that the returns on most assets
move in relation to the returns on the overall market, as measured by the "market
portfolio" (the returns on the "average asset" in the economy). In theory, the market
portfolio is a value-weighted portfolio (index) of all assets in the economy. In practice,
any of several broad-based market indices are used (e.g., the returns on the Sensex
or Nifty). The expression for the random return on asset as per Single index model
is as follow:
Ri = ai + bi Rm - ei
Ri = Return on security i
Rm = Return on Market Index
ai = Constant & return
bi = Measure of the sensitivity of the security its return on the market index
ei = error term
The Sharpe's Single Index Model is based on the following assumptions:
• All investors have homogeneous expectations.
• A uniform holding period is used in estimating risk and return for each
security.
• The price movements of a security in relation to another do not depend
primarily upon the nature of those two securities alone.
• The relation between securities occurs only through their individual
influences along with some indices of business and economic activities.
• The indices, to which the returns of each security are correlated, are
likely to be some securities' market proxy. i) has an expected value zero
(0) and a finite variance. It is not correlated with the return on market
portfolio (Rm) as well as with the error term (ei) for any other securities.

Assets Pricing
8.4 Arbitrage Pricing Theory (APT)
The APT is an approach to determining asset values based on law of one price and
no arbitrage. The Arbitrage Pricing Theory (APT) was developed primarily by
Stephen Ross. Whereas the CAPM is a single factor model, the APT is a multi
factor model. APT is a general theory of asset pricing that holds that the expected NOTES
return of a financial asset can be modelled as a linear function of various macro-
economic factors or theoretical market indices, where sensitivity to changes in each
factor is represented by a factor-specific beta coefficient. The model-derived rate
of return will then be used to price the asset correctly - the asset price should equal
the expected end of period price discounted at the rate implied by the model. If the
price diverges, arbitrage should bring it back into line. More formally, it is based
upon the assumption that there are a few major macro-economic factors that influence
security returns. These factors can be:
• Chances in the level of industrial production in the industry (IIP)
• Change in the shape of yield curve
• Change in the default risk premium
• Change in the inflation rate
• Change in the real interest rate
• Level of personal consumption
• Level of money supply in the economy
The theory (APT) claims that investors will "price" these factors precisely
because they are sources of risk that can't be diversified. That is, they will demand
compensation in terms of expected return for holding securities exposed to these
risks. Just like the CAPM, this exposure is measured by a factor beta. The APT
which was developed by Ross in 1976 holds that there are four factors which explain
risk and risk premium relationship of a security.
Assumption of Arbitrage Price Theory (APT)

The assumptions necessary for Arbitrage Pricing Theory (APT) are:
• All securities have a finite expected values and variances.
• Some agents can form well diversified portfolios
• There are no taxes
• There are no transaction costs
According to APT expected return can be calculated by the following equation:
E(Ri)=Rf+λia.âia+λib âib +λic âic +λid âid

Assets Pricing Where:
E (Ri)= Expected rate of return of security (i)
λia, λib, λic, λid = Average risk premium of each of the four factors.
NOTES
â id, âid, âid, âid = Measure of the sensitivity of the particular security 'i' to each of
the four factors.
8.5 Key Terms

• Abitrage : It is practice of taking advantage of a price difference
between two or more markets with a main objective of earning risk -
free profit.
• Security market line (SML) : is the line that relects an investmen's
risk versus its return, or the return on a given investment in relation to
risk. The measure of risk used for the secirity market line is beta.
• Risk premium : Risk premium is the return in exdcess of the risk-free
rate of return that an investment is expected to yield. An asset's rsk
premium is a form of compensation for investors who tolerate the extra
risk - compared to that of a risk - free asset - in a given investment.
• Systematic Risk : The risk inherent to the entire market or an entire
market segment. Systematic risk, also known as "undiversifiable risk,''
"volatility" or "market risk," affects the overall market, not just a particular
stock or industry. This type of risk is both unpredictable and impossible
to completely avoid.
• Unsystematic Risk : Unsystematic risk, also known as "specific risk,"
"diversifiable risk" or "residual risk," is the type of uncertainty that comes
with the company or industry you invest in, Unsystematic risk can be
reduced through diversification.
• Beta : A measure of the volatility, or systematic risk, of a security or a
portfolio in comparison to the market as a whole. Beta is used in the
capital asset pricing model (CAPM), a model that calculates the expected
return of an asset based on its beta and expected market returns.
8.6 Summary
• The theory of asset pricing is concerned with explaining the price of financial
assets in in an uncertain world. Assets pricing theory tries to determine
the prices of values of claims to uncetain future payments. The aim of
these theories is to determine the fundamental value of an asset.
• The CAPM is a model for pricing an individual security or a portfolio.
The CAPM, in essence, predicts the realtionship of an assets and its
expected return. This relationshkp helps in evaluating various investments Assets Pricing
options. The CAPM assumes that investors hold fully diversified
portfolios. The measure of risk used in the CAPM, which is called 'beta',
is therefore a measure of systematic risk.
• The Sharpe Single - Index Model was developed by William Sharpe as a
NOTES
tool for reducing the number of inputs (estimates) needed for Markowitz
porfolio optimization. The model starts with the observation that the return
on most assets move in relation to the returns on the overall merket, as
measured by the market portfolio.
• The Arbitrage Pricing Theory (APT) was developed primarily by Stephen
Ross. Wherease the CAPM is a single factor model, the APT is a multi
factor model. APT is a general theory of asset pricing that holds that the
expected return of a financial asset can be modelled as a linear function
of various macro-economic factors or theoretical market indices, where
sensitivity to changes in each factor is represented by a factor - specific
beta coefficient.

1. What is capital Assets Pricing Model? Explain the underlying assumption with
its practical implication.
2. What are the inputs are required to apply CAPM.
3. What is the risk free rate? How would you measure it?
4. Suggest an appropriate measure for the market risk premium and justify it.
5. What do you mean by Capital Market Line?
6. Define the return - generating process according to the APT (Assets Pricing
Theory)
7. What is the equilibrium risk return relationship according to APT?
8. Explain the various assumptions of Sharpe Single - Index Model.
9. The following table gives an analyst's expected return on the two stocks for
particular market returns.
Market Return Aggress Stock Defensive stock

5% -5% 8%
25% 40% 18%
Calculate the following -
(a) Beta for the two stocks
(b) Expected return on each stock if the market return is equally likely to be
5% and 25%.
(c) If the risk free return is 8% what is the SML?
Assets Pricing
Books:
NOTES Publication.

3. Van Horne and Wachowicz , "Fundamentals of Financial Management", Pearson
Education

5. Khan, M.Y. and Jain, P.K., "Financial Management- Text, Problems and cases",
TMH Publication.
6. Damodaran, A., "Corporate Finance- Theory & Practice", Wiley Publication

7. Pandey, I.M, "Financial Management", Vikas Publication House Pvt. Ltd, New
Delhi.
Web resources:
1. CAPM, available at:
• h t t p : / / w w w. c h i n a a c c . c o m / u p l o a d / h t m l / 2 0 1 3 / 0 6 / 2 7 /
lixingcunce5adfc9f1024045b1c8644ade158f04.pdf
• h t t p : / / w w w. c h i n a a c c . c o m / u p l o a d / h t m l / 2 0 1 3 / 0 6 / 2 7 /
lixingcunbf36c81a62904f90a4a8790a05e26785.pdf
• http://timsimin.net/Files/Fin406/set4.pdf
2. Arbitrage pricing theory, available at:
• http://viking.som.yale.edu/will/finman540/classnotes/class6.html
3. Numerical Exercise, available at:
• https://sites.google.com/site/investments242/assignments/numerical-practice-
qs

Capital Budgeting
UNIT 9 : CAPITAL BUDGETING DECISION- I Decision - I
Structure
9.1 Unit Objectives
9.2 Meaning of Capital Budgeting
9.3 Importance of Capital Budgeting
9.4 Capital Investment Projects
9.5 Estimation and Evaluation of Cash Flows
9.6 Capital Budgeting Decision Techniques
9.7 Key Terms
9.8 Summary
9.0 Introduction
A logical prerequisite to the analysis of investment opportunities is the creation of
investment opportunities. In order to remain profitable, a firm must continually evaluate
possible investments. Any investment decision depends upon the decision rule that is
applied under circumstances. Investment decisions regarding long-lived assets such
as machinery, technology and other fixed assets are a part of the on-going capital
budgeting process. All ideas about what projects to invest in are generated through
facts gathered at lower management levels, where they are evaluated and screened.
The suggested investments that pass this first level filter up through successive
management levels toward top management or the board of directors, who make
the decisions about which one will get how much capital.
The process of capital budgeting is vital to any responsible, well managed
business. If that business is public and owned by public shareholders, the budgeting
process becomes more crucial, since shareholders can hold management accountable
for accepting unprofitable projects that can have the negative effect on shareholder
value. This unit explains the concept of capital budgeting, types of investment projects,
various methods of evaluating capital budgeting along with their merits and demerits.
9.1 Unit Objectives

This unit is intended to provide:
• An understanding of the importance of capital budgeting in marketing Corporate Finance : 109
decision making
Capital Budgeting • An explanation of the different types of investment project
Decision - I
• An introduction to the economic evaluation of investment proposals
• The importance of the concept and calculation of net present value and
internal rate of return in decision making
• The advantages and disadvantages of the payback method as a technique
NOTES
for initial screening of two or more competing projects.
9.2 Meaning of Capital Budgeting

Capital budgeting (or investment appraisal) is the planning process used to determine
whether an organization's long term investments such as new machinery, replacement
machinery, new plants, new products, and research development projects are worth
pursuing.
Capital budgeting is concerned with planning significant outlays that have
long-run implications, such as acquiring new equipment and the introduction of new
products. Most companies have many more potential projects than can actually be
funded. Hence, managers must carefully select those projects that promise the greatest
future return. The ability of the managers' makes capital budgeting decisions a critical
factor in the long run profitability and survival of the company.
Capital budgeting decision may be defined as the "firm's decision to invest
its current fund more efficiently in the long term assets in anticipation of an expected
flow of benefits over a series of years"(Bhat 2012). The long-term assets are those
that affect the firm's operations beyond the one year period. The firm's investment
decisions would generally include expansion, acquisition, modernisation and
replacement of the long-term asset. Thus, it may be pointed out that capital budgeting
decisions affect the firm's value in long run. The value will increase if the investments
are profitable and add to the shareholders' wealth. Thus, the capital budgeting is a
measurable way for organizations to determine the long-term economic and financial
profitability of any investment project.
9.3 Importance of Capital Budgeting

Capital budgeting is an important because it creates accountability and measurability.
Any business that seeks to invest its resources in a project, without understanding
the risks and returns involved, would be held as irresponsible by its owners or
shareholders. Businesses (aside from non-profits) exist to earn profits. Capital
budgeting is also vital to a business because it creates of the following reasons:
1. Develop and formulate long-term strategic goals - Capital budgeting

involves investment in funds that have long term implications on the firm's
future. Capital budgeting helps in developing and formulating long term strategic
goals. The ability to appraise/value investment projects via capital budgeting
creates a framework for businesses to plan out future long-term direction.
2. Seek out new investment projects - knowing how to evaluate investment Capital Budgeting
Decision - I
projects gives a business the model to seek and evaluate new projects, an
important function for all businesses as they seek to compete and profit in their
industry.
3. Estimate and forecast future cash flows - future cash flows are what create
NOTES
value for businesses overtime. Capital budgeting enables executives to take a
potential project and estimate its future cash flows (both inflows and outflows),
which then helps determine if such a project should be accepted.
4. Facilitate the transfer of information - from the time that a project starts in
form of an idea to the time it is accepted or rejected, numerous decisions have
to be made at various levels of authority. The capital budgeting process facilitates
the transfer of information to the appropriate decision makers within a company
to enable better decision making.
5. Monitoring and Control of Expenditures - Capital budgeting identifies the

necessary expenditures required for an investment project. Since a good project
can turn bad if expenditures aren't carefully controlled or monitored, this step
is a crucial benefit of the capital budgeting process.
6. Help in creating decision rule - when a capital budgeting process is in

place, a company is then able to create a set of decision rules that can categorize
which projects are acceptable and which projects are unacceptable. The result
is a more efficiently run business that is better equipped to quickly ascertain
whether or not to proceed further with a project or shut it down early in the
process, thereby saving a company.
9.4 Capital Investment Projects

In a competitive market, analysing different types of capital investment projects and
investing in the most profitable projects is very important for the survival and growth
of a company. Research and Development department along with usually a committee
composed of finance, marketing, technology and other executives are responsible
for generating new ideas to improve the company and the products and services Check Your Concept
offered by the company. In practice, all well-managed firms go to great lengths to 1. What do you mean by
develop good capital budgeting proposals that provide value to the firm and the capital budgeting?
economy at large. Capital budgeting projects can be categorised in various categories.
2. Define Project?
A brief description is given as below:
3. What is the importance
9.4.1 New products or new markets of capital budgeting?
A new capital investment project is important for the growth and expansion of a 4. Explain how capital
company. It is also important for the economy at large as it means research and budgeting affect form
value?
development that in turn will generate new technologies, products, services in the
economy. This type of project is one that is either for expansion into a new product
line or into a new product market. For example, if Reliance Industries decided to
Capital Budgeting invest a new venture say in Bio-technology industry, it will be categorised under
Decision - I
new product or new market.
9.4.2 Expansion of existing products or markets

The expansion of existing products or target markets means an expansion of the
NOTES business. If a company undertakes this kind of capital budgeting product, they are
effectively acknowledging a surge in growth of demand. A pharmaceutical company
that is concentrating its activities in one country and now decide to enter into a
foreign market is an example of example of expansion decision.
9.4.3 Replacement project necessary to continue operations

as usual
An example of a replacement project necessary to continue operations as usual
would be, in a manufacturing plant, replacing a worn out piece of equipment with a
new piece of the same equipment designed to do the same job. This is a simple
capital budgeting project to evaluate. It would be possible to use one of these simpler
capital budgeting methods to evaluate this project and abide by the decision of the
capital budgeting method.
9.4.4 Replacement projects

These are projects where the firm must either: replace worn out equipment or invest
in new equipment that is expected to lower current production costs and/or increase
current sales. Sometimes, businesses need to replace some projects with others in
order to reduce costs and to compete in the market. An example would be replacing
a piece of obsolete equipment with a more modern piece of equipment that is easier
to have serviced.
9.5 Estimation and Evaluation of Cash Flow
The capital expenditure decisions are evaluated in terms of their cash flows. Cash
flows indicate both cash outflows and cash inflows. It is necessary to estimate the
cash flow in the process of analysing investment proposal. While analysing the cash
flow, it is also necessary to estimate the cash outflow as well as cash inflow. The
estimation of future cash flows for a project is one of the most important steps in
capital budgeting. If future cash flows are not determined and estimated correctly,
then the profitability of project proposal(s) cannot be estimated correctly. Cash flow
need to be adjusted for various non- cash adjustments like depreciation and taxes.
9.5.1 Cash flows versus Accounting Income

Before discussing the cash flows, one should understand the basic difference between
Corporate Finance : 112 cash flows income and accounting income. Sometime, net income is mistaken for
cash flow. While the two items are related they are not the same, especially if you Capital Budgeting
use the accrual method of accounting or have depreciation and/or amortization Decision - I
expenses.
In accounting, net income is the sum total of all the company's revenues
after expenses, depreciation and interest. It includes income from both cash and
non-cash transactions. For example, the payment from a customer who purchases a NOTES
product or service from the company on credit will add to that company's net income
but may not add to its cash flow. Similarly, the company deducts losses to depreciation
(the decline in an asset's value over time) from its net income, but does not lose cash
in this transaction. The cash flow statement is used to reconcile the difference
between the company's reported net income and the actual amount of money that
was received in cash. When computing the cash flow, the company adds back non-
cash losses such as depreciation, capital losses, and increases in debt and decreases
in accounts receivable - money owed to the company. Cash may also come into the
company from investments or capital financing activities, and these too must be
accounted for on the cash flow statement.
9.5.2 Estimation of Net Cash Flows

At this point we have understood that in capital budgeting decisions, the importance
and preference is given to the cash flows rather than to the accounting incomes.
The estimation of the net cash flow in an investment project should cover the following
procedures:
9.5.2.1 Determination of net Investment or Net Cash outlay or Initial

cash outlay (Step 1)
The first step in capital budgeting is determination of initial investment or start-up
costs that constitutes net cash outflows at present cost. It refers to the sum of all
cash outflows and cash inflows occurring at zero time periods. Net investment
refers to the amount of which will be required for the acquisition of fixed assets
(including freight cost, installation charges and custom duty etc.)
Further, in case of replacement decision, the determination of net investment
is different than investment of new proposal. The following factors also have an
effect on the determination of net investment of a replacement proposal.
(1) Salvage Value

Salvage value means the value which is estimated to be realized on account
of the sales of assets at the end of its useful life. To calculate the amount
of depreciation, it is deducted from the cost of assets. Salvage value is
also known as residual value. Salvage value can be divided as follows:
(a) Book Salvage value: Remaining value of the fixed assets after charging
depreciation is known as book salvage value. It is determined as
follows:
Capital Budgeting Book Salvage Value = Cost of assets - Accumulated depreciation
Decision - I
(b) Cash Salvage Value: Actual sales value of remaining assets is known
as cash salvage value. The book salvage value may be equal or more
or less than cash salvage value. The existing asset's cash salvage
value effect the net investment when an asset is replaced.
NOTES
(2) Tax Adjustment
When cash and book salvage value of asset is differentiate in this situation
we have to adjust the tax. Cash salvage value effects on an estimation of
initial cash outlay.
Case- (1) if book salvage value is equal to cash salvage value: If existing
assets are sold at their book value there is no tax adjustment because tax
is adjusted in profit or loss.
Case- (2) if cash salvage value is more than book salvage value but less
than original cost: When company sells fixed assets more than book salvage
value less than original cost this more value is known as normal gain. In
normal gain company has to pay tax.
Example 9.1
The book value of an asset which was purchased at Rs 5, 00,000 five year
ago today is Rs. 2, 50,000 and cash salvage value today is Rs. 3, 00,000. In
this case, the profit will be Rs 50,000, which is known as normal gain. If
there is the provision of 40% normal tax Rs. 20,000 (40% of Rs. 50,000)
must be paid as tax. If the company desired to purchase the new assets of
Rs 5, 00,000, the net investment can be determined as follows:
Purchase price of new assets.................................... - 5, 00,000

Cash salvage value of old assets................................ + 3, 00,000
Taxes paid@40%..................................................... - 20,000
Net investment ……………………………………. - 2, 20,000
Note: (-) indicate cash outflows and (+) indicates cash inflows in above
calculation
Case (3) if cash salvage value is more than book salvage value as well as
original value: The difference between cash salvage value and original
value of assets is known as capital gain and different between original
value and book value is known as normal gain. It should be cleared as
follows:
Normal gain = Original value - Book salvage value
Corporate Finance : 114 Capital gain = Cash salvage value - Original value
Both, Normal and Capital gain have to pay tax but capital gain tax may be Capital Budgeting
Decision - I
low than normal gain tax.
Example: 9.2
Considering the followings:
NOTES
Original value of assets = Rs 3, 00,000,
Book salvage value of assets = Rs 2, 00,000
Cash salvage value of assets = Rs 3, 30,000
Thus,
Capital gain = Cash salvage value - Original value = 3, 30,000 - 3, 00,000
= Rs 30,000/-
Normal gain = Original value - Book salvage value = 3, 00,000 - 2, 00,000
= Rs 1, 00,000/-
Let us assume capital gain tax rate 25% and normal tax rate is 40% in that case
tax paid will be:
Normal tax (40% of 1, 00,000) = Rs 40,000
Capital gain tax (25% of Rs 30,000) = Rs 7,500
If company desired to purchase the new assets of Rs 5, 00,000, the new
investment can be determined as follows:
Purchase price of new assets ................... = -5, 00,000
Cash salvage value of old assets.............. = + 3, 30,000
Tax paid on capital gain............................. = -7,500
Tax paid on normal gain.......................... = -40,000
Net investment........................................ = -2, 17,500
Case (4) if cash salvage value is less than book salvage value: If company sells
fixed assets less than book salvage value, company suffer from loss. In
this situation, it can save tax. In other words, when company faces loss,
the tax needs not to be paid. As a result, the taxable amount comes to be
surplus at a certain percentage.
Example: 9.3
Considering the following:

Book salvage value of assets = Rs 3,00,000
Cash salvage value of assets = Rs 2,50,000
Loss on Sale off Asset = 300,000- 250,000 = Rs 50,000
Computation of Tax saving:
Let tax rate = 40%
Tax saving = 40% of Rs 50,000 = Rs 20,000.
Capital Budgeting If the company desired to purchase the new assets of Rs 5,00,000, the new
Decision - I
investment can be determined as follows:
Purchase price of new assets ............... = - 5,00,000
Cash salvage value of old assets.......... = + 2,50,000
NOTES Tax saving on loss on sale of assets........ = + 20,000
New investment..................................... = -2,30,000
(3) Working Capital

Working capital may be defined as the funds required by a business for
supporting day to day business activities. Working capital may increase in case
of new proposal. The increase in working capital increases cash outflows.
Sometime, working capital may decrease and the decrease in working capital
increases cash inflows. In other words, reduction in working capital refers to
the return of investment, therefore equal to cash inflows from a project.
Increase in working capital = cash outflow (-)
Decrease in working capital = cash inflow (+)
(4) Investment Tax Credit

In order to encourage investment by industry, sometime government may
provide facilities of tax credit (by providing tax holidays and creating special
economic zone). It reduces initial cash outlay. There are many methods of
determining the investment tax credit allowance, however, following method is
considered more appropriate:
Investment tax credit = Original cost of assets x ITC rate/100
Where, ITC = Investment tax credit.
On the basis of the above discussed points, the net cash outlay of the
replacement proposal can be estimated. To estimate the net cash outlay or net
investment the following table can be used:
Table 9.1: Estimation of Net Cash Outlay
Particulars Amount
Purchasing price of new assets (-) XXX
Transportation and installation cost (-) XXX
Increase or decrease in working capital (+/-) XXX
Cash salvage value of existing assets (+) XXX
Tax adjustments (outstanding or saving) (+/-) XXX
Investment Tax credit (+) XXX
Corporate Finance : 116 Net cash outlay (-) XXX
Note : (-) indicate cash outflows and (+) indicates cash inflows in above calculation
9.5.2.2 Determination of Annual Net Cash Inflows or Cash Inflows Capital Budgeting
Decision - I
after Tax (Step 2)
In this step, net cash inflow is determined during the life of the project. It is called
net cash inflows or cash flows after tax. It is determined on the basis of accounting
for cash flow concept. To determine the net cash inflow, interest amount is not
NOTES
included. To determine net cash flow following table is taken:
Table 9.2: Estimation of Net Cash Outlay
Particulars New Machine Old Machine
Annual sales (Revenue) XXX XXX
Less: Cash expenses XXX XXX
Earnings before depreciation and tax XXX XXX
Less: Annual depreciation (D) XXX XXX
Earnings before tax(EBT) XXX XXX
Less: Tax XXX XXX
Earnings after tax (EAT) XXX XXX
Add back depreciation XXX XXX
Net cash flow or cash flow after tax XXX XXX
(CFAT)
There is an alternative way of calculating differential Cash Flows after Taxes (CFAT):
Table 9.3: Alternative Method of estimation of Net Cash Outlay
Particulars Amount
Annual increase in sales XXX
Less: increase in cash expenses or XXX
Add: decrease in cash expenses XXX
Differential cash flows before taxes XXX Check Your Concept
Less: differential depreciation XXX 5. Explain different type

of capital investment
Differential net income before taxes XXX
project?
Less: Tax XXX 6. Different between
Differential net income after taxes XXX accounting income and
cash flow?
Add back differential depreciation XXX
7. How does one estimate
Annual differential CFAT XXX the cash flows?
8. What factors does one
need to keep in mind
9.5.2.3 Determination of net cash inflows for the final year/Terminal while assessing the
value cash flow estimation?
In any project, final year net cash flow may be different due to working capital and Corporate Finance : 117
salvage value of assets. If working capital is invested in initial stage, it needs to be
Capital Budgeting added back in the final year's net cash inflow. It is called release of working capital.
Decision - I
If working capital is reduced in beginning period, add in net cash outflow and deduct
from the final year's net cash inflow. Similarly, final year net cash inflows are affected
by salvage value of assets. If salvage value of assets is not given, cash flow after
taxes (CFAT) is affected only by working capital. The tax is adjusted on profit or
NOTES loss on sales of assets. To determine the final year's CFAT, following table can be
used:
Table 9.4: Calculation of Terminal Cash flows For New Proposal
Annual cash flow XXX

Add: cash salvage value of project XXX
Less: tax paid on profit on sale of assets XXX
Add: tax save on loss on sale of assets XXX
Add: working capital increases XXX
Less: working capital decreases XXX
Net cash inflow for final year XXX
Table 9.5: Differential Cash Flows for Replacement Proposal
Particulars New machine Old machine

Annual cash flow after tax XXX XXX
Add: cash salvage of machine XXX XXX
Less: Tax paid (XXX) (XXX)
Add: Tax save XXX XXX
Add: working capital increase XXX XXX
Less: working capital decrease (XXX) (XXX)
Net cash inflow for the final year XXX XXX
9.6 Capital Budgeting Decision Techniques

After determination of relevant cash flows, the next step in capital budgeting is to
analyse them to assess whether a project is acceptable or not. A number of techniques
are available for performing such analyses. These capital budgeting techniques are
divided into two groups (a) Non-discounting Cash Flows techniques (NCDF) and
(b) Discounting Cash Flows (DCF). Non-discounting cash flow techniques do not
adjust the various cash flows for their respective time value. In such evaluation
techniques, we assume that there exists no opportunity to reinvest the money
generated by the project proposals. There are mainly two types of methods under Capital Budgeting
Decision - I
this head- the payback period (PB) method and the accounting rate of return (ARR)
method.
On the other hand, discounting cash flows techniques discount the future
expected cash flows by the relevant discount factor to arrive at its present value.
NOTES
We can say under DCF techniques, the expected future cash flows are adjusted for
the time value of money to get a clear picture of the real benefits arising from the
project. There are mainly five types of methods under this head namely; net present
value method (NPV), internal rate of return method (IRR), profitability index method
(PI), discounted payback period method (DBP) and terminal value method (TV). A
brief description of all these methods is given below.
9.6.1 Non-discounting Cash Flow Techniques (NDCF)
9.6.1.1 Payback Period (PB) Method

The Payback period are commonly used to evaluate proposed investments. It is
defined as "the amount of time required by the firm to recover its initial investment
in a project, as calculated from cash flows". In case of annuity, the payback period
can be found by dividing the initial investment by annual cash inflow. For mixed
stream of cash inflows, the yearly cash inflows must be accumulated until the initial
investment is recovered.
The basic concept behind the payback method (PB) is that one must get the
recovery of one's investment at the earliest. The earlier the company gets its money
out of the project; the lower is the risk involved. In case the investment recovery
arise late then uncertainty and unpredictability regarding future increases. The payback
(PB) of any project can be computed by using following formula:-
..... Eq. 9.1
Where:
ACF = Constant Annual Inflow from project
Sometime if cash inflows are uneven during the life of project, we need to calculate
the cumulative net cash flow for each period and then use the following formula for
payback period:
Payback Period (PB) = .... Eq. 9.2
Where:
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Capital Budgeting Decision Rule
Decision - I
The PB can be used as a decision criterion to select investment proposal. In order to
arrive at a decision rule using PB criteria, firms compare the project's payback with
a predetermined standard payback. The predetermined standard payback is decided
by the management. The following acceptance rule is applied
NOTES
• If the PB is less than the standard payback period, accept the project.
• If the PB is greater than the standard payback period, reject the project.
• If the PB is equal to the standard payback period, may or may not
accept the project.
Example 9.4
A project involves a total initial expenditure of Rs. 2, 10, 000 and the project is
estimated to generate future cash inflow of Rs. 20,000, Rs 28,000, Rs 38,000, Rs
32,000, Rs 25,000, Rs 45,000, Rs 40,000, Rs 42,000, Rs 26,000 and Rs 22,000 in its
final year. Calculate the payback period of this project.
Solution
Years Cash inflows Cumulative cash inflows
1 20,000 20,000
2 28,000 48,000
3 38,000 86,000
4 32,000 118,000
5 25,000 143,000
6 45,000 188,000
7 40,000 228,000
8 42,000 270,000
9 26,000 296,000
10 22,000 318,000
So after 6 years, Rs 188,000 are recovered. Payback period lies between the sixth
and seventh year. We can calculate the pay back of the project using equation 9.2.
That is:
PB = 6 = 6.55 years
9.6.1.2 Accounting Rate of Return (ARR) Method

The accounting rate of return is also known as average rate of return of return on
capital employed. The ARR is the ratio of the average after tax profit divided by the
average investment. There are a number of alternative methods for calculating
ARR. The most common method of computing ARR is using the following formula:
Average Accounting Profit Capital Budgeting
ARR = × 100 Decision - I
Average Investment ........ Eq. 9.3
Initial Investment +Salvage value ........ Eq. 9.4

Average Investment =
2 NOTES
The average profits after taxes are determined by adding up the PAT for each year
and dividing the result by the number of years. Similarly, average investment is
calculated taking into consideration initial investment and salvage value.
Decision Rule
The ARR method is based on accounting information and in order to select or reject
any project using ARR method, the ARR of any project is compared with the rate of
return established by management. In other words, accept or reject criterion, under
this method is as follow
• Accept all those projects whose ARR is higher than the minimum rate
established the management.
• Reject those projects which have ARR less than minimum rate
established by management.
• May accept or reject those projects which have ARR is equal to minimum
rate established by management.
This method would rank a project number one if it has highest ARR and
lowest rank would be assigned to the project with lowest ARR.
Example: 9.5
A project requires an initial investment of Rs. 10, 00,000 with a useful life of 5 years.
The plant & machinery required under the project will have a scrap value of Rs.
80,000 at the end of its useful life of 5 years. The profits after tax and depreciation
are estimated to be as follows:
Year 1 2 3 4 5
Annual Profit After 50,000 75,000 125,000 130,000 80,000
tax (Rs)
You are required to calculate the ARR of the project.
Solution:
ARR =

Capital Budgeting
Decision - I Average profit after tax = = Rs. 92,000
Average investment =
NOTES
ARR = 17.04 %
9.6.2 Discounting Cash Flow Techniques (DCF)
9.6.2.1 Net Present Value (NPV) Method

The net present value is one of the discounted cash flow or time-adjusted technique.
It recognizes that cash flow streams at different time period differs in value and can
be computed only when they are expressed in terms of common denominator i.e.
present value.
The NPV is the difference between the present value of future cash inflows
and the present value of the initial outlay, discounted at the firm's cost of capital. The
procedure for determining the present values consists of two stages. The first stage
involves determination of an appropriate discount rate. With the discount rate so
selected, the cash flow streams are converted into present values in the second
stage.
Calculation of Net Present Value (NPV)
The important steps for calculating NPV are given below:
1. Cash flows of the investment project should be forecasted based on realistic
assumptions. These cash flows are the incremental cash inflows after taxes
and are inclusive of depreciation (CFAT) which is assumed to be received at
the end of each year. CFAT should take into account salvage value and working
capital released at the end.
2. Appropriate discount rate should be identified to discount the forecasted cash
flows. The appropriate discount rate is the firm's opportunity cost of capital
which is equal to the required rate of return expected by investors on investments
of equivalent risk.
3. The Present value (PV) of cash flows should be calculated using opportunity
cost of capital as the discount rate.
4. The NPV should be found out by subtracting present value of cash outflows
from present value of cash inflows. The project should be accepted if NPV is
positive (i.e. NPV >0). The NPV can be calculated with the help of equation:-
NPV = Present Value of Cash Inflows - Initial investment

Capital Budgeting
Decision - I
....... Eq. 9.5
NPV = C0 ......... Eq. 9.6 NOTES
Where,
CI = cash flows at time t
C0 = Initial investment
K = cost of capital
PVIF = present value interest factor
Decision Rule
The present value (PV) method can be used as an accept-reject criterion. The
present value of the future cash streams or inflows would be compared with present
value of outlays. The present value outlays are the same as the initial investment.
• If the NPV is greater than zero, accept the project.
• If the NPV is less than zero, reject the project.
Symbolically, accept-reject criterion can be shown as below:
PV > Co Accept [NPV > 0]
PV < Co Reject [NPV < 0]
Where, PV is present value of inflows and C is the outlays. This method can be
used to select between mutually exclusive projects also. Using NPV the project
with the highest positive NPV would be ranked first and that project would be
selected. The market value of the firm's share would increase if projects with positive
NPVs are accepted.
Example: 9.6
XYZ Company needs a machine for its manufacturing process. The cost of the new
machine is Rs 80,700. The expected useful life of the machine is 8 years. At the end
of 8-year period, the machine would have no salvage value. After installation, the
machine would increase cash inflows by Rs 30,000 per year. XYZ is interested to
know the net present value of the machine to accept or reject this investment. The
minimum required rate of return of the company is 16% on all capital investments.
Compute net present value of the machine.

Capital Budgeting Solution:
Decision - I
Net present value computation
Years Amount of 16% Factor present
Cash flows value of
NOTES Cash flows
Annual cash
inflow 1-8 Rs 30,000 4.344 Rs 130,320
Initial cost of
the machine 0 year Rs (80,700) 1.000 Rs (80,700)
Net present
value (NPV) Rs 49,620
Example: 9.7
Suhana Trading Company has obtained a license to introduce a new product for 6
years. The product would be purchased from manufacturing company for Rs 10 per
unit and sold to customers for Rs 20 per unit. The estimated annual cash expenses
to sell the new product would be Rs 18,000. Other information associated with the
new product is given below:
Cost of equipment needed Rs 30,000

Working capital needed Rs 40,000
Repairs and maintenance of equipment in 5 years Rs 2,000
Residual value of equipment in 6 years Rs 5,000
The working capital would be released at the end of 6-year period. The
expected annual sales are 5,000 units per year. The discount rate of the company is
16%. Compute Net Present value of the new product. Would you recommend its
addition?
Solution:
Sales Revenue (5,000 units × Rs 20) = Rs 100,000
Cost of goods sold (5,000 units × Rs 10) = Rs (50,000)
Expenses = Rs (18,000)
Net annual Cash Inflows = Rs 32,000

Item Years Amount of PV @ 16% Present value Capital Budgeting
Decision - I
cash flow of cash flow
Cost of equipment 0 Rs 30,000 1.000 Rs (30,000)
Working capital
requirement 0 Rs 40,000 1.000 Rs (40,000)
Repair of equipment 5 Rs 2,500 0.476 Rs (1,190) NOTES
Annual cash inflow
from sale of new
product 1-6 Rs 32,000 3.685 Rs 117,920
Residual value of the
equipment 6 Rs 5,000 0401 Rs 2,050
Release of working
capital 6 Rs 40,000 0.410 Rs 16,400
Net Present Value Rs 65,180
9.6.2.2 Internal Rate of Return (IRR) Method

This technique is also known as yield on investment, marginal productivity of capital,
marginal efficiency of capital, rate of return, and time-adjusted rate of return and so
on. It also considers the time value of money by discounting the cash flow streams,
like NPV technique. While computing the required rate of return and to find out the
present value of cash flows is not considered. But the IRR depends entirely on the
initial outlay and the cash proceeds of the projects which are being evaluated for
acceptance or rejection. It is, therefore, appropriately referred to as internal rate of
return. The IRR is usually the rate of return that a project earns.
The internal rate of return (IRR) is the discount rate that equates the NPV
of an investment opportunity with Rs.0 (because the present value of cash inflows
equals the initial investment). It is the compound annual rate of return that the firm
will earn if it invests in the project and receives the given cash inflows. Mathematically,
IRR can be determined by solving following equation for r:
CIt
CIt = Cash Flows at time t

Co = Cash outflow
Where,
IRR = r = required rate of return or discount rate
Calculation of IRR
When any project generates equal cash flows every year, we can calculate IRR as
follows:

Capital Budgeting Example 9.8
Decision - I
An investment requires an initial investment of Rs. 6,000. The annual cash flow is
estimated at Rs. 2000 for next 5 years. Calculate the IRR.
Solution
NOTES
Using 9.6 equation:
NPV = (Rs.6, 000) +Rs.2, 000 (PVAIF5,r) = 0
Rs. 6,000 = 2,000 (PVAIF5,r)
PPVAIF5,r = 3
The rate which gives a PVAIF of 3 for 5 years is the project's IRR approximately.
While referring PVAIF table across the 5 years row, we find it approximately under
20% (2.991) column. Thus 20% (approximately) is the project's IRR which equates
the present value of the initial cash outlay (Rs. 6000) with the constant annual cash
flows (Rs. 2000 p.a.) for 5 years.
When any project generates uneven cash flows: The IRR can be found out by trial
and error. If the calculated present value of the expected cash inflow is lower than
the present value of cash outflows a lower rate should be tried and vice versa. This
process can be repeated unless the NPV becomes zero.
For example, A project costs Rs. 32,000 and is expected to generate cash
inflow of Rs. 16,000, Rs.14,000 and Rs. 12,000 at the end of each year for next 3
years. Calculate IRR. Let us take first trial by taking 10% discount rate randomly. A
positive NPV at 10% indicates that the project's true rate of return is higher than
10%. So another trial is taken randomly at 18%. At 18% NPV is negative. So the
project's IRR is between 10% and 18%.
Decision Rule
To evaluate a project using IRR method, manager compare the IRR of any project
with the required rate of capital as decided by the management. The required rate
of return is also known as cost of capital, cut-off rate or hurdle rate. When IRR is
used to make accept-reject decisions, the decision criteria are as follows:
• If the project IRR is greater than project cost of capital, accept the
project. (r >k)
• If the project IRR is less than project cost of capital, reject the project.
(r<k)
• If the IRR is equal to project cost of capital, may or may not accept the
project (r=k)
Example: 9.9
A machine can reduce annual cost by Rs 40,000. The cost of the machine is Rs 2,
23,000 and the useful life is 15 years with zero residual value. Compute internal rate
of return of the machine.
Solution: Capital Budgeting
Decision - I
Internal rate of return factor = Investment required or cash outflows/ Net
annual cash inflows
= Rs 223,000/ Rs 40,000
= 5.575 NOTES
Now refer the internal rate of return factor (5.575) in 15 year of the present
value of an annuity if Rs 1 table. After finding this factor, see the corresponding
interest rate written at the top of the column. It is observed to be 16%. Therefore,
internal rate of return is 16%.
9.6.2.3 Profitability Index (PI) Method

Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach.
This approach measures the present value of returns per rupee invested. It is observed
in shortcoming of NPV that, being an absolute measure, it is not a reliable method to
evaluate projects requiring different initial investments. The PI method provides
solution to this kind of problem. PI method is a relative measure and can be defined
as the ratio which is obtained by dividing the present value of future cash inflows by
the present value of cash outlays.
PI = ............ Eq. 9.8
Decision Rule
Using the PI method
• Accept the project when PI>1
• Reject the project when PI<1
• May or may not accept when PI=1, the firm is indifferent to the project.
Example: 9.10
ABC ltd. has an initial cash outlay of Rs 1,00,000 and it can generate cash inflows of
Rs 42,000, Rs 30,000, Rs 45,000 and Rs 21,000 in years 1 through 4. Assume a 10%
rate of discount and calculate the PI for the project.
Solution
PV of Cash Inflow
Year Cash inflows PV @ 10% Present value of cash inflow
1 42,000 0.909 38,178
2 30,000 0.826 24,780
3 45,000 0.751 30,040
4 21,000 0.683 14,343 Corporate Finance : 127
Capital Budgeting Total present value of cash inflows = Rs 1,07,341
Decision - I
PI = = 1.073
Since PI of the project is greater than 1, so project should be accepted.

NOTES
9.6.2.4 Discounted Payback Period (DPB) Method
The Discount pay back (DPB) method is almost the same as payback method. The
only difference between simple payback and discounted payback is that the cash
flows involved in a project are discounted back to the present value term. The cash
flows are then directly compared to the original investment in order to identify the
period taken to payback the original investment in present values terms.
Example: 9.11
Minotab Manufacturing Company uses discounted payback period to evaluate
investments in capital assets. The company expects the following annual cash flows
from an investment of Rs 35,00,000.
Year Cash flow Year Cash flow
0 Rs. (30,50,000) 4 Rs 9,00,000
1 Rs. 9,00,000 5 Rs 9,00,000
2 Rs. 9,00,000 6 Rs 9,00,000
3 Rs 9,00,000 7 Rs 9,00,000
No salvage value (residual value) is expected. The company's cost of capital is

12%. You are required to compute discounted payback period of the investment.
Check Your Concept
9. What is discount Solution
Rate?
In order to compute the discounted payback period, we need to compute the present
10. How discount rate is
different from value of each cash flow.
opportunity cost of Year Cash inflows PV @ 12% Present value Cumulative
capital?
of cash flows Cash flow
11. What is the payback
period? Explain its 1 9,00,000 0.893 8,03,700 8,03,700
decision rule.
2 9,00,000 0.797 7,17,300 15,21,000
12. Define ARR.
13. Discuss merits of 3 9,00,000 0.712 6,40,800 21,61,800
ARR Method over
4 9,00,000 0.636 5,72,400 27,34,200
Payback Method?
5 9,00,000 0.567 5,10,300 32,44,500
6 9,00,000 0.507 4,56,300 37,00,800

7 9,00,000 0.452 4,06,800 41,07,600
Capital Budgeting
Discounted payback period = 5 + = 5.56 year Decision - I
9.10 Key Terms

• Accounting Rate of Return (ARR): The amount of profit, or return, NOTES
that an individual can expect based on an investment made. Accounting
rate of return divides the average profit by the initial investment in order
to get the ratio or return that can be expected.
• Annuity: series of equal periodic payments or receipts. Examples of an
annuity are semi-annual interest receipts from a bond investment and
cash dividends from a preferred stock.
• Budget: estimate of revenue and expenditure for a specified period.
• Capital Budget: (1) The amount of money set aside for the purchase
of fixed assets (e.g., equipment, buildings, etc.). Also, (2) a request for
authorization to purchase new fixed assets.
• Cash flow: cash receipts minus cash disbursements from a given
operation or asset for a given period. Cash flow and cash inflow are
often used interchangeably. In capital budgeting, monetary value of the
expected benefits and costs of a project.
• Discounted cash flow: value of future expected cash receipts and
expenditures at a common date, which is calculated using Net or Internal
Rate of Return.
• Discounted payback: A capital budgeting method that generates
decision rules and associated metrics that choose projects based on how
quickly they return their initial investment plus interest.
• Future Value: The value of an asset or cash at a specified date in the
future that is equivalent in value to a specified sum today.
• Initial Investment: The present value of all cash outflows associated
with the project. More generally, we think of this as the total cost of the
project.
• Internal Rate of Return (IRR): A capital budgeting method that
generates decision rules and associated metrics for choosing projects
based on implicit expected geometric average of a project's rate of return.
• Modified IRR: A capital budgeting technique method that converts a
project's cash flows using a more consistent reinvestment rate prior to
applying the IRR decision rule.
• Net Present Value (NPV): A capital budgeting technique that generates
a decision rules and associated metrics for choosing projects based on
the total discounted value of their cash flows.
• NPV profile: A graph of a project's NPV as a function of the cost of
capital. Corporate Finance : 129
Capital Budgeting • Payback: A capital budgeting method that generates decision rules and
Decision - I
associated metrics for choosing projects based on how quickly they return
their investment.
• Present value: The current worth of a future sum of money or stream
of cash flows given a specified rate of return. Future cash flows are
NOTES discounted at the discount rate, and the higher the discount rate, the
lower the present value of the future cash flows.
• Salvage Value: The estimated value that an asset will realize upon its
sale at the end of its useful life. The value is used in accounting to
determine depreciation amounts and in the tax system to determine
deductions.
9.11 Summary
• Capital budgeting decision may be defined as the firm's decision to invest
its current fund more efficiently in the long term assets in anticipation of
an expected flow of benefits over a series of years. The long-term assets
are those that affect the firm's operations beyond the one year period.
• Capital budgeting is important because it creates accountability and
measurability. The decision of whether to accept or reject an investment
project as part of a company's growth initiatives, involves determining
the investment rate of return that such a project will generate.
• The capital expenditure decisions are evaluated in terms of their cash
flows. Cash flow indicates a cash outflow and cash inflows. It is necessary
to estimate the cash flow in the process of analysing investment proposal.
• When computing the cash flow, the company adds back non-cash losses
such as depreciation, capital losses, and increases in debt and decreases
in accounts receivable - money owed to the company.
• The various techniques used for capital budgeting decisions are divided
into two broad groups: Non-discounting cash flow techniques (NCDF)
and Discounting cash flow techniques (DCF) (time-adjusted techniques).
• Non-discounting cash flow techniques do not adjust the various cash
flows for their respective time value. In such evaluation techniques, we
assume that there exists no opportunity to reinvest the money generated
by the project proposals. There are mainly two type of methods under
this head- the payback period (PB) method and the accounting rate of
return (ARR) method.
• Discounting cash flow techniques discount the future expected cash
flows by the relevant discount factor to arrive at its present value. There
are mainly five type of methods under this head - net present value
method (NPV), internal rate of return method (IRR), profitability index
method (PI), discounted payback period method (DBP) and terminal
value method (TV).
• The payback period is the amount of time required by the firm to recover Capital Budgeting
Decision - I
its initial investment in a project, as calculated from cash flows.
• The accounting rate of return is also known as average rate of return of
return on capital employed. The ARR is the ratio of the average after
tax profit divided by the average investment.
NOTES
• The NPV is the difference between the present value of future cash
inflows and the present value of the initial outlay, discounted at the firm's
cost of capital.
• The internal rate of return (IRR) is the discount rate that equates the
NPV of an investment opportunity with Rs.0 (because the present value
of cash inflows equals the initial investment). It is the compound annual
rate of return that the firm will earn if it invests in the project and receives
the given cash inflows
9.12 Questions and Excercise

1. "The decision to start your own firm can be thought of as a capital budgeting
decision. You only go ahead if projected returns look attractive on financial
basis". Discuss this statement in the light of concept of capital budgeting.
2. Explain capital budgeting and its importance.
3. Discuss the 'Accounting Rate of Return'. What are the merits and demerits
of 'Accounting Rate of Return' in the context of capital budgeting.
4. Differentiate between accounting income and cash flows.
5. How do you calculate net present value (NPV) of a project? Explain with a
suitable example.
6. What do you mean by payback period? Differentiate between payback and
discounted payback period.
7. Explain Internal Rate of Return (IRR) method in brief. Distinguish between
Net Present Value method and Internal Rate of Return method of ranking of
projects.
8. Explain with example the term 'Profitability Index'.
9. Below are the cash flows for two mutually exclusive projects.
Year CFX CFY
0 (5,000) (5,000)
1 2,085 0
2 2,085 0
3 2,085 0
4 2,085 9,677
Capital Budgeting a. Calculate the payback for both projects.
Decision - I
b. Initially, the cost of capital is uncertain, so construct NPV profiles for
the two projects (on the same graph) to assist in the analysis. The profiles
cross at what cost of capital? What is the significance of that?
NOTES c. It is now determined that the cost of capital for both projects is 14%.
Which project should be selected? Why?
10. Cash flows for two mutually exclusive projects are shown below:
Year CFM (Rs in millions) CFN(Rs in millions )

0 (100) (100)
1 10 70
2 60 50
3 80 20
Both projects have a cost of capital of 10%.

(a) Calculate the payback for both projects.
(b) Calculate the NPV for both projects.
(c) Calculate the IRR for both projects.
11. A machine has a cost of Rs 180 millions. It will have a life of 3 years,
and will be depreciated straight line to zero salvage value. It will result in
sales revenue of Rs 200 million per year and cash operating costs of Rs
110 million per year. Use of the machine will require an increase in
working capital of Rs70million for the 3 years, beginning at year 0. The
appropriate discount rate is 8% and the firm's tax rate is 40%.
(a) Calculate the initial cash flow at time 0.
(b) Calculate the annual operating cash flows (they are identical each year).
(c) Calculate the relevant terminal cash flows at the end of year 3.
(d) What is the NPV for the machine?
12. XYZ Manufacturing is considering two projects, A & B, with cash flows
as shown below:
Period CFA (Rs.) CFB (Rs.)
0 -50,000 -100,000
1 20,000 50,000
2 10,000 30,000
3 20,000 25,000
4 30,000 30,000
The opportunity cost of capital for A is 14 percent. The opportunity cost of Capital Budgeting
Decision - I
capital for B is 10 percent.
a. Calculate the NPV for each project.
b. Calculate the IRR for each project.
c. Which project(s) should be accepted in each of the following situation NOTES
I. The projects are mutually exclusive and there is no capital constraint.
II. 'The projects are independent and there is no capital constraint.
Books:
Publication.
3. Van Horne and Wachowicz , "Fundamentals of Financial Management", Pearson
Education
5. Khan, M.Y. and Jain, P.K., "Financial Management- Text, Problems and cases",
TMH Publication.
7. Pandey, I.M, "Financial Management", Vikas Publication House Pvt. Ltd, New
Delhi
8. Kapial, Seeba "Financial Management", Pearson Education.
Web resources:
1 "Introduction and meaning of capital budgeting" available at http://
.
www.investopedia.com/university/capital-budgeting/
2 "Meaning and importance of capital budgeting" available at https://
.
www.boundless.com/finance/capital-budgeting/
.
3 "Cash flow estimation" available at http://accountlearning.blogspot.in/2011/
07/procedures-of-cash-flows-estimation-in.html
4 "Capital investment projects" available at http://bizfinance.about.com/od/
.
Capital-Budgeting/tp/
5 "Numerical problems" available at http://www.accounting formanagement.org/
.
problem-2-cbt/
6 Singh, S, Jain, P. and Yadav, S.S (2012) "Capital budgeting decisions: evidence
.
from India, Journal of Advances in Management Research, Vol. 9 Iss: 1, pp.96
- 112
Capital Budgeting Decision - II
UNIT 10 : Capital Budgeting Decision - II
Structure
10.1 Unit Objectives
10.2 Capital Rationing
10.3 Capital budgeting under Risk and Uncertainty
10.4 Capital budgeting practices in Indian Companies
10.5 Key Terms
10.6 Summary
10.7 Questions and Exercise
10.0 Introduction
In the previous unit, we have already discussed the concept, importance and various
methods of capital budgeting. As we have learnt that capital budgeting decisions are
associated with the long term investment decisions of the firms and organisations.
Therefore, capital budgeting decisions are vital and very crucial because they affect
the firm’s value in long term. Apart from it, Capital rationing is an important concept
in capital decisions as it maximise the value of the shareholders. Generally, risk and
uncertainty are associated with all the investment decisions. An investment option
having high profitability also have high level of risk and vice versa. Thus, for the
managers it becomes very important to analyse the risk or uncertainty related to the
investment proposals. This unit explains the capital budgeting under risk or uncertainty
and how capital budgeting is done in practice in Indian companies.

This unit is intended to provide:
• Concept of capital rationing
• Importance of Risk in Capital budgeting
• An understanding of various risk evaluation techniques in capital budgeting
• Capital budgeting practices in India.
10.2 Capital Rationing

Capital rationing is a process through which a limited capital budget is allocated
between different projects in a way that maximizes the shareholder’s wealth. It is a
Capital Budgeting Decision - II method used to select a project mix in a situation when the total funds available for
investment are less than total net initial investment needed by all the projects under
consideration. It involves calculation of profitability indices for all projects and selecting
projects that yield highest combined net present value (NPV).Under such situation,
managers use a number of capital budgeting methods such as accounting rate of
NOTES return (ARR) method, net present value (NPV) method and internal rate of return
(IRR) method to allocate money to various feasible projects.
The main advantage of capital rationing is budgeting a company’s corporate
resources. When a company issues stock or borrows money, it can use these
resources for new investments. However, if the company does not expect a good
return on investments, it is wasting these resources. By capital rationing, the company
can make sure it takes on fewer projects with highest positive NPV. Further, it can
take on only projects for which the anticipated return on investment is high as
compared to others. It helps the company to efficiently allocate the funds available
for investment.
10.2.1 Types of Capital Rationing

Capital rationing is of two types :
• Soft Rationing: Soft rationing is when the firm itself limits the amount of
capital that is going to be used for investment decision in a given time period.
This could happen because of a variety of reasons:
i. The promoters may be of the opinion that if they raise too much capital
too soon, they may lose control of the firm’s operations. Rather, they
may want to raise capital slowly over a longer period of time and retain
control. Besides if the firm is constantly demonstrating a high level of
proficiency in generating returns it may get a better valuation when it
raises capital in the future.
ii. Secondly, the management may be worried that if too much debt is
raised it may exponentially increase the risk raising the opportunity cost
of capital. Most firms have written guidelines regarding the amount of
debt and capital that they plan to raise to keep their liquidity and solvency
ratios intact and these guidelines are usually adhered to.
iii. Thirdly, many managers believe that they are taking decisions under
imperfect market conditions i.e. they do not know about the opportunities
available in the future. Maybe a project with a better rate of return can
be found in the future or maybe the cost of capital may decline in the
future. Either way, the firm must conserve some capital for the
opportunities that may arise in the future. After all raising capital takes
time and this may lead to a missed opportunity.
This type of rationing is called soft because it is the firm’s internal decision. They can
change or modify it in the future if they think that it is in their best interest to do so.
• Hard Rationing : Hard rationing, on the other hand, is the limitation on capital Capital Budgeting Decision - II
that is forced by factors external to the firm. This could also be due to a variety
of reasons:
i. For instance, a young start-up firm may not be able to raise capital no
matter how lucrative their project looks on paper and how high the
NOTES
projected returns may be.
ii. Even medium sized companies are dependent on banks and institutional
investors for their capital as many of them are not listed on the stock
exchange or do not have enough credibility to sell debt to the common
people.
iii. Lastly, large sized companies may face restrictions by existing investors
such as banks who place an upper limit on the amount of debt that can
be issued before they make a loan. Such covenants are laid down to
ensure that the company does not borrow excessively increasing risk
and jeopardizing the investments of old lenders.
So, hard rationing arises because of market imperfections and because of limitations
created by external parties.
10.2.2 Process of Capital Rationing

An effective capital rationing usually consists of the following three steps
Step 1
In the first step of capital rationing, the alternative projects are screened using payback
period and accounting rate of return methods. The Management sets maximum
desired payback period or minimum required accounting rate of return for all
competing alternative projects. The payback period or accounting rate of return of
various alternatives is then computed and compared to the management’s desired
payback period and accounting rate of return.
Step 2
In this step, the projects that pass the test in step 1 are further analysed using net
present value and internal rate of return methods to know whether money should be
allocated in such projects or not.
Step 3
The projects which left after the screening of step 2 are ranked using a predetermined
criteria and compared with the available funds. Finally, the projects are selected for
funding.The projects that remain unfunded may be reconsidered on the availability
of funds.

10.3 Capital Budgeting Under Risk & Uncertainity
10.3.1 Measures of project risk

In investment appraisal, managers are concerned with evaluating the riskiness of a
NOTES
project’s future cash flows. In other words, they evaluate the chance that the cash
flows will differ from expected cash flows, NPV will be negative or the IRR will be
less than the cost of capital. In the context of risk assessment, the decision-maker
does not know exactly what the outcome will be but it is possible to assign probability
weights to the various potential outcomes. There are various statistical measures
available for the evaluation of risk associated with a project’s possible outcome such
as range, standard deviation ( ), coefficient of variation (CV).
10.3.1.1 Range
Range in statistical term, means the difference between the two extreme outcomes
of the probability distribution. It is simply the difference between the highest and
lowest score in the sample. In capital budgeting range means the difference between
the best and the worst outcomes of a given project as shown below in equation 10.1:
Range = Best outcome possible – Worst outcome possible ....Eq. 10.1
The larger is the range, higher is the risk inherent in the project large range denotes
that the outcome of the project will fall under two extreme values; means high
variations in outcomes and vice- versa.
10.3.1.2 Standard Deviation

Standard deviation is an absolute measure of risk analysis and it can be used when
Check Your Concept projects under consideration are having same cash outlay. Statically, standard deviation
1. Explain capital rationing.
is the square root of variance and variance measures the deviation of expected
Why should companies
undertake capital cash flow. The formula for calcuating standard deviation is as follows :
rationing?
2. What are the reasons for 2 2 2
σx== P
σ σi1 (Cf1 - Cf) + Pi2 (Cf2 - Cf) + Pin (Cfn - Cf)
capital rationing?
3. How to select a project n
σx = Pn (Cfn - Cf)2
under capital rationing? i=1
...Eq. 10.2
where - σ = Standard diviation
CF = Cash Flow
CF = Average of Cash Flow Capital Budgeting Decision - II
P = Probability (o) occurrence of cash flow
Standard deviation is the square root of the mean of the squared deviation, where
deviation is the difference between an outcome and the expected mean value of all
outcomes and the weights to the square of each deviation is provided by its probability NOTES
of occurrence. Higher the value of the standard deviation for the given project
higher is the variation in the actual and the projected figure and, thus, higher is the
risk involved in the investment.
Example: 10.1
Calculate the standard deviation from the data given in table 10.1 and 10.2 below:
Table 10.1 Standard deviation of project X
CF CF (CFi - CF) (CFi - CF)2 Pi (CFi - CF)2 P i
4,000 6,000 -2,000 4000000 0.1 400000
5,000 6,000 -2,000 1000000 0.2 200000
6,000 6,000 0 0 0.4 0
7,000 6,000 1,000 1000000 0.2 200000
8,000 6,000 2,000 4000000 0.1 400000
1200000 1095
n
i=1
= 1200000 = 1095
Table 10.2 Standard deviation of project Y
CF CF (CFi - CF) (CFi - CF)2 Pi (CFi - CF)2 P i
12,000 8,000 4,000 16000000 0.1 1600000

10,000 8,000 2,000 4000000 0.15 600000
8,000 8,000 0 0 0.5 0
6,000 8,000 -2,000 4000000 0.15 600000
4,000 8,000 -4000 16000000 0.1 1600000
4400000 2098
n
i=1
4400000 = 2098
In the above example, Project Y is riskier as standard deviation of project Y is higher
than the standard deviation of project X. However, the project Y has higher expected
value also so the decision-maker is in a dilemma for selecting project X or project Y. Corporate Finance : 139
Capital Budgeting Decision - II But, ultimately, the selection of the project will depend upon the risk preference of
the decision maker.
10.3.1.3 Coefficient of Variation

If the projects to be compared involve different outlays/different expected value,
NOTES the coefficient of variation is the correct choice, being a relative measure. It can be
calculated using following formula:
CV = ..............................Eq. 10.3
Example: 10.2
Based on the data given in example 10.1, calculate the coefficient of variation of
project X and Y.
Solution
For project X = CVx = = 0.1825
For project Y = CVy = = 0.2623`

The higher the coefficient of variation, riskier the project. Project Y is having higher
coefficient so it is riskier than the project X. It is a better measure of the uncertainty
of cash flows returns than the standard deviation because it adjusts for the size of
the cash flows.
10.3.2 Conventional Techniques for Risk Analysis in Capital

Budgeting
There are various methodsto quantify risk in capital budgeting. These include
Payback, Risk-adjusted Discount Rate, and Certainty Equivalent approach.
10.3.2.1 Payback Period

As discussed above, payback is most commonly used method of project evolution.
Payback as a method of risk analysis is useful in allowing for a specific types of risk
only, i.e., the risk that a project will go exactly as planned for a certain period will
then suddenly stop generating returns, the risk that the forecasts of cash flows will
go wrong due to lower sales, higher cost etc.
10.3.2.2 Risk Adjusted Discount Rate Method (RADR)

In order to allow risk component in project, manager must incorporate risk premium
over and above risk free rate. The risk premium is incorporated into the capital
budgeting analysis through the discount rate. To allow for the riskiness of the future
cash flows a risk premium rate may be added to risk free discount rate. Such a
composite discount would account for both time preference and risk preference.
Corporate Finance : 140 The adjusted discount rate method can be expressed as follow ;
n Capital Budgeting Decision - II
NPV = ENCFt ........Eq. 10.4
- C0
t=1 (1+krt)
RADR = Risk free rate + Risk Premium
NOTES
Where,
ENCFt = the expected cash flow after tax
krt = risk adjusted discount rate = Risk free rate + Risk Premium
C0 = Initial cash outflows
Decision Rule
The risk adjusted approach can be used for both NPV & IRR.
• If NPV method is used for evaluation, the NPV would be calculated using risk
adjusted rate. If NPV is positive, the proposal would qualify for acceptance, if
it is negative, the proposal would be rejected.
• In case of IRR, the IRR would be compared with the risk adjusted required
rate of return. If the ‘r’ exceeds risk adjusted rate, the proposal would be
accepted, otherwise not.
Example: 10.3
An investment project has following cash flows:
Cash outflows = Rs 1,50,000
ENCFt year 1 = Rs 50,000
ENCFt year 2 = Rs 40,000
ENCFt year 3= Rs 45,000
Its risk free rate is 6% and Risk adjusted rate is 10%. Determine the NPV of
project using the RADR method.
Solution Check Your Concept

Year ENCFt (Rs) PV @ 10% PV (Rs.) 4. Discuss range and
standard deviation.
1 50,000 0.909 45,450
5. Explain the concept of
2 40,000 0.826 33,040 certainty equivalent
approach.
3 45,000 0.751 33,795
6. What is Risk adjusted
EPV 1,12,285 discount rate (RADR) ?
How it is different from
Less: Only Investment 1,50,000
normal discount rate?
NPV (37,715)

Capital Budgeting Decision - II 10.3.2.3 Certainty Equivalent Approach
This approach overcome the weakness of the risk adjusted discount rate (RADR)
approach. Under this approach, riskiness of project is taken into consideration by
adjusting the expected cash flows and not discount rate. This method eliminates the
problem arising out of the inclusion of risk premium in the discounting process.The
NOTES
certainty equivalent coefficient (á) can be determined as a relationship between the
certain cash flows and the uncertain cash flows. The calculation of certainty
equivalent approach (CEA) involves two step:
Step 1
Estimating the certainty equivalent coefficient (±) – it represents the relationship
between the certain cash flows and the uncertain cash flows. This can be determined
by using following Eq. 10.5
CE factor (αt) = ................ Eq. 10.5
Example: 10.4
A company is considering investment in machine. By investing in Machine Company
expect a risky cash flows of Rs. 80,000 and a risk free cash flows of Rs. 65,000.
You are required to calculate certainty equivalent coefficient of investment in machine.
Solution : Certainty Equivalent Factor can be calculated or
CE factor (α
α t) =
Step 2
Determining the present value of future cash flows: After determining
thecertainty equivalent factor, we need to determine the present value of the expected
cash flows with the help of the discount rate. The discount rate is the normal risk
free rate, which reflects the time value of money. It is used in determining the net
present value of future cash flows to evaluate investment proposals :
NPV =
α1 (CF1) α2 (CF2) α3 (CF3)
+ n
(CFn) α
+ 2
+ 3
- C0
(1+krf) (1+krf) (1+krf) (1+krf)n
n
αt(CF )
t
. Eq. 10.6
-C t 0
t=1 (1+krt)

Where, Capital Budgeting Decision - II
αt = certainty equivalent factor in time period, t.

CFt = annual expected cash flow in time period, t
C0 = initial investment
n = expected life of the project NOTES
krf = risk free interest rate
Example: 10.5
A project is costing Rs. 100000 and it has following estimated cash Flows and
certainty equivalent coefficients. If the risk free discount rate is 5%. Calculate
NPV of the project.
Year Cash Flows CEF

1 70,000 0.6
2 40,000 0.7
3 60,000 0.8
Solution
Year NCF (Rs.) CE Coefficient Adjusted PV @ 5% PV (Rs)
NCF
(Rs.)
1 70,000 0.6 42,000 0.952 39,984

2 40,000 0.7 28,000 0.907 25,396
3 60,000 0.8 48,000 0.864 41,472
NPV = PV - initial investmet

= 106852 - 100000
= 6852
Decision Rule
Following decision criteria is applied for selection/rejection of the project:-
• If NPV method is used, the proposal would be accepted if NPV of CE cash
flows is positive, otherwise it is rejected.
• If IRR is used, the Internal Rate of Return which equates the present value of
CE cash inflows with the present value of the cash outflows, would be
Capital Budgeting Decision - II compared with risk free discount rate. If IRR is greater than the risk free
rate, the investment project would be accepted otherwise it would be rejected.
10.3.3 Other Risk Evaluation Techniques in Capital Budgeting

We have studied some techniques which are used to quantify the risk inherent in any
NOTES project. There are many other techniques used by managers to analyse risk inherent
in a project. These include, Sensitivity Analysis, Scenario Analysis, Simulation Analysis,
and Decision Tree Approach. These techniques help in handling and making control
over the risk component of the given projects.
10.3.3.1 Sensitivity Analysis

Sensitivity analysis is a procedure used to determine the sensitivity of the outcomes
of an alternative to changes in its parameters.While evaluating any capital budgeting
project, there is a need to forecast cash flows.The forecasting of cash flows depends
on sales forecast and costs. The Sales revenue is a function of sales volume and unit
selling price. Sales volume will depend on the market size and the firm’s market
share. The NPV and IRR of a project are determined by analysing the after-tax
cash flows arrived at by combining various variables of project cash flows, project
life and discount rate. The behaviour of all these variables are very much uncertain.
The sensitivity analysis helps in identifying how sensitive are the various estimated
variables of the project. It shows how sensitive is a project’s NPV or IRR for a
given change in particular variables.The more sensitive the NPV, the more critical is
the variables.
Steps in calculation of sensitivity analysis
The following three steps are involved in the calculation of sensitivity analysis.
1. Identify the variables which can influence the project’s NPV or IRR.
2. Define the underlying relationship between the variables.
3. Analyse the impact of the change in each of the variables on the project’s
NPV or IRR.
Example: 10.6
XYZ Ltd. has two mutually exclusive projects for process improvement. The
management has developed following estimates of the annual cash flows for each
project having a life of fifteen years and 12% discount rate.
Table 10.3 Sensitivity Analysis of Mutually Exclusive projects
Project A
Net Investment (Rs) 90,000
CFAT estimates: PVAIF12%, 15 years PV NPV
Pessimistic 10,000 6.811 68110 (21890)
Most likely 15,000 6.811 102165 12165

Corporate Finance : 144 Optimistic 21,000 6.811 143031 53031
Project B

NOTES
CFAT estimates: PVAIF12%, 15 years PV NPV
Pessimistic 13,500 6.811 91948.5 1948.5
Most likely 15,000 6.811 102165 12165
Optimistic 18,000 6.811 122598 32598
The NPV calculations of both the projects suggest that the projects are equally
desirable on the basis of the most likely estimates of cash flows. However, the
Project A is riskier than Project B because its NPV can be negative to the extent of
Rs. 21,890 but there is no possibility of incurring any losses with project B as all the
NPVs are positive. Since both projects are mutually exclusive, the actual selection
of the projects depends on decision maker’s attitude towards the risk. The manager
will select Project A (if manager is risk taker) or Project B(if he is risk averse).
10.3.3.2 Scenario Analysis

In sensitivity analysis, typically one variable is varied at a time. If variables are
interrelated, as they are most likely to be, it is helpful to look at some plausible
scenarios, each scenario representing a consistent combination of variables.The
steps involved in scenario analysis are as follows:
1. Select the factor around which scenarios will be built. The factor chosen
must be the largest source of uncertainty for the success of the project.
It may be the state of the economy or interest rate or technological
development or response of the market.
2. Estimate the values of each of the variables in investment analysis
(investment outlay, revenues, costs, project life, and so on) for each
scenario.
3. Calculate the net present value and/or internal rate of return under each
scenario.
Example: 10.7
A company is evaluating a project for introducing a new product. Depending on the
response of the market - the factor which is the largest source of uncertainty for the
success of the project - the management of the firm has identified three scenarios:
• Scenario 1: The product will have a moderate appeal to customers across
the board at a modest price.
• Scenario 2: The product will strongly appeal to a large segment of the
market which is highly price-sensitive.
Capital Budgeting Decision - II • Scenario 3: The product will appeal to a small segment of the market which
will be willing to pay a high price.
The table10.4 shows the net present value calculation for the project for the three
scenarios
NOTES Table: 10.4 - Scenario Analysis

NPV Calculation for Three Scenario
(Rs in millions)
Scenario 1 Scenario 2 Scenario 3
Initial investment 400 400 400
Unit selling price (Rs) 50 30 80
Demand (Units) 40 80 20
Sales Revenue 2,000 2,400 1,600

VC (Rs 12/- pu) 960 1,920 480
Fixed costs 100 100 100
Depreciation 40 40 40
Pre-tax profit 900 340 980
Tax @ 35% 315 119 343
PAT 585 221 637
Net cash flows (PAT + 625 261 677
Depreciation)
Project life 20 years 20 years 20 years
NPV @ 20% (Rs) 3043.487 1270.96 3296.70548
Best and Worst Case analysis using scenario analysis

In the above example, an attempt is made to develop scenarios in which the values
of variables were internally consistent. For example, high selling price and low
demand typically go hand in hand. Firms often do another kind of scenario analysis
are considered: Best case and worst case analysis. In this kind of analysis the
following scenarios are considered:
• Best scenario: High demand, high selling price, low variable cost, and
so on.
• Normal scenario: Average demand, average selling price, average
variable cost, and so on.
• Worst Scenario: Low demand, low selling price, high variable cost,
and so on.
The objective of such scenario analysis is to get a feel of what happens under the
most favourable or the most adverse configuration of key variables, without bothering
much about the internal consistency of such configuration.
10.3.3.3. Simulation Analysis Capital Budgeting Decision - II
Sensitivity analysis and Scenario analysis are quite useful to understand the uncertainty
of the investment projects. But, both methods do not consider the interactions between
variables and also, they do not reflect on the probability of the change in variables.
The use of the computer can help to incorporate risk into capital budgeting through
a technique called Monte Carlo simulation. The term “Monte Carlo” implies that the NOTES
approach involves the use of numbers drawn randomly from probability distributions.
It is statistically based approach which makes use of random numbers and pre
assigned probabilities to simulate a project’s outcome or return. It requires a
sophisticated computing package to operate effectively. It differs from sensitivity
analysis in the sense that instead of estimating a specific value for a key variable, a
distribution of possible values for each variable is used.
The simulation model building process begins with the computer calculating
a random value simultaneously for each variable identified for the model like market
size, market growth rate, sales price, sales volume, variable costs, residual
asset values, project life etc. From this set of random values a new series of cash
flows is created and a new NPV is calculated. This process is repeated numerous
times, perhaps as many as 1000 times or even more for very large projects, allowing
a decision-maker to develop a probability distribution of project NPVs. From the
distribution model, a mean (expected) NPV will be calculated and its associated
standard deviation will be used to gauge the project’s level of risk. The distribution
of possible outcome enables the decision-maker to view a continuum of possible
outcomes rather than a single estimate.
10.3.3.4 Decision Tree Approach

Sometimes cash flow is estimated under different managerial options with the help
of decision-tree approach. A decision tree is a graphic presentation of the present
decision with future events and decisions. The sequence of events is shown in a
format that resembles the branches of a tree. Following steps are used in constructing
decision tree:
Check Your Concept
The first step in constructing a decision tree is to define a proposal. It may
7. What is the difference
be concerning either a new product or an old product entering a new market. It may
between certainty
also be an abandonment option or a continuation option, expansion option or no- equivalent and risk
expansion option, etc. adjusted discount rate
The Second step involves identifying various alternatives. For example, if a approach?
firm is launching a new product, it must chalk out the demand possibilities and on 8. Discuss the scenario
that basis it identifies different alternatives-whether to have a large factory or a analysis
medium-size or only a small plant. Each of the alternatives will have varying 9. Differentiate between
consequences on the cash flow. sensitivity analysis and
decision tree approach to
The third step is to lay out the decision tree showing the different alternatives measure the risk in capital
through different branches. And finally, the estimates of cash flow with probabilities budgeting decision.
in each branch are made. The results of the different branches are calculated that
show desirability of a particular alternative over the others. Corporate Finance : 147
10.4 Capital Budgeting Practices in Indian Companies
Business enterprises all over the globe have been undertaking various kinds of capital
investment projects. Thus, a process of capital budgeting decision making exists in
every organisation whether it is in public or private sector, big or small.The success
NOTES of capital budgeting decisions depended on numerous factors. It had to be viewed
within the broad framework of its structure and setting rather than with a focus on
the technical apparatus involved (Kolb, 1968; Klammer, 1973; Pike, 1986; Mukherjee
and Henderson, 1987). Various studies has been conducted to know the capital
budgeting practices all over the world. Block (2005) studied the use of capital budgeting
procedures among industries. Various researchers have observed an increasing
preference for non-discounted capital budgeting techniques (Velez and Nieto, 1986;
Gupta et al., 2011). The payback method is found to be most popular amongst the
capital budgeting techniques.
Most companies used internal rate of return (IRR) or net present value
(NPV) as either the primary or secondary method (Bierman, 1993; Cherukuri, 1996).
Graham and Harvey (2001) indicated that large firms relied heavily on present value
techniques and the capital asset pricing model; in contrast, small firms relied more
on the payback criterion. Sandahl and Sjogren (2003) showed that the public sector
companies were most frequent users of discounted cash flow (DCF) methods.
10.5 Key Terms

• Capital rationing: selecting the mix of acceptable projects that provides the
highest overall Net Present Value (NPV) when a company has a limit on the
budget for capital spending. The profitability index is used widely in ranking
projects competing for limited funds.
• Mutually Exclusive Projects:Groups or pairs of projects where you can
accept one but not all.
• Range: In arithmetic, the range of a set of data is the difference between
the largest and smallest values.
• Risk adjusted discount rate:The rate established by adding an expected
risk premium to the risk-free rate in order to determine the present value of a
risky investment.
• Risk free rate of return:The theoretical rate of return of an investment with
zero risk. The risk-free rate represents the interest an investor would expect
from an absolutely risk-free investment over a specified period of time.
• Risk premium: An extra rate of return that is earned in exchange for accepting
extra risk.
• Standard deviation: In finance, standard deviation is applied to the annual
rate of return of an investment to measure the investment’s volatility. Standard
deviation is also known as historical volatility and is used by investors as a
Corporate Finance : 148 gauge for the amount of expected volatility.
10.6 Summary
• Capital rationing is a process through which a limited capital budget is
allocated between different projects in a way that maximizes the
shareholder’s wealth.
• Risk can be defined as the chance that the actual outcome will differ NOTES
from the expected outcome. Uncertainty relates to the situation where a
range of differing outcome is possible, but it is not possible to assign
probabilities to this range of outcomes.
• Standard deviation is the square root of variance and variance measures
the deviation about expected cash flow of each of the possible cash
flows.
• Payback, Risk-adjusted Discount Rate, and Certainty Equivalent
approach are some of the conventional techniques for the risk analysis
in the capital budgeting.
• The certainty equivalent coefficient (±) can be determined as a relationship
between the certain cash flows and the uncertain cash flows.
• Sensitivity analysis is a procedure used to determine the sensitivity of
the outcomes of an alternative to changes in its parameters. While
evaluating any capital budgeting project, there is a need to forecast cash
flows.
• A decision tree is a graphic presentation of the present decision with
future events and decisions. The sequence of events is shown in a format
that resembles the branches of a tree.
10.7 Questions and Excercise

1. What is capital rationing? Explain the type of capital rationing and various
factors leading to capital rationing.
2. Discuss various techniques to measure a projects risk.
3. Distinguish between sensitivity analysis and scenario analysis with an
appropriate example.
4. Explain the decision tree approach of risk analysis in capital budgeting
and the major steps to be followed while making decision tree.
5. XYZ manufacturing is considering a project that requires initial
investment of Rs 9,600 and has a 4-year life. XYZ’s corporate
weighted average cost of capital (WACC) is 10%. The probability
distribution of annual operating cash flows (over its 4-year life) is
shown below. There are no other cash flows associated with the
project.

Capital Budgeting Decision - II Scenario probabilities Annual CF NPV @ annual CF
Worst Case 0 .3 Rs 2,500 Rs -1,675
Most Likely 0 .4 Rs 3,000 Rs -90
Best Case 0 .3 Rs 4,000 Rs 3,079
NOTES
a. Calculate the expected NPV.
b. Calculate the standard deviation of NPV.
c. Calculate the coefficient of variation (CV) of NPV.
10.8 Further Reading and References
Books:
1. Ross, Westerfield & Jaffe, “Fundamental of Corporate
Finance”, TMH Publication.
2. Brealey, Myers & Allen, “Principles of Corporate Finance”, TMH
Publication.
3. Van Horne and Wachowicz , “Fundamentals of Financial
Management”, Pearson Education
4. Chandra, Prasanna, “Financial Management”, TMH Publication.
5. Damodaran, A., “Corporate Finance- Theory & Practice”, Wiley
Publication
6. Pandey, I.M, “Financial Management”, Vikas Publication House Pvt.
Ltd, New Delhi
7. Kapial, Seeba “Financial Management”, Pearson Education
• Bierman, H. (1993), “Capital budgeting in 1992: a survey”,
Financial Management, pp. 24-24.
• Block, S. (2005),"Are there differences in capital budgeting
procedures between industries? An empirical study”, The
Engineering Economist, Vol.50 Issue 1, pp. 55-67.
• Cherukuri, U. R. (1996), "Capital budgeting practices: a
comparative study of India and select South East Asian
countries”, ASCI Journal of Management, Vol. 25 Issue 2, pp.
30-46.
• Graham, J. R. & Harvey, C. R. (2001), "The theory and practice
of corporate finance: evidence from the field", Journal of
financial economics, Vol. 60 Issue 2, pp. 187-243.
• Kolb, B. A. (1968), "Problems and pitfalls in capital
budgeting", Financial Analysts Journal, pp. 170-174.
• Mukherjee, T. K. & Henderson, G. V. (1987),"The capital
budgeting process: theory and practice”, Interfaces, Vol. 17 Issue Capital Budgeting Decision - II
2, pp. 78-90.
• Sandahl, G. & Sjögren, S. (2003), "Capital budgeting methods
among Sweden’s largest groups of companies. The state of the
art and a comparison with earlier studies”, International Journal
of Production Economics, Vol. 84 Issue 1, pp. 51-69. NOTES
• Velez, I., & Nieto, G. (1986), "Investment decision-making
practices in Colombia: A survey" Interfaces, Vol. 16 Issue 4, pp.
60-65.

The Cost of Capital
UNIT 11 : THE COST OF CAPITAL
Structure
11.2 Concept of Cost of Capital
11.3 Significance of Cost of Capital
11.4 Concept of Opportunity Cost of Capital
11.5 Cost of Debt
11.6 Cost of Preference Capital
11.7 Cost of Equity Capital
11.8 Cost of Retained Earnings
11.9 Weighted Average Cost of Capital (WACC)
11.10 Terms
11.11 Summary
11.0 Introduction
Making an investment decision is of utmost importance for an organisation. Under
investment decision process, the cost and benefit of prospective project is analysed
and the best alternatives is selected on the basis of the result of analysis. The
benchmark of computing present value and comparing the profitability of different
investment alternatives is cost of capital. The Cost of capital is the minimum required
return necessary to make a capital budgeting project, such as building a new factory,
investing in a new machine. The Cost of capital includes both the cost of debt and
the cost of equity. A company uses debt, common equity and preferred equity to
fund new projects. In the long run, companies typically adhere to target level for
each of the sources of funding. When a capital budgeting decision is being made, it
is important to keep in mind how the capital structure may be affected.
The Capital structure is a mix of a company's long-term debt, specific short-
term debt, common equity and preferred equity. The capital structure represents
how a firm finances its overall operations and growth by using different sources of
funds. Debt comes in the form of bond issues or long-term notes payable, while
equity is classified as common stock, preferred stock or retained earnings. Short-
term debt such as working capital requirements is also considered to be part of the
capital structure. Selection of sources for financing from debt and equity depends
The Cost of Capital on the cost associated with them. Each of these sources of finance has cost and can
be measured as opportunity cost of capital. The main objective of this unit is to
understand the costs associated with each of the source of finance, how to compute
the cost of each source of finance and overall cost of capital.
NOTES 11.1 Unit Objectives

• Explain the concept of cost of capital
• Understand the significance of cost of capital
• Understand the drivers of the firm's overall cost of capital
• Measure the costs of debt, preferred stock, and common stock
• Discuss the different type of preference capital and understand the
calculation of their costs
• Calculate the cost of equity and discuss the Dividend Growth Model
(DDM)
• Understand the concept of Weighted Average Cost of Capital (WACC)
• Know how to calculate of Weighted Average Cost of Capital (WACC)
11.2 Concept of Cost of Capital

The money/funds/capital is an essential factor of production. Like other factors of
productions (land, labour, raw material etc.), capital also bear a cost to the company.
Under capital expenditure decision, the cost of capital helps to understand the
profitability of long term investments and justifies their adoption by the firm by
comparing it to its cost. The cost of obtaining required funds from different sources
is termed as cost of capital for the company.
Cost of capital is defined "as the minimum rate of return that a firm must
earn on its investment so that market value per share remains unchanged". The
minimum rate of return is the compensation expected by the investors from the
company for the time and risk taken up by them. The greater the time and the risk
involved for a particular lending, the greater would be the return required by the
investors.
The return to the investor on the invested amount is the cost to the company
on the borrowed amount. Suppose the companies get their required funds at a cost
(Ko). This amount is utilized and invested by the company in the various activities
that generate a positive return (r) for the company. Now, common sense tells us that
r > Ko, i.e. the return on the invested money should be greater than the cost of
money. Thus, the concept of cost of capital helps companies in deciding what should
be the return on their investment activities. Therefore, a company should accept an
investment proposal whose rate of return is above is above its cost of capital. Cost
Corporate Finance : 154 of capital acts as a minimum benchmark return, a firm should earn enough profits to
meet its cost of capital. The cost of capital concept, thus, helps the company in The Cost of Capital
evaluating its investment decisions, designing its fund structure, deciding its managerial
decisions and appraising the financial performance of the firm. The cost of capital
also known as overall cost of capital consists of the following elements:-
• Cost of Debt, includes both Debentures, Bonds and Term loan (Kd)
NOTES
• Cost of Preference Capital (Kp)
• Cost of Equity Capital (Ke)
• Cost of Retained Earnings (Kr)
11.3 Significance of Cost of Capital

Cost of capital is very important for the management in decision making. It is
considered as a standard of comparison for making different decisions. Cost of
capital is significant for the company in the following ways:-
• Capital budgeting decision
Cost of capital is the minimum rate of return that must be earned by the company
to maintain the value of its shares. The firm, naturally, will choose the project
which gives a satisfactory return on investment which would in no case be less
than the cost of capital incurred for its financing. In various methods of capital
budgeting, cost of capital is the key factor in deciding the project out of various
proposals pending before the management. It measures the financial
performance and determines the acceptability of all investment opportunities.
• Designing the corporate financial structure

The cost of capital is significant in designing the firm's capital structure. The
cost of capital is influenced by the chances in capital structure. A manager
always keeps an eye on capital market fluctuations and tries to achieve the
sound and economical capital structure for the firm. He may try to substitute
the various methods of finance in an attempt to minimise the cost of capital so
as to increase the market price and the earning per share.
• Deciding about the method of financing
A capable financial executive must have knowledge of the fluctuations in the
capital market and should analyse the rate of interest on loans and normal
dividend rates in the market from time to time. Whenever company requires
additional finance, he may have a better choice of the source of finance which
bears the minimum cost of capital. Although cost of capital is an important
factor in such decisions, but equally important are the considerations of relating
control and of avoiding risk.
• Performance of top management
The cost of capital can be used to evaluate the financial performance of the
top executives. Evaluation of the financial performance will involve a comparison Corporate Finance : 155
The Cost of Capital of actual profitability of the projects and taken with the projected overall cost
of capital and an appraisal of the actual cost incurred in raising the required
funds.
• Formulating dividend policy
Dividend is that part of the total profit of the firm which is distributed to
NOTES
shareholders. However, the firm can retain all the profit in the business if it has
the opportunity of investing in such projects which can provide higher rate of
return in comparison of cost of capital. On the other hand, all the profit can be
distributed as a dividend in the firm has no opportunity investing the profit.
Therefore, cost of capital plays a key role formulating the dividend policy.
11.4 Concept of Opportunity Cost of Capital

There can be several alternative uses or several investment opportunities of a certain
amount of funds. Decision making is a process of selecting among various alternatives.
The opportunity cost is the rate of return foregone on the next best alternative
investment opportunity of comparable risk. For example, you may invest your savings
of Rs 10,000 either in 8.5 percent in 5 year postal certificates or in 9 percent 5 year
fixed deposits in a nationalized bank. In both the cases, the government assures the
payment; so the investment opportunity reflects equivalent risk. If you decide to
deposit your savings in the postal certificates, you have to forego the opportunity of
depositing in bank. You have, thus, incurred an opportunity cost equal to the return
on the forgone investment opportunity. It is 9 percent in case of above example.
Similarly, the cost of capital is the opportunity cost of capital used by the firm.
11.5 Cost of Debt

A company may raise debt in a variety of ways. Debt may be in the form of
debentures, bonds, term loans from financial institutions and banks etc. Debentures
and bonds are debt instruments issued by the corporations to the public or institutions
at a specified interest rate (coupon rates) for a specified period of time, creating
creditors to the company. A debenture or bond may be issued at par or at a discount
or premium as compared to its face value. Interest paid on debentures/ bonds is tax
deductible. So, form can reduce its taxable income by the amount of money it pays
Check Your Concept to the bondholders.
1. Define Cost of Capital.
The rate of interest at which debt is issued is the basis of calculating the
2. What is the importance of cost of any type of debt. The explicit cost of debt, i.e., kb is the discount rate which
cost of capital? equate the present values of cash flows to the creditors (suppliers of the debt) with
3. What is Overall cost of
the current market price of the new debt issue (before-tax cost of debt).
capital? n It + Pt
P0 = t
..............Eq. 11.1
t=1 (1 + k )
b

Where The Cost of Capital
It = interest payment in period t on the principal

Pt = principal payment in period t
Po = current market price of debt
kb = cost of debt before tax NOTES
Before-tax cost of debt (kb) can be determined by simply considering the interest
payable as follows:
kb =
While calculating the cost of debt, we use after tax cost of debt because interest
payments are tax deductible for the firm. After-tax cost of debt, which is denoted by
kd, can be determined by using following equation:
After-tax cost of debt (kd) = kb (1-tax rate) ................Eq. 11.2
It is important to note that in the calculation of average cost of capital, the
after-tax cost of capital must be used instead of before-tax cost of debt.
Example: 11.1
Star Ltd. borrows Rs. 5, 00,000 for five years at 10 per cent. The cost of debt is Rs
5,000 which is the annual interest. You are required to calculate the after tax cost of
debt if the corporate tax rate is 30 per cent.
Solution
kb = 50,000/ 5, 00,000 = 10%
After tax cost of debt, i.e., kd is calculated by adjusting before-tax cost for the tax
rate (t) applicable.
kd = kb (1-tax rate)
= 10 (1-0.3) = 7%
11.5.1 Cost of Perpetual/ Irredeemable Debt

The perpetual debt is the debt that has no maturity value. Such debts do not have
any principal repayment during the life of the company. In case of perpetual debt or
irredeemable debt, the company continuously pays interest at the given rate per
annum forever (because company is a perpetual entity). Cost of perpetual/
irredeemable debt can be calculated by Eq. 11.3
kb = or kd = ...........Eq. 11.3
Where I = Annual interest payments

NP = Net proceeds of issue of debentures, bonds, trem loans etc.
t = tax rate Corporate Finance : 157
The Cost of Capital Example 11.2
XYZ Ltd. issue irredeemable debt bearing an annual interest rate of 10 per cent.
The market price of the debt having face value of Rs 100 is Rs. 109. The current
corporate tax is 40 per cent. Determine the cost of the debt of the XYZ Ltd.
NOTES Solution
Using equation 11.3, we can calculate the cost of irredeemable debt as follow:
kd = (0.10 × (100 / 109) × 0.60)
= 5.5 %
Example 11.3
Zee Limited owns perpetual debt in its capital structure that amounts to Rs. 2,
00,000. The rate of interest on debt is 12%. Given the corporate tax rate is 40 per
cent, calculate the cost of debt capital under the following conditions: a) at par, b) 12
per cent discount, c) 10 per cent premium.
Solution
(a) Debt issued at par for Zee Ltd.
kd = =
(b) Debt issued at discount for Zee Ltd.
kd = =
(c) Debt issued at premium for Zee Ltd.
kd = =
11.5.2 Cost of redeemable debt

Redeemable debt has a maturity value, i.e., these debt are issued for a specific time
period say 10 years. Generally redeemable debt is more popular over irredeemable
debt because company prefers to repay the debt at some time in the future.
Cost of redeemable debt can be calculated by Eq. 11.4
kd= ..................Eq. 11.4

The Cost of Capital
Where,
kd = cost of debt
I = annual interest payments
Rv = redeemable value of debt at the time of maturity
Sv = sale value less discount and floating expenses NOTES
N = number of years to maturity
t = tax rate
Example 11.4
A company issues 10% Rs 100 debentures. The floatation cost is Rs 4. Tax rate is
30%. Debentures are redeemable after 5 years at a premium of Rs 3. The difference
between the redemption value and the net amount realised is to be written off during
the life time of the debentures. Find the cost of debt.
Solution
Kd = [{10 × (1 - 0.30)} + {(103 - 96)/5} × {1 - 0.30)] / (103 + 96)/2
= 0.0802 = 8.02%
11.6 Cost of Preference Capital

The cost of preference share capital is the rate of return that must be earned on
preference capital financed to keep unchanged the earnings available to the equity
shareholders. Like equity, the preference share dividend is paid after the corporate
tax has been paid. Thus, the cost of preference share is not adjusted for tax. The
cost of preference share is automatically computed on an after-tax basis. Thus, the
past-tax cost of preference dividend is higher than the post-tax cost of debt, even if
their return is same.
8.6.1 Cost of Irredeemable Preference Shares:
(a) For the existing share

Check Your Concept
The cost of irredeemable preference share is:
4. Discuss the concept of
opportunity cost of
kp = ..............Eq. 11.5 capital
5. How to calculate the cost
Where, of Debt?
kp = cost of irredeemable preference shares 6. Differentiate between
before and after-tax cost
D = preference share dividend of debt.
MP = market price of the preference share

The Cost of Capital Example 11.5
Calculate the cost of 10% preference capital of 10,000 preference shares issued by
XYZ limited. The face value of share is Rs 100 and current market price of is Rs
115.
NOTES Solution
Annual dividend = 10% of Rs 100 = Rs 10 per share
kp = 10/115 = 0.087 or 8.7%
(b) For the newly issued preference shares
The cost of irredeemable preference share is:
kp = ....................... Eq. 11.6
Where,
kp = cost of preference shares
D= dividend paid on preference shares
NP = net proceed received from issue of preference shares after deducting
the issue expenses
Example 11.6
XYZ Ltd. issues 8% irredeemable preference shares. The face value of
share is Rs 100 but t issued at Rs 105. The cost of floatation is Rs 3 per share.
Calculate the cost of preference share capital.
Solution
kp = 8 / (105- 3) = 0.0784 or 7.84%
11.6.2 Cost of Redeemable Preference Shares

The cost of redeemable preference shares is calculated as shown in Eq. 11.7
kp = .................Eq. 11.7
Check Your Concept

7. Differentiate between Where,
debt and preference kp = cost of preference shares
capital?
D = constant annual preference dividend payments
8. What is Coupon?
9. How to calculate the cost Rv = redeemable value of preference shares at the time of redemption
of preference shares? Sv = sale value of preference shares less discount and floating expenses
N = no. of years to redemption
Example 11.7 The Cost of Capital
A company has recently issued redeemable preference to be matured after 10 years.

The face value of share is Rs 100 with an annual dividend of 10%. The cost of
flotation is Rs 4 per share. You are required to calculate the cost of preference
share capital.
NOTES
Solution
Using Eq. 11.7 above, cost of preference share is:
kp = {10 + (4/10)}/ {(100 + 96)/2} = 0.1061 = 10.61%
11.7 Cost of Equity Capital

Many companies raise equity capital internally by retaining earnings. Alternatively,
they distribute the entire earnings to equity shareholders and raise equity capital
externally by issuing new shares. Money raised by issuing new equity shares need
not to repayable during the life time of the organisation. The equity shareholders are
considered to be the owners of the company. The main objective of the firm is to
maximize the wealth of the equity shareholders. The determination of the rate of
return required by equity investor is difficult to measure. The cost of equity may be
defined as the "minimum rate of return that a company must earn on the equity
share capital financed portion of an investment project so that market price of share
remains unchanged". There are various methods available for calculating the cost of
equity. These methods are discussed in the following section:-
11.7.1 Dividend Yield (DY) Method

Under this method, cost of equity capital can be defined as "the discount rate that
equates the present value of all expected future dividend per share with the net
proceeds of the sale (or the current market price) of a share." The dividend yield
method considers dividend per share and market value of shares for calculating the
cost of equity capital. This method is based on the following assumption-
1. The market value of equity shares is directly related to future dividends
on those shares.
2. The future dividend per equity share is expected to be constant means
no growth rate. But in reality, a shareholder expects the returns from his
equity investment to grow over time.
The cost of equity using dividend yield can be calculated by the following
formula
D1
ke = .....................Eq. 11.8
P0
The Cost of Capital Where,
ke = cost of equity capital
D1 = Annual dividend per share on equity capital in period 1
P0 = Current market price of equity share
NOTES
Note: In case shares are issued first time, then NP (net proceed from equity share
issue) will be used in place of P0 (Current market price of equity share).
Example 11.8
ABC limited is expected to distribute a dividend of Rs 20 on each equity share of
Rs. 10. The current market price of share is Rs 120. Calculate the cost of equity as
per dividend yield method.
Solution
Ke = Rs 20/ Rs 120 = .167 or 16.7 %
11.7.2 Dividend Growth Model

The equity shareholders normally expects dividend to grow year after year and not
to remain constant in perpetuity. In dividend growth method the future growth in
dividend is added to the current dividend yield. It is recognised that current market
price of share reflects expected future dividends. The Cost of equity share can be
calculated by the following formula
D1
ke = +g .................Eq. 11.9
Where, P0
ke = Cost of equity capital
D1 = Expected dividend per equity share
g = growth rate by which dividends are expected to grow per year at a
constant compound rate
Example 11.9 (Constant dividend growth)
The market price of BIL limited equity share is Rs 220. The expected dividend per
share is Rs 20. It is expected to grow at a constant rate of 6% p.a. You are required
to calculate the cost of equity share capital.
Solution
ke =

Example 11.10 (Variable dividend growth) The Cost of Capital
The current price of Star limited share is Rs. 250 with a face value of Rs 10. The
flotation cost per share is Rs 15.The gross dividends per share over the last three
are given below-
Year Dividend (Rs) NOTES

2009 12.0
2010 13.2
2011 14.5
Calculate the cost of equity shares for the year 2012.
Solution
Expected current year dividend = Rs. 1.45 (1 + 0.10) = Rs 16
The dividend is growing at 10% and is expected to continue to grow at this rate.
ke =
Note: In some cases, dividend growth model formula for the calculation of equity
share capital is also written as follows, if last declared dividend is known
D0 (1+g)
ke ............................... Eq.11.10
= +g
Where, P0
D0 = Recent dividend paid per equity share
g = dividend growth rate
Example 11.11
Aranav limited recently paid a dividend of Rs 2 per share. The firm's common stock
has a current market value of Rs 35 per share. It is expected that firm's annual
dividend are expected to grow 5 per cent per year. Calculate the cost of equity.
Solution
Using equation 11.10, we can calculate the cost of equity capital of Aranav limited
ke =
Where,
The Cost of Capital D0 = Recent dividend paid per equity share
g = dividend growth rate
11.7.3 Price- Earning (P/E) Method

NOTES
Price- Earning method is based on the earnings per share (EPS) and the market
price of the share (MPS). It is based on the assumption the investor capitalise the
stream of future earnings of the share and the earnings of the share need not to be
in the form of dividend and also it need to be distributed to the shareholders. Cost of
equity using PE method can be determine by the following formula
ke = ........ Eq. 11.11
Where,
ke = cost of equity capital
EPS = earnings per share
MPS = market price per share
Example 11.12
ABC Ltd. Profit after tax for the current year is Rs 2, 00,000 and the current market
value of its share is Rs 90. The firm has 10,000 shares outstanding of Rs 10 each
and has no debt. Calculate cost of equity based on PE method.
Solution
EPS = 20, MPS = 90
ke = 20/90 = 22.22-1
Where,
EPS = current earnings per share
MPS = market price per share
11.7.4 Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is the most widely used method to calculate
the cost of equity. This model divides the cost of equity in two components, the near
risk free rate of return available on investing in government securities and an additional
risk premium for investing in a particular share or investment. The model also considers
to specify the relationship between the market return and the individual equity. The
expected rate of return of an equity share can be calculated by using following equation:
Expected return = Risk free rate + Risk premium …… Eq.11.12
Thus, CAPM requires the following three parameters to estimate a firm's cost of
equity:
1. The risk-free rate (Rf) the yields on the government securities, bank The Cost of Capital
etc. by all investors.
2. The beta coefficient which expresses the market risk of the equity stock
in relation to the market.
3. The market risk premium (Rm - Rb) the market risk premium is measured
NOTES
as the difference between the long-term, historical arithmetic averages
of market return and the risk free rate.
As per the CAPM, the cost of equity can be determined as follow:-
ke = Rf + β (Rm - Rf) ............ Eq. 11.13
Where,
ke = rate of return on security or cost of equity
Rf = the risk-free rate of return
β = sensitivity of the security to market movements
(Rm - Rf) = the market risk premium
Example 11.13
The Blue line limited has common stock that has a current price of Rs 200 per share
and Rs 5 dividend. Blue line's dividends are expected to grow at a rate of 3% per
year forever. The expected risk-free rate of interest is 2.5% and the expected
market premium is 5%. The beta of Blue line's stock is 1.2.
a. What is the cost of equity for Blue line using the dividend valuation model?
b. What is the cost of equity for Blue line using the capital asset pricing model?
Solution
a. ke = + 0.03 = 0.0557 or 5.57%
b. ke = [0 .025 + (0.05) 1.2] = 8.5%
11.8 Cost of Retained Earnings

The part of profit that is not distributed to the shareholders is refereed as retained
earnings. It is one of the major sources of finance available for the established
companies to finance its expansion and diversification. The cost of retained earnings
is the required rate of return on equity. Retained earnings are the earnings left after
deducting dividend payments and other provisions from profit after tax. The cost of
retained earnings is similar to the cost of equity. Retained earnings belong
shareholders. The shareholders forgo their current income (current dividend) when
they allow the company to use the retained earnings in profitable investments.
Generally, cost of retained earnings is slightly less than the cost of equity since no
flotation cost is incurred. It is also known as internal equity as it is the amount of Corporate Finance : 165
The Cost of Capital earnings not distributed to shareholders and is retained with the firm. The cost of
retained earnings can be calculated using following formula:
kre = ke (1- f) .........................Eq.11.14
NOTES Where:
ke = cost of equity
kre = cost of retained earnings
f = floatation cost
Example 11.14
Vaibahv limited received Rs 10 lakhs of retained earnings and Rs 100 lakhs of equity
through new issue. The equity investors are expecting a desired return of 14 per
cent. The cost of issue external equity is 5 per cent. You are required to calculate:
(a) Cost of retained earnings and
(b) Cost of external equity.
Solution
(a) Cost of retained earnings (kre) = 14%
(b) Cost of external equity (ke)
ke = kre ÷ (1- f)
ke = 0.14 ÷ (1 - 0.05)
= 14.74%
Ke = 14.74%
11.9 Weighted Average Cost of Capital (WACC)

The capital that a company procures is derived from various sources. A company
has different sources of finance, namely common stock, retained earnings, preferred
stock and debt. The overall cost of capital is termed as weighted average cost of
capital. The weighted average cost of capital (WACC) is the average after tax cost
of all the sources. It is calculated by multiplying the cost of each source of finance
by the relevant weight and summing the product of cost of individual source.
11.9.1 Steps in calculation of WACC

The calculation of WACC includes the following steps:
1. Determine the cost of all individual components of capital used by the
firm like, Debt, preference share capital, equity capital, retained earnings.
2. Assign weight to each source of capital. The weight is the proportion of
each source of funds in the capital structure. This can be done by dividing
the value of the individual component of capital and by the total value of
the total capital employed. The Cost of Capital
3. Add all the weighted cost of various components of capital to arrive at

the weighted average cost of capital.
The WACC can be calculated by the following formula:
WACC = Wd (kd) + We (ke) + Wp (kp) + Wre (kre) ................Eq. 8.15 NOTES
Where,
Wd = weight of debt
kd = cost of debt
We = weight of equity
ke = cost of equity
Wp = weight of preferred stock
kp = cost of equity
Wre = weight of retained earnings

kre = cost of equity
11.9.2 Determination of Weights

There are two methods by which weights are assigned to the each source of capital
for determining the weighted average cost of capital of the firm. These are book
value method and market value method.
11.9.2.1 Book value method

Under this method weights are assigned on the basis of book value. The book value
of various type of capital used by the firm can be obtained from its financial statements
such as balance sheet. The weights determined by the book value method are based
on the accounting procedures that use the par value of the securities to calculate
balance sheet values and represent past conditions.
Example 11.15
A firm has debt in the form of 2000 bonds each of face value Rs 1000 per bond.
The book value of the bond is Rs 20, 00,000. The firm has 30,000 preferred share Check Your Concept
issued at a par value of Rs 10 each and 3,00,000 equity share issued at par value of 10.Explain different methods
Rs 10 each. Compute the cost of each source on the basis of their book value. The to calculate cost of
equity.
weights of different fund sources for a given firm.
11.What is cost of equity?
12.Define Beta.
13.What is floatation Cost

The Cost of Capital Solution
Weights Calculation on Book Value Method
Book value Amount (Rs) Weightage ( %)
Debt 2,000 debenture @ Rs. 1,000 20,00,000 37.73
NOTES
Preferred stock 30,000 shares @ 3,00,000 5.66
Rs 10 par value
Equity shares 3,00,000@ Rs.10 30,00,000 56.60
par value
Total book value of capital 53,00,000 100
11.9.2.2 Market Value Method

The market value approach is more realistic compare to book value approach. This
method is based on the market value of individual component of capital rather than
book value. One drawback of the book value method of assigning weights is that it
does not reflect the current market value of debt or equity. For the purpose of
valuation, market value weights are used by the firms.
Example 11.16
The capital structure of a company consist of 5000 debentures with a face value of
Rs 100 each issued at par. The current market price of debenture is Rs 800 The firm
also has 10,000 preferred share currently traded at Rs 200 per share and 2,00,000
equity share with current market value of Rs 190 . Using market value method,
determine the weights of each source of finance.
Solution
Weights Calculation on Market Value Method
Market value Amount (Rs) Weights
Debenture: 5,000 at current market price Rs 800 40,00,000 9.09
Preferred stock: 10,000 share at current market 20,00,000 4.5
price of Rs 200
Equity shares 2,00,000 at current market price 3,80,00,000 86.36
of Rs 190.
Total market value of capital 44,000,000 100

Example 11.17 The Cost of Capital
A firm is considering a new project which would be similar in terms of risk to its
existing projects. The firm needs a discount rate for evaluation purposes. The firm
has enough cash in hand to provide the necessary equity financing for the project.
The capital structure of the company is composed of following sources:
NOTES
a. 10,00,000 equity shares outstanding at current price 112.5 per share. The next
year's dividend expected to be Rs 10 per share and the firm estimate that
dividends will grow at 5% per year after. The flotation costs for new shares
would be Rs 2 per share.
b. 1,50,000 preferred shares current traded at price is Rs 95 per share. The
current dividend is Rs 10 per share. If new preferred shares are issued, it will
be sold at 5% less than the current market price (to ensure full subscription)
and involve direct flotation costs of Rs 2.5 per share.
a. Rs 10,00,00,000 (par value) debt in the form of bonds with 10 years left to
maturity. It pay annual coupons @ of 11.3% p.a. Currently, the bonds sell at
106% of par value. Flotation costs for new bonds would equal 6% of par
value.
The firm's tax rate is 40%. What is the appropriate discount rate for the new project?
Solution
Calculation of total market value:
Market value of debt = Rs 10,00,00,000 (1.06) = Rs 10,60,00,000

Market value of preferred stock = Rs 95 × 1,50,000 = Rs 1,42,50,000
Market value of equity share = Rs 112.5 × 10,00,000 = 11,25,00,000
Total value of firm = Rs 23,27,50,000
Check Your Concept

Calculation of cost of capital 14. How to calculate cost
of retained earnings?
Cost of Debt (kd) = 11.3 (1- 0 .4) = 6.78%
cost of equity and cost
of retained earnings.
Cost of Preferred stock (kp) = = = 11.39%
16. What is weighted
average cost of capital?
Cost of Equity share (ke) = +g= + 0.05 = 13.88% between book value
and market value
weights?
18. How to calculate
WACC?

The Cost of Capital Capital Market value Weight Cost Weighted cost
component
Debt (Bonds) Rs 1,06,00,000 45.54 % 6.78% 3.08%
Preferred Shares Rs 1,42,50,000 6.12% 11.39% 0.697 %
Equity Shares Rs 11,25,00,000 48.33% 13.88% 6.71%
NOTES
(Note: floatation costs ignored for common equity because cash on hand is
enough to finance the project.)
WACC = 3.08% + 0.697% + 6.71%
= 10.49%
11.10 Key Terms

• Average cost of capital : The average percentage cost that a company
pays for the money that it is currently using (i.e., money raised in the
past).
• Bond : A bond is a negotiable certificate that acknowledges the
indebtedness of the bond issuer or borrower (debtor) to the holder or
lender (creditor). The ownership of the certificate can be transferred.
• Book Value : Book value is an accounting term that describes the
value of an asset according to its balance sheet. For assets, the value is
based on the original cost of the asset less any depreciation or amortization.
A company's net book value is its total assets minus liabilities.
• Business risk : the risk from a project arising from the line of business
it is in, the variability of a firm's division's cash flow.
• Capital : Capital for a small business is simply money. It is the financing
for the small business or the money used to operate and buy assets.
• Capital Asset Pricing Model (CAPM) : A financial model expressing
the relationship between expected risk and expected return. Investors
demand higher returns for higher risks.
• Common stock : A unit of ownership of a corporation. In the case of a
public company, the stock is traded between investors on various
exchanges. Owners of common stock are typically entitled to vote on
the selection of directors and other important events and in some cases
receive dividends on their holdings.
• Component cost : the individual cost of each type of capital- bond,
preferred stock and common stock.
• Cost of capital : as the minimum rate of return that a firm must earn on
its investment so that market value per share remains unchanged.

The Cost of Capital
• Cost of debt : The rate of return that must be earned on the investment
of borrowed money in order to keep the common stock price unchanged.
• Cost of new common equity : The rate of return that must be earned
on the investment of money raised from the sale of new common stock
in order to keep the common stock price unchanged.
NOTES
• Cost of preferred stock : The rate of return that must be earned on
the investment of money collected from the sale of preferred stock in
order to keep the common stock price unchanged.
• Cost of retained earnings : The rate of return that must be earned on
the investment of retained earnings in order to keep the common stock
price unchanged.
• Dividend : The payments designated by the Board of Directors to be
distributed among the shares outstanding. The type of share determines
the amount. On preferred shares, it is generally a fixed amount.
• Equity : Equity is ownership of the residual claim or interest in a company,
usually in the form of stock or stock options. It is the claim on assets,
after all liabilities are paid, i.e., total assets minus total liabilities-also
called net worth or book value
• Face value : Also known as "par value" or simply "par", it is the value of
a bond, note, mortgage, or other security as given on the certificate or
instrument.
• Financial risk : The risk of a project to equity holders stemming from
the use of debt in the financial structure of the firm; refers to the issue of
how a firm decides to distribute the business risk between debt and
equity holders.
• Flotation cost : Fees paid by firms to investment bank for issuing new
securities.
• Marginal cost of capital : The average percentage cost that a company
will have to pay to raise money now (i.e., money to be raised in the
future).
• Preference share : Shares of a firm that give preferential rights over
common shares, such as the first right to dividends and any capital
payments or liquidations; the dividends are typically fixed, whereas
common stock dividends are not.
• Price/Earnings ratio : The relationship of earnings per share to current
stock price. It is used in comparing the relative attractiveness of stocks,
bonds, and money market instruments.
• Systemic risk : It is the risk that applies to the entire market and not
just one company. This type of risk has can have a chain reaction in the
economy as more and more sectors are affected.
The Cost of Capital
11.11 Summary
• A company uses debt, common equity and preferred equity to fund new projects,
typically in large sums. In the long run, companies typically adhere to target
weights for each of the sources of funding. When a capital budgeting decision
NOTES is being made, it is important to keep in mind how the capital structure may be
affected.
• Capital structure is a mix of a company's long-term debt, specific short-term
debt, common equity and preferred equity. The capital structure represents
how a firm finances its overall operations and growth by using different sources
of funds.
• Cost of capital is defined 'as the minimum rate of return that a firm must earn
on its investment so that market value per share remains unchanged'. The
minimum rate of return is the compensation expected by the investors from
the company for the time and risk taken up by them.
• The cost of capital concept helps the company in evaluating its investment
decisions, designing its fund structure, deciding its managerial decisions and
appraising the financial performance of the firm.
• The opportunity cost is the rate of return foregone on the next best alternative
investment opportunity of comparable risk.
• Debt may be in the form of debentures, bonds, term loans from financial
institutions and banks etc. A debenture or bond may be issued at par or at a
discount or premium as compare to its face value. Interest on debentures/
bonds is a deductible tax.
• Perpetual debt is the debt that has no maturity value. Such debts do not have
any principal repayment as long as the company is operating. In case of perpetual
debt or irredeemable debt, the company continuously pays interest at the given
rate per annum forever (because company is a perpetual entity).
• The cost of preference share capital is the rate of return that must be earned
on preference capital financed investments, to keep unchanged the earnings
available to the equity shareholders. Like equity, the preference share dividend
is paid after the corporate tax has been paid.
• The cost of equity may be defined as the minimum rate of return that a company
must earn on the equity share capital financed portion of an investment project
so that market price of share remain unchanged. The main objective of the
firm is to maximize the wealth of the equity shareholders.
• Cost of retained earnings is the required rate of return on equity. Retained
earnings are the earnings left after deducting dividend payments and other
provisions from profit after tax.

• The overall cost of capital is termed as weighted average cost of capital. The Cost of Capital
Weighted average cost of capital (WACC) is the average after tax cost of all
the sources. It is calculated by multiplying the cost of each source of finance
by the relevant weight and summing the products up.
11.12 Questions and Excercise NOTES
1. "Cost of capital is used by a company as a minimum benchmark for

its yield" Explain the statement with suitable examples.
2. Discuss various methods available for the calculation of cost of debt?
3. What is the significance of cost of capital?
4. "Retained earnings have no cost" Do you agree? Explain it with reason.
5. What are the different methods to calculate cost of equity?
6. What to do mean by overall cost of capital? What are different
components of overall cost of capital?
7. What do you understand by cost of preference share capital? How it is
different from cost of debt?
8. Explain the concept of opportunity cost of capital.
9. What is the difference between book value and market value while
calculating the overall cost of capital?
10. Discuss the steps for the calculating the cost of equity using capital
asset pricing model (CAPM)?
11. Sharma Corporation is planning to issue bonds with a par value of Rs
1,000 with a maturity of 28 years and an annual coupon rate of 16.0%.The
Flotation costs associated with a new debt issue would equal 9.0% of the
market value of the bonds. Currently, the appropriate discount rate for
bonds of firms similar to Sharma Corporation is 6%. The firm's marginal
tax rate is 30%. Calculate the cost of debt for this new bond issue.
12. Zee Ltd. is considering the issue of preferred stock. The preferred would
have a par value of Rs 400 with an annual dividend equal to 18.0%. The
company believes that the market value of the stock would be Rs 968.00
per share with a flotation cost of Rs 68.00 per share. The firm's marginal
tax rate is 40%. Determine the cost of preference share issue.
13. Costly Corporation is considering the use of equity financing for
investment in new project. Currently, the firm's stock is selling for Rs
47.00 per share. The firm's dividend for next year is expected to be Rs
3.40 with an annual growth rate of 5.0% thereafter indefinitely. If the
firm issues new stock, the flotation costs would equal 14.0% of the
stock's market value. The firm's marginal tax rate is 40%. What is the
firm's cost of internal equity?
The Cost of Capital 14. ABC Ltd. is considering use of equity financing. Currently, the firm's
stock is selling at Rs 50.00 per share. The firm's dividend for next year
is expected to be Rs 5.50 with an annual growth rate of 5.0% thereafter
indefinitely. If the firm issues new stock, the flotation costs would equal
15.0% of the stock's market value. The firm's marginal tax rate is 40%.
NOTES What is the firm's cost of external equity?
15. EPS (earnings per share) of Star Limited for the current year is Rs 5
and company declare dividend of Rs 2 per share. The Market price per
share is Rs 50 and it is expected growth rate is 8 per cent. Calculate
cost of retained earnings for the company.
16. The capital structure of XYZ corporation is consists of 12 per cent
debentures, 9 per cent preference shares and equity shares of Rs 100 in
ratio of 3:2:5. The company is thinking to add additional funds by raising
term loan at 14 per cent interest rate from State Bank of India (SBI).
The new ratio of above sources of fund will go down by 1/10, 1/15, 1/16,
respectively. What will be the impact on WACC of the firm if the tax
rate is 50 per cent and expected dividend of Rs 9 is given at the end of
the year and growth rate is 5 per cent.

Books:
TMH Publication.
Publication.
Publication
Ltd, New Delhi
8. Kapial, Seeba "Financial Management", Pearson Education.
Web resources:
1 "Introduction to cost of capital" available at -http://www.investopedia.com/
walkthrough/corporate-finance/5/cost-capital/cost-of-capital.aspx

Capital Structure Decision
UNIT 12 : CAPITAL STRUCTURE DECISION
Structure
12.2 Meaning of Financing Decision
12.3 Source of Long Term Finance
12.3.1 Equity Financing
12.3.2 Debt Financing
12.4 Concept of Leverage
12.4.1 Operating Leverage
12.4.2 Degree of Operating Leverage
12.4.3 Financial Leverage
12.4.4 Degree of Financial Leverage
12.4.5 Degree of Financial Leverage
12.5 Capital Structure
12.6 Determinants of Capital Structure
12.7 Capital Structure Theories
12.7.1 Relevance Theories
12.7.2 Irrelevance Theories
12.8 Key Terms
12.9 Summary
12.0 Introduction
There are two fundamental types of financial decisions that every finance manager
needs to make in a business: investment and financing. These two decisions are
related with how to spend money and how to borrow money. Every time a firm
make an investment decision, it is at the same time making a financing decision also.
An investment decision is related to spending capital on assets that will yield the
highest return for the company over a desired time period. On the other hand financing
decision deals with how the firm should raise money to undertake the desired
investment projects. It is up to the finance department to figure out the different
options and the process of financing. There are broadly two ways to finance an
investment: using a company's own money (using reserve and surplus) or by raising
money from external sources. Each has its advantages and disadvantages. There Corporate Finance : 175
Capital Structure Decision are two ways to raise money from external funders: by taking on debt or selling
equity. It is the financing decision process that determines the optimal way to finance
the investment. This unit explore the financing decisions of firm, concept of capital
structure, theories of capital structures and various factor that affect the choice of
sources of finance for a firm.
NOTES

• Understand the financing decision
• Explain the concept of leverage
• Make a distinction between operating and financial leverage
• Understand the concept of capital structure
• Explain different theories of capital structure
12.2 Meaning of Financing Decision

Every business no matter how large and complex needs finance to fund its investment
decisions. Financing decision is the second important function to be performed by
the financial manager. Decision related to raise fund comes under the category of
financing decisions. Primarily financing decisions deal with issues like:-
• How much funds are required?
• From where should the funds be arranged?
• At what cost should the funds be procured?
The money like other resources has to be procured at a cost. So, it is the
duty of financial manager to design the best financial mix to procure the funds so
that overall cost can be reduced. The funds can be raised with a mix of borrowed
money (debt) and owner's funds (equity). The central issue before financial manager
is to determine the proportion of equity and debt. The mix of debt and equity is
known as the firm's capital structure. The financial manager must strive to obtain
the best financing mix or the optimum capital structure for the firm. The firm's
capital structure is considered to be optimum when the market value of shares is
maximized. The use of debt affects the return and risk of shareholders; it may
increase the return on equity funds but it always increases risk. A proper balance
will have to be struck between return and risk. When the shareholders' return is
maximized with minimum risk, the market value per share will be maximized and the
firm's capital structure would be considered optimum. Once the financial manager
is able to determine the best combination of debt and equity next step is to raise the
appropriate amount through the best available sources.

12.3 Sources of Long Term Finance
The long term sources of finance needed over a longer period of time- generally
over a year. The reasons for needing long term finance are generally different to
those relating to short term finance. The long term finance may be needed :
NOTES
1. To finance expansion projects
2. To buy new premises in another part of the country
3. To develop a new product or technology
4. To buy another company through mergers and acquisitions
5. To modernised existing business operations
The methods of financing these types of projects will generally be quite
complex and can involve huge amount. It is important to remember that in most
cases, a firm will not use just one source of finance but a number of sources. The
debt and equity are the two major sources of financing.
12.3.1 Equity Financing

It is the most common source of funding any business requirement. The equity
financing means exchanging a portion of the ownership of the business for a financial
investment in the business. The ownership stake resulting from an equity investment
allows the investor to share in the company's profit. It involves a permanent investment
in a company. The equity funding can be of various types and designs, but most
frequently is subcategorized into either common or preferred equity. The common
equity is the oldest and frequently used method for companies to obtain equity
investments. It comes with standard distribution, liquidation, and voting privileges to
the holders. The simplest corporate structures deploy a single class of common
equity. On the other hand, preference equity is a separate class, distinct from common
equity and is known as "preferred" because it carries with it certain preferential
features compared with common equity. In virtually every case, preferred equity
will have liquidation preference over common equity (in case of the company is sold
or otherwise shut down). Oftentimes, preferred equity carries with it defined
"minimum yields or returns," which could be in the form of dividends, etc. Any
unpaid yields due on preferred equity generally have to be addressed before payments
are made to holders of common equity.
12.3.2. Debt Financing

Debt financing is another important and easily available source of financing. Generally,
debt financing involves borrowed funds from a lender at a fixed rate of interest and
with a predetermined maturity date. The principal must be paid back in full by the
maturity date, but periodic repayments of principal may be part of the loan
arrangement. In finance, debt is also referred to as "leverage." The most popular
source for debt financing is the loan or the sale of bonds, project financing from
specialized financial institutions such as IFCI, TFCI, IDBI and PFC etc. The debt
financing may be secured or unsecured. The Secured debt has collateral (a valuable Corporate Finance : 177
Capital Structure Decision asset which the lender can attach to satisfy the loan in case of default by the borrower).
Conversely, unsecured debt does not have collateral and places the lender in a less
secure position relative to repayment in case of default. Debt can be raised by either
issuing bonds or by taking up the loan.
NOTES
12.4 Leverage
A firm can used different source of financing which are differing in terms of cost.
The debt involves fixed interest while equity returns vary according to the earnings
of company. The fixes return sources have implication for those who are entitled to
a variable return. Thus the return of equity share holder is affected by the magnitude
of debt in the capital structure of the firm. Leverage, as a business term, refers to
debt or to the borrowing of funds to finance the purchase of a company's assets.
Business owners can use either debt or equity to finance or buy the company's
assets. Using debt, or leverage, increases the company's risk of bankruptcy. It also
increases the company's returns; specifically its return on equity. This is true because,
if debt financing is used rather than equity financing, then the owner's equity is not
diluted by issuing more shares of stock. There are two types of leverage operating
and financial leverage.
12.4.1 Operating Leverage

Total operating cost of and company is divided in two categories: (1) fixed costs (2)
variable cost. Operating leverage can be defined, simply, as the degree to which a
firm incurs a combination of fixed and variable costs and the firm's ability to use
fixed operating costs to magnify the effects of changes in sale on its earnings before
interest and taxes. Operating leverage can be also defined as the impact of a change
in revenue on profit or cash flow. It arises, whenever a firm can increase its revenues
without a proportionate increase in operating expenses. The degree of operating
leverage is directly proportional to a firm's level of business risk, and therefore it
serves as a proxy for business risk. The reason why operating leverage exists in a
typical firm and why there is a magnified effect on operating earnings due to change
in sales is presented in Table.12.1
Check Your Concept

1. Explain the advantages
of equity financing.
leverage?

Table: 12.1 Effect of Fixed cost on Operating Leverage Capital Structure Decision
Firm-A Firm-B
Sales 20000 22000
Fixed cost 16000 2000
Variable cost 2000 16000 NOTES
EBIT 2000 4000
FC/TC 8/9 1/9
50% increase in sales
Sales 30000 33000
Fixed cost 16000 2000
Variable cost 4000 23000
EBIT* 10000 8000
% change in EBIT 400 100
% change in EBIT= (EBIT*-EBIT)/EBIT
12.4.2. Degree of Operating Leverage

The degree of operating leverage (DOL) is defined as the percentage change in the
earnings before interest and taxes relative to a given percentage change in sales. In
effect, the DOL is an index number that measures the effect of a change in sales on
operating income, or EBIT.
DOL = Percentage change in EBIT/ Percentage change in sales

DOL= (rDEBIT/ EBIT)/ (rSales/Sales)....12.1
12.4.3 Financing Leverage

The use of the fixed-charges sources of funds such as debt and preference capital
along with the owners' equity in the capital structure is described as financial leverage
or gearing or trading on equity. The use of the term trading on equity is derived from
the fact that it is the owner's equity that it is used as a basis to raise debt; i.e. the
equity that is traded upon.
The financial leverage employed by a company is intended to earn more
return on the fixed-charge funds than their costs. The surplus or deficit will increase
or decrease the return on the owners' equity. The rate of return on the owners'
equity is leverage above or below the rate of return on total assets. For example, if
a company borrows Rs.100 at 8% interest and invests it to earn 12% return, the
balance of 4% after payment of interest belong to the shareholders, and it constitutes
the profit from financial leverage. On the other hand, if the company could earn only
a return of 6% on Rs.100, the loss to the shareholders would be Rs.2 per annum.
Thus, financial leverage at once provides the potentials of increasing the shareholders'
earnings as well as creating the risks of loss to them. It is double-edged sword that
Capital Structure Decision give both advantage and disadvantage to the company.Financial leverage has two
primary advantages:
• Enhanced earnings: Financial leverage may allow an entity to earn a
disproportionate amount on its assets.
NOTES • Favorable tax treatment: In many tax jurisdictions, interest expense is

tax deductible, which reduces its net cost to the borrower
Example 12.1 (Effect of Financial leverage on EPS)
The management of XYZ Ltd is expecting a before-tax rate of return of 24
per cent on total investment of Rs 500,000. This implies EBIT = Rs 500,000 x
0.24 = Rs 120,000. The firm is considering two alternative financial plans: (i)
either to raise the entire funds by issuing 50,000 ordinary shares at Rs 10 per
share, or (ii) to raise Rs 2, 50,000 by issuing 25,000 ordinary shares at Rs 10
per share and borrow Rs 2, 50,000 at 15 per cent rate of interest. The corporate
tax rate is 50 per cent. The effect of the alternative plans for the shareholders'
earnings is presented in Table 12.2
Table 12. 2: Effect of Financial leverage on EPS and ROE
Particulars Financial Plan

All- equity Debt-equity
(non levered) (levered firm)
Earnings before interest and taxes (EBIT) 120000 120000
Less: Interest, INT 0 37500
Profit before taxes, PBT = EBIT - INT 12000 82500
Less: Taxes, T (EBIT - INT) 60000 41250
Profit after taxes [PAT = (EBIT - INT) (1 - T)] 60000 41250
Total earnings of investors, PAT + INT 60000 78750
Number of ordinary shares, N 50000 25000
EPS = (EBIT - INT) (1 - T)/N 1.2 1.65
ROE = (EBIT - INT) (1 - T)/E 12% 16.5%
From Table 12.2, we can see that the impact of the financial leverage is
quite significant when 50 percent debt (debt of Rs 250,000 to total capital of Rs
Check Your Concept 500,000) is used to finance the investment. The firm earns Rs 1.65 per share, which
3. Explain degree of is 37.5 per cent more than Rs 1.20 per share earned with no leverage. Similarly,
operating leverage. ROE is also greater by the same percentage.
4. What is capital
structure? 12.4.4 Degree of Financing Leverage
5. What is EPS-EBIT Operating leverage affects earnings before interest and taxes (EBIT), whereas
analysis?
financial leverage affects earnings after interest and taxes, or the earnings available
to common stockholders. The degree of financial leverage (DFL) is defined as the
percentage change in earnings per share that results from a given percentage change
in earnings before interest and taxes (EBIT), and it is calculated as follows:
Percentage Change in EPS
DFL =
Percentage Change in EBIT
(r EPS/EPS) NOTES
DFL =
(rEBIT/EBIT) .............................. Eq. 12.2
The degree of financial leverage or DFL helps in calculating the comparative change
in net income caused by a change in the capital structure of business. It helps in
determining the fate of net income of the business. DFL also helps in determining
the suitable financial leverage which is to be used to achieve the business goal. The
higher the leverage of the company, the more risk it has and a business should try to
balance it as leverage is similar to having a debt.
12.4.5 Degree of Combined Leverage

The Degree of Combined Leverage (DCL) is the leverage ratio that sums up the
combined effect of the operating (DOL) and the Financial Leverage (DFL) has on
the earnings per share or EPS given a particular change in sale. This ratio helps in
ascertaining the best possible financial and operational leverage that is to be used in
any firm or business. This ratio has been known to be very useful to a company as
it helps the firm to understand the effects of combining financial and operating
leverage on the total earnings of the company. A high level of combined leverage
shows the risk involved in the company as there are more fixed costs in the company,
while a low combined leverage would mean better for the company. The formula
used for ascertaining the Degree of Combined Leverage is:
DCL = percentage change in EPS/ percentage change in Sales
DCL = % Change in EPS / %Change in Sales
DCL = DOL × DFL .............................. Eq. 12.3
Example: 12.2
From the following data under Situation I and II and Financial Plan A and B calculate
the operating leverage and financial leverage.
Installed Capacity 4,000 units
Actual Production and Sales 75% of the Capacity
Selling Price Rs. 30 Per Unit
Variable Cost Rs. 15 Per Unit
Fixed Cost: Under Situation I Rs. 15,000
Under Situation-II Rs.20,000
Capital Structure
Financial Plan A Equity:10000
Debt : 10000 @ 20% interest rate
Financial Plan B Equity:15000
Debt: 5000@ 5 % interest rate
Capital Structure Decision Solution.12.2
S.No Particulars Plan A Plan B

I II I II
A Sales 90000 90000 90000 90000
NOTES
B Less-Variable Cost 45000 45000 45000 45000
C Contribution 45000 45000 45000 45000
D Less-Fixed Cost 15000 20000 15000 20000
E EBIT 30000 25000 30000 25000
F Less-Interest 2000 2000 250 250
G EBT 28000 23000 29750 24750
Financial Leverage (F/L) 1.0714 1.0869 1.0084 1.0101
Operating Leverage (C/E) 1.5 1.8 1.5 1.8
Note: As the Tax rate is not mentioned in the question that is why EBIT/EBT is
used for calculating financial leverage.
12.5 Capital Structure

The Capital structure refers the way a corporation finances its assets by using a
combination of equity, debt, or hybrid securities. A firm's capital structure is the
composition or 'structure' of its liabilities. The essence of capital structure decision
is to determine the relative proportion of equity and debt. The equity here in broader
sense means owners' funds which can be raised by issue of equity shares and
preference shares and by retaining earnings. The debt can be raised by issuing
debentures/ bonds or by taking long-term borrowings. For example, a firm that sells
Rs. 20 billion in equity and Rs. 80 billion in debt is said to be 20% equity-financed
and 80% debt-financed. The capital structure decision is a significant financial decision
because it affects the shareholders' return and risk and, consequently, the market
value of shares. To design capital structure, finance manager should consider the
following two assumptions:
• Wealth maximization is attained.

• Best approximation to the optimal capital structure
The capital structure decision and its link on firm value can be described using figure 12.1

Firm’s decisions Dynamism of environment
Expansion Changing interest rates,

Modernization government policy and market
Purchase of plant & machinery conditions
Other long term decision
NOTES
Capital Structure Decisions
Raising additional money through

restructuring the proportion of different
sources of funds
Creates an impact on
Expansion
Modernization
Purchase of plant & machinery
Other long term decision
Optimum capital structure
Maximizes the value of the firm
Figure 12.1: Capital structure decision and firm objective
12.6 Determinants of Capital Structure

The capital structure decision is the second most crucial decision that a finance
manager has to take. The choice of proper mix of debt and equity depends on the
various factors like nature of product, earnings, stage of growth of the company and
management attitude towards control etc. The following are the main determinants
or factors affecting capital structure of a firm:
• Cost of Capital : The process of raising the funds involves some cost.
While planning the capital structure, it should be ensured that the use of
the capital should be capable of earning the revenue enough to meet the
cost of capital
• Management Control : The capital of the business enterprise is also
influenced by the intention of the promoters of having effective control.
This is also a very important factor in deciding the capital structure. In
case management doesn't want to retain control in few hands, they will
raise a large amount of money by issuing debentures and preference
shares which hardly enjoy any voting rights.
Capital Structure Decision • Legal Requirements: One has to comply with the provisions of the
law in regard to the issue of different types of securities. For example, in
order to raise money by issuing shares, company are required to meet
the various provisions of SEBI guidelines for new issue of shares and
also provisions of The Companies Act 2013.
NOTES
• Duration of Finance: Period of finance, i.e., short, medium or long
term is also another factor which determines the capital structure of a
business enterprise. For example, short-term finances are raised through
borrowings as compared to long-term finance which is raised through
issue of shares, stocks etc.
• The Purpose of Financing: The purpose of financing should also be
kept in mind in determining the type of financing. The funds may be
required either for betterment expenditure or for some productive
purposes. The betterment expenditure, being non-productive, may be
incurred out of funds raised by issue of shares or from retained profits.
On the contrary, funds for productive purposes may be raised through
borrowings.
• The Economic Conditions: While planning the capital structure, the
general economic conditions should be considered. If the economy is in
the state of depression, preference will be given to equity form of capital
as it involves less amount of risk. But sometimes it is not be possible to
raise funds by issuing equity as the investors may not be willing to take
the risk. Under such circumstances, the company may be required to go
for borrowed capital. If the capital market is in boom and the interest
rates are likely to decline in further, equity form of capital may be
considered immediately, leaving the borrowed form of capital to be tapped
in future. It may also be possible to raise more equity capital in boom as
the investors may be ready to take risk and to invest.
• Tax Policy: The corporate taxation policy of the Government has to be
viewed from the angles of corporate taxation and as well as individual
taxation. The return on borrowed capital i.e. interest is an allowable
deduction for income tax purposes while computing taxable income of
the company. On the other hand, return on equity capital i.e. dividend is
not considered like that as it is the appropriation out of the taxable profits.
As far as individual taxation is concerned, both interest as well as dividend
will be taxable in the hands of investor of the capital subject to specified
deductions available for the purposes.
•" Characteristics of Company: Characteristics of the company, in terms
of size, age and credit standing play very important role in deciding capital
structure. Very small companies and the companies in their early stages
of life have to depend more on the equity capital, as they have limited
bargaining capacity, they can't tap various sources of raising the funds Capital Structure Decision
and they do not enjoy the confidence of the investors. Similarly, the
companies having good credit standing in the market may be in the position
to get the funds from the sources of their choice. But this choice may
not be available to the companies having poor credit standing.
NOTES
• Stability of Earnings: lf the sales and earnings of the company are not
likely to be stable enough over a period of time and are likely to be
subject to wide fluctuation, the risk factor plays more important role and
the company may not be able to have more borrowed capital in its capital
structure as it carries more risk. However, if the earnings and sales of
the company are fairly constant and stable over the period of time, it
may afford to take the risk, where the cost factor or control factor may
play important role
12.7 Theories of Capital Structure

From the above discussion it is clear that a deciding on mixture of debt and equity to
finance assets is of paramount importance for the finance manager. The capital
structure theories facilitate the manager to identify the optimum capital structure.
The optimum capital structure is that at which the shareholder's value is maximum.
There are two set of approaches with reference to capital structure on the basis of
their impact on firm's value.
• Relevance theories
• Irrelevance theories
12.7.1 Relevance Theories of Capital Structure

The Relevance theories state that capital structure is important for all firms. According
to these theories capital structure influence the value of firm through influencing
cost of capital. The following are the various relevance theories of capital structure:
• Net income approach
• Traditional approach
12.7.1.1 Net Income (NI) Approach

Net Income theory also known as NI approach was introduced by David Durand.
As per this approach, the capital structure decision is relevant to the valuation of the
firm. This means that any change in the capital structure will automatically lead to
change in the overall cost of capital as well as the total value of the firm. The value
of the firm is sum of market value of debt and market value of equity. According to
NI approach, the cost of debt is considered as cheaper source of financing than
equity capital. The more and more use of debt in the capital structure lowers the
total cost of capital. The Debt is less expensive source of financing due to the fact Corporate Finance : 185
Capital Structure Decision that its interest is deductible from net profit before taxes. Thus, due to deduction of
interest as expense, a business has to pay reduced tax. Thus, the weighted average
cost of capital of a business will decrease thereby increasing the value of the firm.
The value of the firm is higher in the case of lower overall cost of capital because of
more use of leverage in the capital structure.
NOTES
Cost of Capital Ke
(WACC)
Ke
Ko
Kd
Leverage (Debt/Equity)
Figure 12.2: The effect of leverage on the cost of capital under

NI approach
Assumptions of NI approach
The Net income approach is based on the following assumptions:
1. There is only two type of finance i.e. debt and equity
2. There are no taxes
3. The cost of debt (Kd) is less than the cost of equity (Ke).
4. The use of debt does not change the risk perception of the investors
5. The dividend payout is 100% i.e. no retained earnings.
The value of the firm on the basis of Net Income approach can be ascertained
as follows:
V= S+B .. .................. Eq. 12.4
Check Your Concept Where:
6. Assumptions of Net V= Value of the firm
income approach? S= Market value of Equity
7.What is optimum capital B= Market value of debt
structure? Market value of equity can be ascertained as follows:
8. Differentiate between S= NI/ Ke . .........................................
Eq. 12.5
levered and unlevered Where:-
firm?
S= Market value of Equity
NI= Earnings available for equity shareholder
Corporate Finance : 186 Ke= Equity capitalization rate
Example: 12.3 Capital Structure Decision
X limited is expecting an annual EBIT of Rs. 1 lakh. The company has Rs. 4 lakhs
in 10 % debenture and 60,000 shares of Rs 10 each. The cost of equity capital is
12.5%. Yor are requred to
a. Calculate the total value of the firm.
NOTES
b. Calculate the overall Cost of capital (WACC)
c. Show the effect on the value of the firm and WACC if debt is raised to
Rs 6, 00,000 from Rs 4, 00,000.
Solution
Particulars Amount
Earnings before interest and tax (EBIT) 1,00,000
Less: Interest at 10 % on Rs. 4 Lakhs 40,000
Earnings available for equity share holders (NI) 60,000
Capitalization rate (Ke) 12.5 per cent
Market Value of Equity (S): NI/Ke (60000/12.5*100) 4,80,000
Market value of debt (B) 4,00,000
(a) Total Value of Firm (S+B) 8,80,000
(b) Overall Cost of capital (K=EBIT/V) 11.36
(c) Effect on firm value of debt is increased to Rs 6,00,000:-
Earnings before interest and tax (EBIT) 1,00,000
Less: Interest at 10 % on Rs. 6 Lakhs 60,000
Earnings available for equity share holders (NI) 40,000
Capitalization rate (Ke) 12.5 per cent
Market Value of Equity (S): NI/Ke (40000/12.5*100) 3,20,000
Market value of debt (B) 6,00,000
Total Value of Firm (S+B) 9,20,000
Overall Cost of capital (K=EBIT/V) 10.86
The above example show that value of the firm increased from 8,80,000 to
9,20,000 in case the amount of debt is decreased from Rs 4 laks to Rs 6 lakhs and
also the cost of capital reduced from 11.36% to 10.86% . Thus leverage has effect
on value of the firm.
12.7.1.2 The Traditional View

The traditional view has emerged as a compromise to the extreme position taken by
the NI approach. According to the theory, an optimal capital structure exists when
the Weighted Average Cost of Capital (WACC) is minimized and the market value
of its assets is maximized. The Traditional theory of capital structure explains that
with the use of leverage (more debt), the firm's value increases to a certain level,
after which it tends to remain constant and eventually begins to decrease. Thus,
Capital Structure Decision there exists an optimal capital structure at a point where the firm value is maximum.
In other words, this theory advocates that there is a right combination of equity and
debt in the capital structure, at which the market value of a firm is maximum.
Using this approach it can be concluded that debt should exist in the capital
structure only up to a specific point beyond which any increase in leverage would
NOTES
result in reduction in value of the firm. Once the firm crosses that optimum value of
debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC.
Above the threshold, the WACC increases and market value of the firm starts a
downward movement. Thus, the traditional theory on the relationship between capital
structure and the firm value has three stages.
• First Stage: Increasing Value
In the first stage, the cost of equity (Ke) i.e. the rate at which the
shareholders capitalize their net income, either remains constant or rises
slightly with debt. The cost of equity does not increase fast enough to
offset the advantage of low-cost debt. Further, during this stage, the
cost of debt (Kd) remains constant since the market views the use of
debt as a reasonable policy. As a result, the overall cost of capital, WACC
or Ko, decreases with increasing leverage and thus, the total value of
the firm V also increases.
• Second Stage: Optimum Value
Once the firm has reached at a certain degree of leverage, increase in
leverage have a negligible effect on WACC and hence, on the value of
the firm. This is so because the increase in the cost of equity due to the
added financial risk just offsets the advantage of low cost debt. Within
that range or at the specific point, the overall cost of capital will be
minimum and the maximum value of the firm will be obtained.
• Third Stage: Declining Value
Beyond the acceptable limit of leverage, the value of the firm decreases
with increase in leverage as WACC increases with leverage. This happens
because investors perceive a high degree of financial risk and demand a
higher equity-capitalization rate (in form of dividend), which exceeds
the advantage of low-cost debt. The overall effect of these three stages
is to suggest that the cost of capital (WACC) is a function of leverage. It
first declines with leverage and after reaching a minimum point or range
starts rising. Figure 12.3 depicts the three stages of capital structure
under traditional view.

NOTES
Figure. 12.3: The effect of leverage on the cost of capital under

traditional approach
Example 12.4: The Traditional Theory of Capital Structure

Suppose Micro limited is expecting a perpetual EBIT of Rs 150 crore on assets of
Rs 1,500 crore, which are entirely financed by equity. The firm's equity capitalization
rate (the cost of equity) is 10 per cent. It is considering substituting equity capital by
issuing perpetual debentures of Rs 300 crore at 6 per cent interest rate. The cost of
equity is expected to increase to 10.56 per cent. The firm is also considering the
alternative of raising perpetual debentures of Rs 600 crore to replace equity. The
debt-holders will charge interest of 7 per cent, and the cost of equity will rise to 12.5
per cent to compensate shareholders for higher financial risk. You are required to
show the effect of Market Value and the Cost of Capital of the firm on different
alternatives.
Solution
Market Value and the WACC of Micro limited (Traditional Approach)
Particulars No Debt 6% Debt 7% Debt
EBIT 150 150 150
Less: Interest Cost Kd*D - 18 42
Net Income 150 132 108
Cost of equity, Ke 0.1000 0.1056 0.1250
Market Value of equity E= NI/Ke 1500 1250 864
Market Value of debt, D 0 300 600
Total Value of firm, V= E+D 1500 1550 1464
Cost of Capital (WACC) NOI/V 0.1000 0.0970 0.1030 Corporate Finance : 189
Capital Structure Decision 12.7.2. Irrelevance Theories of Capital Structure
The irrelevance theories advocate that the firm's capital structure does not affect its
value because firm value is independent of its capital structure. These theories
argue that the value of the firm is a function of investment decision rather than of
financing decision. The firm's profitability on investment decision determines the
NOTES
actual value of firm not the way its projects are financed. Due to this reason there is
no optimum capital structure rather one capital structure is as good as other and
thereby no matter whether company raise money by debt or equity. The main
irrelevance theories are:
• Net Operating Income Approach
• Modigliani- Miller (MM) Model
12.7.2.1 Net Operating Income (NOI) Approach

The Net Operating Income approach was also suggested by Durand and do not
agree with the NI approach. This approach to capital structure believes that the
value of a firm is not affected by the change of debt component in the capital
structure. It assumes that the benefit that a firm derives by infusion of debt is negated
by the simultaneous increase in the required rate of return by the equity shareholders.
With increase in debt, the risk associated with the firm, mainly financial risk or
bankruptcy risk, also increases and such a risk perception increases the expectations
of the equity shareholders and the benefit of using low cost debt (leverage) is wiped
out and overall cost of capital remains at the same level as before. Therefore, the
overall value of the firm is independent of the degree of leverage in capital structure.
Similarly, the overall cost of capital is not affected by any change in the degree of
leverage in capital structure.
Assumptions of NOI Approach

The NOI is based on the following assumptions:
• The market capitalizes the value of the firm as a whole. Therefore, the
split between debt and equity is not important.
• The overall cost of capital/ capitalization is a constant.
• The use of less costly debt funds increases the risk to shareholder. This
causes the equity capitalization rate to increase. Thus, the advantage of
debt is offset exactly by the increase in the equity-capitalization rate.
• The debt capitalization rate is constant.
• No corporate taxes exist.

NOTES
Figure. 12.4 : The Cost of capital under NOI approach
Value of firm
According to the NOI Approach, the value of a firm can be determined by the
following equation:
V= EBIT/K .................................... Eq. 12.6
Where:
V=value of firm
K=overall cost of capital
EBIT= Earnings before interest and tax
12.7.2.2 Modigliani- Miller (M-M) Approach

This approach was devised by Franco Modigliani and Merton Miller during 1950s.
The fundamentals of Modigliani and Miller Approach resemble to that of Net
Operating Income Approach. Similar to NOI approach, M-M approach also advocates
that capital structure is irrelevant. This suggests that the valuation of a firm is irrelevant
to the capital structure of a company. Whether a firm is highly leveraged or has
lower debt component in the financing mix, it has no bearing on the value of a firm.
The Modigliani and Miller hypothesis was based on the assumption that a company's
shares trade in a perfect market. In such a market, managers cannot alter the firm's
value by changing a company's level of gearing. In a perfect capital market, a
company's capital structure has no bearing on its value because the share price is
only affected by its expected future cash flows (earrings of the company) and the
required rate of return by equity investors. The market value of a company in such
a market is, therefore, based on the present value of its cash flows and not on how
they are distributed between its shareholders and long term.

Capital Structure Decision Assumptions of MM Approach
M-M approach is based on various assumptions. These are:
• Perfect Capital markets.
• Homogeneous risk classes i.e. all firms within an industry have the same
NOTES risk regardless of capital structure.
• No Corporate Income taxes
• No transactions costs
• Individuals and corporate can borrow and lend at same rates
• 100% payout.
• The average cost of capital is constant
The Modigliani and Miller's hypothesis can be best explained under two propositions
namely; proposition I and proposition II.
Proposition I
Modigliani and Miller explained that with the assumptions of "no taxes and perfect
capital market", the capital structure does not influence the valuation of a firm. In
other words, leveraging the company does not increase the market value of the
company. It also suggests that debt holders in the company and equity share holders
have the same priority i.e. earnings are split equally amongst them. Modigliani and
Miller showed that two identical firms, differing only in their capital structure, must
have identical total values. If they did not, individuals would engage in arbitrage and
create the market forces that would drive the two values to be equal.
MM's Proposition I states that for firms in the same risk class, the total
market value is independent of the debt-equity mix and is given by capitalising the
expected net operating income by the capitalisation rate (i.e., the opportunity cost of
capital) appropriate to that risk class. In other words, Value of levered firm = Value
of unlevered firm).
V = NOI/Ko.......................... Eq.12.7
Where:
V= Value of the firm
NOI = Net operating income
Ko = Firm's opportunity cost of capital

NOTES
Figure. 12.5: The Cost of Capital under MM Proposition I
Arbitrage process
Arbitrage process is the operational justification for the Modigliani-Miller hypothesis.
It is the process of purchasing a security in a market where the price is low and
selling it in a market where the price is higher and thereby locking into riskless profit.
This results in restoration of equilibrium in the market price of a security asset. This
process is a balancing operation which implies that a security cannot sell at different
prices. The MM hypothesis states that the total value of homogeneous firms that
differ only in leverage will not be different due to the arbitrage operation. Generally,
investors will buy the shares of the firm that's price is lower and sell the shares of
the firm that's price is higher. This process or this behaviour of the investors will
have the effect of increasing the price of the shares that is being purchased and
decreasing the price of the shares that is being sold. This process will continue till
the market prices of these two firms become equal or identical. Thus the arbitrage
process drives the value of two homogeneous companies to equality that differs
only in leverage.
Limitations of MM Proposition I
• Investors would find the personal leverage inconvenient. Check Your Concept
• The risk perception of corporate and personal leverage may be different. 9. What is homemade
• Arbitrage process cannot be smooth due the institutional restrictions. leverage?
• Arbitrage process would also be affected by the transaction costs. 10. Explain the arbitrage
• The corporate leverage and personal leverage are not perfect substitutes. process
• Corporate taxes do exist. However, the assumption of "no taxes" has 11. What is interest tax
been removed later. shield

Capital Structure Decision Example 12.5 : Assume there are two firms, L and U, which are identical in all
respects except that firm L has 10 per cent, Rs 5,00,000 debentures. The earnings
before interest and taxes (EBIT) of both the firms are equal, that is, Rs 1, 00,000.
The equity-capitalization rate (ke) of firm L is higher (16 per cent) than that of firm
U (12.5 per cent).
NOTES
Solution
Calculation of total value of levered and unlevered firm
Levered (L) Unlevered (U)
EBIT 100000 100000
Less- Interest 50000 -
Earnings Available to Equity Holder 50000 100000
Equity capitalization rate(Ke) 0.16 0.125
Total Market Value of Equity(S) 312500 800000
Total Market value of Debt (D) 500,000
Total Market Value (V) {S+D} 812500 800000
WACC .123 .125
Thus, the total market value of the firm which employs debt in the capital structure
(L) is more than that of the unlevered firm (U). According to the MM hypothesis,
this situation cannot continue as the arbitrage process, based on the substitutability
of personal leverage for corporate leverage, will operate and the values of the two
firms will be brought to an identical level.
Suppose an investor, Mr. X, holds 10 per cent of the outstanding shares of
the levered firm (L). His holdings amount to Rs 31,250 (i.e. 0.10 x Rs 3, 12,500) and
his share in the earnings that belong to the equity shareholders would be Rs 5,000
(0.10 x Rs 50,000).He will sell his holdings in firm L and invest in the unlevered firm
(U). Since firm U has no debt in its capital structure, the financial risk to Mr. X
would be less than in firm L. To reach the level of financial risk of firm L, he will
borrow additional funds equal to his proportionate share in the levered firm's debt on
his personal account. That is, he will substitute personal leverage (or home-made
leverage) for corporate leverage. In other words, instead of the firm using debt, Mr.
X will borrow money. The effect, in essence, of this is that he is able to introduce
leverage in the capital structure of the the unlevered firm by borrowing on his personal
account. Mr. X in our example will borrow Rs 50,000 at 10 per cent rate of interest.
His proportionate holding (10 per cent) in the unlevered firm will amount to Rs
80,000 on which he will receive a dividend income of Rs 10,000. Out of the income
of Rs 10,000 from the unlevered firm (U), Mr. X will pay Rs 5,000 as interest on his
personal borrowings. He will be left with Rs 5,000 that is, the same amount as he
was getting from the levered firm (L). But his investment outlay in firm U is less (Rs
30,000) as compared with that in firm L (Rs 31,250). At the same time, his risk is
identical in both the situations.
Proposition II Capital Structure Decision
According to MM proposition II, financial leverage is in direct proportion to the cost

of equity. Financial leverage also increases shareholders' financial risk by amplifying
the variability of EPS and ROE. This phenomenon is discussed above under financial
leverage section. Thus, financial leverage causes two opposing effects: it increases
NOTES
the shareholders' return but it also increases their financial risk. The shareholders
will demand increase in the required rate of return (i.e., the cost of equity) on their
investment to compensate for the financial risk. The higher the financial risk, the
higher the shareholders' required rate of return or the cost of equity. The MM's
Proposition II provides justification for the levered firm's opportunity cost of capital
remaining constant with financial leverage. In simple words, it states that the cost of
equity will increase enough to offset the advantage of cheaper cost of debt so that
the opportunity cost of capital does not change. A levered firm has financial risk
while an unlevered firm is not exposed to financial risk. Hence, a levered firm will
have higher required return on equity as compensation for financial risk. The cost of
equity for a levered firm should be higher than the opportunity cost of capital.
Figure. 12.6: The Cost of Capital under MM Proposition II

M- M Approach: Propositions with Taxes (The Trade-Off Theory of
Leverage)
The Modigliani and Miller approach assume that there are no corporate taxes. But
in real world, this is far from truth. Most countries, if not all, tax a company. This
theory recognizes the tax benefits are accrued by interest payments. The interest
paid on borrowed funds is tax deductible. However, the same is not the case with
dividends paid on equity. To put it in other words, the actual cost of debt is less than
the nominal cost of debt because of tax benefits. The trade-off theory advocates
that a company can capitalize its requirements with debts as long as the cost of Corporate Finance : 195
Capital Structure Decision distress i.e. the cost of bankruptcy exceeds the value of tax benefits. Thus, the
increased debts, until a given threshold value will add value to a company.
This approach with corporate taxes does acknowledge tax savings and thus
conclude that a change in debt equity ratio has an effect on WACC (Weighted
Average Cost of Capital). This means higher the debt, lower is the WACC. This
NOTES
Modigliani and Miller approach is one of the modern approaches of capital structure
theory.
12.7.2.1 Pecking Order Theory

Pecking order theory of capital structure states that firms have a preferred order for
financing decisions. The highest preference is to use internal financing (retained
earnings and the effects of depreciation) before resorting to any form of external
funds. Internal funds incur no flotation costs and require no additional disclosure of
proprietary financial information that could lead to more severe market discipline
and a possible loss of competitive advantage. If a firm must use external funds, the
preference is to use the following order of financing sources: debt, convertible
securities, preferred stock, and common stock. This order reflects the motivations
of the financial manager to retain control of the firm (since only common stock has
a "voice" in management), reduce the agency costs of equity, and avoid the seemingly
inevitable negative market reaction to an announcement of a new equity issue.
The pecking order theory is based on two key assumptions about financial
managers. The first of these is asymmetric information, or the likelihood that a firm's
managers know more about the company's current earnings and future growth
opportunities than do outside investors. There is a strong desire to keep such information
proprietary. The use of internal funds precludes managers from having to make public
disclosures about the company's investment opportunities and potential profits to be
realized from investing in them. The second assumption is that managers will act in the
best interests of the company's existing shareholders. The managers may even forgo
a positive NPV project if it would require the issue of new equity, since this would give
much of the project's value to new shareholders at the expense of the old.
12.8 Key Terms

• Agency costs : A type of internal cost that arises from, or must be paid
to, an agent acting on behalf of a principal. Agency costs arise because
of core problems such as conflicts of interest between shareholders and
management.
• Arbitrage: The simultaneous purchase and sale of an asset in order to
profit from a difference in the price. It is a trade that profits by exploiting
price differences of identical or similar financial instruments, on different
markets or in different forms.
Corporate Finance : 196 • Capital Structure: A mix of a company's long-term debt, specific short-
term debt, common equity and preferred equity. The capital structure is Capital Structure Decision
how a firm finances its overall assets.
• Capitalization rate: A rate of return on a real estate investment property
based on the expected income that the property will generate.
Capitalization rate is used to estimate the investor's potential return on
NOTES
his or her investment
• Debt Capacity: Assessment of the amount of debt an individual or firm
can repay in a timely manner (from available means or resources) without
jeopardizing its financial viability.
• Debt Equity Ratio: A measure of a company's financial leverage
calculated by dividing its total liabilities by stockholders' equity. It indicates
what proportion of equity and debt the company is using to finance its
assets.
• Financial Risk: The possibility that shareholders will lose money when
they invest in a company that has debt, if the company's cash flow
proves inadequate to meet its financial obligations. When a company
uses debt financing, its creditors will be repaid before its shareholders if
the company becomes insolvent.
• Homemade Leverage: A substitution of risks that investors may undergo
in order to move from overpriced shares in highly levered firms to those
in unlevered firms by borrowing in personal accounts.
• Leverage: It is a practice of using borrowed funds (such as loan and
other fixed charge securities) along with equity capital with a view to
increase shareholders wealth. It is also known as trading on equity.
• Optimum capital structure: A capital structure that has the best
possible mix of debt, preferred stock, and common equity. The optimum
mix should provide the lowest possible cost of capital to the firm.
• Pecking order Theory: A theory of capital structure that postulates
that the cost of financing increases with asymmetric information.
Financing comes from three sources, internal funds, debt and new equity.
Companies prioritize their sources of financing, first preferring internal
financing, and then debt, lastly raising equity as a "last resort".
• Tax Shield: A reduction in taxable income for an individual or corporation
achieved through claiming allowable deductions such as mortgage interest,
medical expenses, charitable donations, amortization and depreciation.
• Trade- off Theory: refers to the idea that a company chooses how
much debt finance and how much equity finance to use by balancing the
costs and benefits. It considered a balance between the costs of
bankruptcy and the tax saving benefits of debt.
12.9 Summary
• Every firm for its growth and survival has to take certain decision related
to capital investment. Theses capital expenditures have to be funded by
different financing options. Selection of theses financing options comes
NOTES under the category of financing decision.
• Manager has to decide about the best mix of Equity and Debt so that
overall cost of funding can be reduced and market value of firm can be
maximized. This best mix of Debt and Equity is called optimum capital
structure.
• Decision related to capital structure depends upon variety of internal
and external factors like; nature of company, profitability, managerial
control, economic condition and tax policy.
• Theories of capital structure can be divided into relevance and irrelevance
on the basis of their impact on overall firm's value.
• Relevance theories include; net income approach and traditional approach
which advocate that firm value can be influenced by changing its capital
structure. That is why firm should focus on finding optimum capital
structure.
• The irrelevance theories suggest that the firm's capital structure does
not affect its value because firm value is independent of its capital
structure. It includes Net operating income approach and MM Approach.
• Under MM hypothesis preposition, market value of firm is independent
to its capital structure. That is the reason firm can choose any combination
of debt and equity. Justification of this hypothesis is the arbitrage process,
which is employed by investors to re correct its investment returns by
using homemade leverage.
• MM hypothesis with corporate tax supports relevance theories as the
debt portion of capital structure provide tax benefits which can increase
the EPS and subsequently the market value of the firm.
12.10 Questions and Excersises

1. What do you mean by financial risk? How the leverage affect the financial
risk of a company.
2. Explain the effect of financial leverage on firm value.
3. What do you understand by capital structure of a corporation?
4. Explain the factors determinants capital structure of an organization
5. There is nothing like an optimum capital structure for a firm. Critically
evaluates this statement?
Corporate Finance : 198 6. A company has operating income of Rs 50,000. It has Rs 1, 00,000 of
debt carrying 10% interest rate. The equity capitalization rate is 20%. Capital Structure Decision
Indicate the market value of the firm assuming no taxes.
7. Firm A being a levered one has 10% Rs 4, 00,000 debentures. Firm B is
an unlevered firm. Both firms earn 20% operating profit on their assets
valued at Rs 10, 00,000. The tax rate is 30% and equity capitalization
rate is 20%. Calculate WACC for the two firms NOTES
8. X ltd. has 2,000 bonds outstanding with a face value of Rs.1,000 each
and a coupon rate of 9%. The interest is paid semi-annually. What is the
amount of the annual interest tax shield if the tax rate is 34%?
9. Evaluate firm A and B in terms of financial and operating leverage
S.No. Particulars Firm-A Firm-B
1 Sales 2,0,00,000 3,0,00,000
2 Variable Cost 40% of sales 30% of Sales
3 Fixed Cost 500,000 700,000
4 Interest 100,000 125,000
10. Companies P and Q are identical in all respects including risk factora
expect for Debt/Equity , P having 10% debentures of 9 lakhs while Q
has issued only equity. Both the companies earn 20% before interest
and tax on their total assets of Rs.15 lakhs. Assuming tax rate of 50%
and capitalization rate of 15% for all equity company, compute the value
of companies P and Q according to net income approach.
11. Thompson & Thomson is an all equity firm that has 500,000 shares of
stock outstanding. The company is in the process of borrowing 8 million
at 9% interest to repurchase 200,000 shares of the outstanding stock.
What is the value of this firm if you ignore taxes?

Books:
TMH Publication.
Publication.
Publication
Capital Structure Decision 7. Pandey, I.M, "Financial Management", Vikas Publication House Pvt.
Ltd, New Delhi.
Web resources:
NOTES 1. Determinants of capital structure, available at:
• http://www.publishyourarticles.net/knowledge-hub/business-
studies/capital-structure.html
2. Sources of long term finance, available at:
• http://www.bized.co.uk/educators/level2/finance/activity/
sources13.htm
• http://kalyan-city.blogspot.com/2012/10/what-are-sources-of-fixed-
capital-long.html
• http://www.wsscapital.com/blog/funding-sources
3. Operating and financial leverage, available at:
• http://wps.aw.com/wps/media/objects/222/227412/ebook/ch11/
chapter11.pdf
• http://steconomiceuoradea.ro/anale/volume/2006/finante-
contabilitate-si-banci/64.pdf
4. Traditional view of capital structure, available at:
• http://www.efinancemanagement.com/financial-leverage/232-
capital-structure-theory-traditional-approach
5. Theories of capital structure, available at:
• http://shodhganga.inflibnet.ac.in/bitstream/10603/5253/10/
11_chapter%203.pdf

Dividend Decision
UNIT 13 : DIVIDEND DECISION
Structure
13.2 Meaning of Dividend
13.3 Conflicting Dividend Theories
13.3.1 Irrelevance Theory of Dividend
13.3.1 Relevance Theory of Dividend
13.4 Dividend Policy
13.4.1 Objectives of Dividend Policy
13.4.2 Factors Affecting the Dividend Policy
13.4.3 Practical Considerations in Dividend Policy
13.5 Dividends Policy Analysis of Indian Companies
13.5.1 Factors Favoring Higher and Lower Dividend
13.6 Forms of Dividends
13.6.1 Cash Dividend
13.6.2 Stock Dividend
13.6.3 Property
13.6.4 Scrip Dividend
13.6.5 Liquidating Dividend
13.7 Bonus Shares
13.7.1 Reasons for Issuing Bonus Shares
13.7.2 Stock Splits
13.7.3. Advantages of Bonus Shares to Company
13.7.4. Advantages of Bonus Shares to Shareholders
13.7.5. Disadvantages of Bonus Shares to Company
13.8 Key Terms
13.9 Summary

Dividend Decision
13.0 Introduction
In corporate finance, it is perceived that the finance manager is to face two major
decisions: first related to the investment (or capital budgeting) and second, the
financing decisions. The capital budgeting decision is concerned with what real
NOTES assets the firm should acquire while the financing decision is concerned with how
these assets should be financed. These decisions are required normally during the
establishment of the business or in the initial phase. But when the firm starts to
make the profits a third type of decision is required. This third decision relates to the
dividend policy or management of earnings. The decision whether a firm should
distributes all or proportion of earned profits in the form of dividends to the
shareholders, or should it be ploughed back into the business come under the ambit
of dividend decision. Dividend decision is linked with firm's objective of wealth
maximization. Therefore, the managers not only consider the question of how much
of the company's earnings are needed for investment, but also take into consideration
the possible effect of their decisions on share prices.
The present unit shows the importance of dividend decisions for the finance
manager and would analyze the various dividend decision theories and discuss the
relationship between the dividend policy and value of the firm.

• Explain the meaning, nature of dividend
• Understand the divided relevance and irrelevance theories
• Know the objectives of the dividend policy
• Analyse the considerations necessary in deciding the dividend policy
• Know various forms of dividends
• Understand various provisions related to the issue of the Bonus shares
• Understand the dividend policies followed by Indian companies
13.2 Meaning of Dividend

Dividend is that portion of the firm's earnings which is paid to the shareholders/
owners of the firm. Dividends provides an added incentive (in the form of a return
on your investment) to own stock in stable companies even if they are not
experiencing much growth. Dividends are often paid out quarterly, semi-annually or
annually and it gives stockholders a steady return regardless of what happens to the
stock price. The companies use dividends to pass on their profits directly to their
shareholders. In every period, the earnings that remain after satisfying the obligation
to the creditors, the government and the preference shareholders can either be Dividend Decision
retained by the company or distributed as dividends or bifurcated between the retained
earnings and dividends. The profits not distributed are known as retained earnings.
The retained earnings can be invested in assets or new project that will help the firm
to maintain or increase its growth. The dividend decisions require the financial manager
to decide the distribution policy of the left over earnings. NOTES
A company can have both the preference capital as well as equity share
capital. The dividend may be paid on both the capitals but the dividend on preference
capital do not involve any decision because they are paid at affixed rate and are
more or less like a contractual liability. While, the dividends on equity share capital
are paid after considering a number of factors and is an important decision for the
management. The determination and establishment of an effective dividend policy is
of significant importance for the overall objective of the firm and is not an easy job.
Lease et al. (2009) defines dividend policy as "the practice that management follows
in making dividend payout decisions or, in other words, the size and pattern of cash
distributions over time to shareholders".
13.3 Conflicting Dividend Theories

The dividend theories relates with the impact of dividend on the value of the firm.
According to one school of thought the dividends are irrelevant and the amount of
dividends paid does not affect the value of the firm while the other theory considers
that the dividend decision is relevant to the value of the firm. Thus there are conflicting
theories on dividends.
10.3.1 Irrelevance Theory of Dividend

The advocates of this school of thought argue that the dividends have no impact on
the share price or market value of the firm. The argue that the shareholders do not
differentiate between the present dividend and the future capital gains and are basically
interested in higher returns either earned by the firm by investing the profits in future
profitable investments. They believe that the profits are distributed as dividends only
if no adequate investment opportunities for investments for the business. The various
theories supporting this thought are as follows.
1. Residuals Theory of Dividends
.
2 Modigliani and Millers Approach
1. Residuals theory of Dividends

The theory is based upon the assumptions that since the external financing has
excessive costs and may not be available to the firm. The firm finances its
investment by retained earnings or by retaining earnings. The retaining earnings
are that portion of profits that is not distributed to the investors. The residual
theory of dividend policy is that the firm will only pay dividends from residual
Dividend Decision earnings, that is, from earnings left over after all suitable (positive NPV)
investment opportunities have been financed. With the residual dividend policy,
the primary focus of the firm's management is indeed on investment, not
dividends. Thus the firm's decision to pay the dividends is influenced by:
a. The investment opportunities available to the business
NOTES
b. The availability of the internal funds. If the internal funds are excessive
and all the investments are finances the residual is paid as dividends.
Thus, the divided policy is totally passive in nature and has no influence on the
market price of the firm.
2. Modigliani and Miller (MM) Approach

This theory was proposed by Franco Modigliani and Merton Miller in 1961
who argued that the value of the firm is determined by the basic earning power,
the firm's risk and not by the distribution of earnings. The value of the firm
therefore depends on the investment decisions and not the dividend decision.
However, their argument was based on some assumptions.
Assumptions of MM hypothesis
i. The capital markets are perfect and all the investors behave rationally.
ii. There are no taxes and flotation costs and if the taxes are there then
there is no difference between the dividends tax and capital gains tax.
iii. No transaction costs associated with share floatation
iv. The firm's investment policy is independent of the dividend policy. The
effect of this assumption is that the new investments out of retained
earnings will not change and there will not change in the required rate of
return of the firm..
v. There is perfect certainty by every investor as to future investments and
profits of the firm. Thus investors are able to forecast earnings and
dividends with certainty.
The MM hypothesis is based upon the arbitrage theory. The arbitrage process
involves switching and balancing the operations. Arbitrage leads to entering into
two transactions which exactly balance or completely offset the effect of each
other. The two transactions are paying of dividends and raising external capital.
Since the firm uses retained earnings to finance new investments, the paying of
dividends will require the firm to raise the capital externally. The arbitrage theory
suggests that the dividend effect will be exactly offset by the effect of raising
additional share capital. When the dividends are paid to the shareholders, the market
price of share decreases (because of external financing). Thus what is gained by
the shareholders as a result of dividends is completely neutralized by the reduction
in the market value of the shares. According to MM, the investors will thus be
indifferent between dividends and retained earnings. The market value of the shares
will depend entirely on the expected future earnings of the firm.
Proof of MM Hypothesis Dividend Decision
The MM provides proof for their hypothesis in the following manner:-

Step 1
The market price of the share in the beginning is equal to the present value of the
dividends paid at the end of the period plus the market price of the share at the end NOTES
of the period.
Thus,
D1 + P1
P0 = ............. Eq. 13.1
(1+ ke)
Where,
P0 = the stock price at time 0
D1 = the next dividend (i.e., at time 1),
ke = Cost of equity
P1 = Market price of share at the end of period 1
Step 2
Assuming there is no external financing, the total capitalized value of the firm would
be simply the number of shares (n) times the price of each share (P0).
...................... Eq. 13.2
Step 3
The company can finance its investment either by retained earnings or by issue of
new shares. The value of the firm will thus be defined as:
.................... Eq. 13.3
Where,
rn = is the number of new shares issued at the end of year 1 at price P1.
Step 4
Check Your Concept
The new number of shares issued at the end of year 1 at price P1 in case the firm
finance all the investment proposals. 1. What is dividend ?
P1 = I - (E - nD1).............Eq. 13.4 2. Why firm distribute

dividend ?
Where,
P1 = Market price of share at the end of period 1 Corporate Finance : 205
Dividend Decision I = Total investment to be made at year 1
E = Total earnings of the firm
nD1= Total dividend paid
Step 5
NOTES
Substituting equation 13.4 with equation 13.3
Eq....13.5
Solving the equation and cancelling the positive and negative , we have
.........Eq. 13.6
Step 6
Since the dividend are not there in the last equation, MM concludes that dividends
do not count and that dividend policy has no impact on the share price of the firm.
Example 13.1
A company whose capitalization rate is 10% has outstanding shares of 25,000 selling
at INR100 each. The firm is expecting to pay a dividend of INR 5 per share at the
end of the current financial year. The company's expected net earnings are INR.
250,000 and the new proposed investment requires 500,000. Using MM model show
how the dividend payment does not affect the value of the firm.
Solution
1. Value of the firm when dividends are paid:
i. Price per share at the end of year 1:
P0 = 1/(1 + ke) x (D1 + P1)
INR.100 = 1/(1 + 0.10) x (INR.5 + P1)
P1 = INR.105
ii. Amount required to be raised from the issue of new shares:

r n P1 = I - (E - nD1)
=> INR.500,000 - (INR.250,000 - INR.125,000)

Dividend Decision
=> INR375,000
iii. Number of additional shares to be issued:
rn = INR 375,000 / 105 => 3571.42857 shares (unrounded)

iv. Value of the firm: NOTES
=> (25,000 + 3571.42857) (105) -INR500,000 + INR 250,000
(1 + 0.10)
=> INR.2,500,000
2. Value of the firm when dividends are not paid:

i. Price per share at the end of year 1:
P0 = 1/(1 + ke) x (D1 + P1)
INR 100 = 1/(1 + 0.10) x ($0 + P1)
P1 = INR.110
ii. Amount required to be raised from the issue of new shares:
=> INR.500,000 - (INR.250,000 -0) = Rs.250,000
iii. Number of additional shares to be issued:

rn = Rs.250,000/Rs.110 = 2272.7273 shares (unrounded)
iv. Value of the firm:
=> (25,000 + 2272.7273) (110) - Rs.500,000 + Rs.250,000
(1 + 0.10)
=> Rs.2,500,000
Thus, according to MM model, the value of the firm remains the same whether
dividends are paid or not. This example proves that the shareholders are indifferent
between the retention of profits and the payment of dividend.
Criticism of MM Model
1. The assumption of perfect capital market is unrealistic. In real world there
exist taxes, floatation costs and transaction costs.
2. Investors cannot be indifferent between dividend and retained earnings under
conditions of uncertainty. This can be proved at least with the aspects of (i)
near Vs distant dividends, (ii) informational content of dividends, (iii) preference
for current income and (iv) sale of stock at uncertain price.

Dividend Decision 13.3.2 Relevance Theory of Dividend
The relevance theory of dividend argues that dividend decision affects the market
value of the firm and therefore dividend matters. This theory suggests that investors
are generally risk averse and would rather have dividends today ("bird-in-the-hand")
than possible share appreciation and dividends tomorrow. The relevance theory of
NOTES
dividend proposes that dividend policy affect the share price. Therefore, according
to this theory, optimal dividend policy should be determined which will ensure
maximization of the wealth of the shareholders. Relevance theory can discussed
with following models:
.
1 Walter Approach
.
2 Gorden Approach
.
3 Dividend Capitalization
.
4 Dividend Signaling
1. Walter Approach
The Walter approach was given by James E Walter and is based on a simple argument
that where the reinvestment rate, that is, rate of return that the company may earn
on retained earnings, is higher than cost of equity (rate of return of the shareholders),
then it would be in the interest of the firm to retain the earnings. If the company's
reinvestment rate on retained earnings is the less than shareholders' rate of return,
the company should not retain earnings. If the two rates are the same, then the
company should be indifferent between retaining and distributing.
The Walter's model is based on the following assumptions:
1. The firm finances its entire investments by means of retained earnings only.
2. Internal rate of return (r) and cost of capital (KE) of the firm remains constant.
3. The firms' earnings are either distributed as dividends or reinvested internally.
4. The earnings and dividends of the firm will never change.
5. The firm has a very long or infinite life.
The Walter formula is based on a simple analysis that the market value of equity is
the capitalization of the current earnings and growth in price.
Hence, the basis of Walter formula is:
VE = D /KE - g) ................Eq. 13.7
Where,
VE = market value of equity shares
D = initial dividend
KE = costs of equity and
g = expected growth rate of earnings
Here, the growth factor occurs because the rate of return on retention done by the Dividend Decision
company is higher than the cost of equity. That is to say, the company continues to
earn at r rate of return on the retained earnings, and this is what causes growth g.
Hence,
g = r (E-D)/ KE...........................Eq. 13.8
NOTES
Inserting equations 13.8 into 13.7, we have
..............Eq. 13.9
Where,
VE = market value of equity shares
r = rate of return on retained earnings of the company
E = earnings rate
D = dividend rate
Example 13.2
Supposing a company the nominal value equity is Rs. 100, and the dividends at the
rate of 10 % are Rs.10. Supposing the company earns at the rate of 12%, what is
the market value of equity if the cost of equity is 8%?
Solution
The market value of the share comes to Rs. 162.50. This is explainable easily. As
the company is earning Rs.12, and distributing Rs.10, it retains Rs. 2 every year, on
which it earns at 12%. The capitalized value of 0.24 at 8% will be the expected
growth. Therefore, the sustainable earnings of the shareholders will be Rs. 10 +3,
which, when capitalized at 8%, produces the value Rs. 162.50.
The key learning from Walter's approach is not what the market value of
equity is, but how the market value of equity can be maximized by following a
proper distribution policy. For instance, in the present case, it is not advisable for the
company to distribute any dividend at all, as the company earns more than the
shareholders' opportunity rate. If the company was not to distribute anything, the
market value of the share may increase to Rs. 225.
Walter's view on optimum dividend payout ratio can be summarized as below:
a. Growth Firms (R> KE)
The firms having R> KE may be referred to as growth firms. The growth firms
are assumed to have ample profitable investment opportunities. These firms
naturally can earn a return which is more than what shareholders could earn
on their own. So, optimum payout ratio for growth firm is 0%. Corporate Finance : 209
Dividend Decision b. Normal Firms (R= KE)
If R is equal to KE, the firm is known as normal firm. These firms earn a rate
of return which is equal to that of shareholders. In this case dividend policy will
not have any influence on the price per share. So there is nothing like optimum
payout ratio for a normal firm. All the payout ratios are optimum.
NOTES
c. Declining Firm (R< KE)
If the company earns a return which is less than what shareholders can earn
on their investments, it is known as declining firm. Here it will not make any
sense to retain the earnings. So, entire earnings should be distributed to the
shareholders to maximise price per share. Optimum payout ratio for a declining
firm is 100%.
Limitations of Walter Model
1. Walter's model assumes that the firm's investments are purely financed
by retained earnings. Thus, this model would be applicable only to all-
equity firms.
2. The assumption of r as constant is not realistic.
3. The assumption of a constant Ke ignores the effect of risk on the value
of the firm.
2. Gordon Approch (The Bird-in-the-Hand Theory)
The essence of the bird-in-the-hand theory of dividend policy (advanced by John
Litner in 1962 and Myron Gordon in 1963) is that shareholders are risk-averse and
prefer to receive dividend payments rather than future capital gains. Shareholders
consider dividend payments to be more certain that future capital gains- thus a
"bird in the hand is worth more than two in the bush".
Gordon contended that the payment of current dividends "resolves investor
uncertainty". Investors have a preference for a certain level of income now rather
that the prospect of a higher, but less certain, income at some time in the future.
The key implication, as argued by Litner and Gordon, is that because of the less
risky nature dividends, shareholders and investors will discount the firm's dividend
stream at a lower rate of return, 'r', thus increasing the value of the firm's shares.
Assumptions of Gordon's Model

The Gordon's Model is based on the following assumptions:
1. The firm is an all equity firm.
2. There is no outside financing and all investments are financed exclusively
by retained earnings.
3. Internal rate of return (R) of the firm remains constant.
4. Cost of capital (KE) of the firm also remains same regardless of the
Corporate Finance : 210 change in the risk complexion of the firm.
5. The firm derives its earnings in perpetuity. Dividend Decision
6. The retention ratio (b) once decided upon is constant. Thus the growth
rate (g) is also constant (g = br).
7. Corporate tax does not exist.
According to the constant growth dividend valuation (or Gordon's growth) model, NOTES
the value of an ordinary share, SV0 is given by:
SV0 = D1/ (KE -g)
Where, the constant dividend growth rate is denoted by g, ke is the investor's required
rate of return, and D1, represents the next dividend payments. Thus the lower ke is
in relation to the value of the dividend payment D1, the greater the share's value. In
the investor's view, according to Linter and Gordon, KE, the return from the dividend,
is less risky than the future growth rate g. The Gordon's view on the optimum
dividend payout ratio can be summarized as below:
1. The optimum payout ratio for a growth firm (R> KE) is zero.
2. There no optimum ratio for a normal firm (R= KE).
3. Optimum payout ratio for a declining firm R< KE is 100%.
Thus the Gordon's Model's conclusions about dividend policy are similar to
that of Walter. This similarity is due to the similarities of assumptions of both the
models.
3. Dividend Capitalization Model

According to Gordon, the market value of a share is equal to the present value of the
future streams of dividends. A simple version of Gordon's model can be presented
as below:
E (1 - b)
P =
KE - br ........... Eq. 13.10
Where:
P = Price of a share
E = Earnings per share
b = Retention ratio
1-b = Dividend payout ratio
KE = Cost of capital or the capitalization rate
br = Growth rate (rate or return on investment of an all-equity firm)
Example 13.3
From the following data given below, determination the value of shares:

Dividend Decision Case A Case B
D/P Ratio 40 30
Retention Ratio 60 70
Cost of capital 17% 18%
NOTES Required rate of return 12% 12%

EPS (Earning per share) Rs. 20 Rs.20
Rs.20 (1 - 0.60)
P = => Rs. 81.63 (Case A)
0.17 - (0.60 x 0.12)
Rs. 20 (1 - 0.70)
P = => Rs.62.50 (Case B)
0.18 – (0.70 x 0.12)
Gordon's model thus asserts that the dividend decision has a bearing on the market
price of the shares and that the market price of the share is favourably affected with
more dividends.
4. Dividend Signaling Theory

This is a theory which asserts that announcement of increased dividend payments
by a company gives strong signals about the bright future prospects of the company.
In practice, change in a firm's dividend policy can be observed to have an effect on
its share price- an increase in dividend producing an increasing in share price and a
reduction in dividends producing a decrease in share price. This pattern led many
observers to conclude, contrary to M&M's model, that shareholders do indeed prefer
dividends to future capital gains.
The change in dividend payment is to be interpreted as a signal to shareholders
and investors about the future earnings prospects of the firm. Generally a rise in
dividend payment is viewed as a positive signal, conveying positive information about
a firm's future earnings prospects resulting in an increase in share price. Conversely
a reduction in dividend payment is viewed as negative signal about future earnings
prospects, resulting in a decrease in share price.
13.4 Dividend Policy

Once a company makes a profit, management must decide on what to do with those
profits. The management could continue to retain the profits within the company, or
they could pay out the profits to the owners of the firm in the form of dividends. The
part of the profit that is distributed is termed as dividend. The ratio of the actual
distribution or dividend, and the total distributable profits, is called dividend payout
ratio. Once the company decides on whether to pay dividends they may establish a
Corporate Finance : 212 somewhat permanent dividend policy, which may in turn impact on investors and
perceptions of the company in the financial markets. The decision about management Dividend Decision
of profit depends on the current and future situation of the company. It also depends
on the preferences of investors and potential investors.
How much of profits should a corporation distribute as dividend is a very
critical area of concern for the management. There are several considerations that
NOTES
apply in answering this question. Hence, company has to frame and work on a
definitive policy of dividend payout ratio. In practice, no corporate management can
afford to stick to a fixed dividend payout ratio year after year-neither such fixity of
dividend payout ratio required or expected. However, management has to broadly
decide its policy on its broad attitude towards distribution - liberal dividend payout
ratio, or conservative dividend payout ratio, etc.
13.4.1. Objectives of Dividend Policy

A finance manager may treat the dividend decision in the following two ways:
1. As a long term financing decision- When dividend is treated as a source of
finance, the firm will pay dividend only when it does not have profitable
investment opportunities. On the other hand, the firm can also pay dividend
and raise an equal amount by the issue of shares but this does not make any
sense.
2. As a wealth maximisation decision- Payment of current dividend has a positive
impact on the share price. So, in order to maximise share price, the firm must
pay more and more dividends.
13.4.3. Factors Affecting Dividend Policy

1. Dividend payout ratio: It refers to the percentage share of the net earnings
distributed to the shareholders as dividends. Dividend policy involves the decision
to pay out earnings or to retain them for reinvestment in the firm. The retained
earnings constitute a source of finance. The optimum dividend policy should
strike a balance between current dividends and future growth which maximizes
the price of the firm's shares. The dividend payout ratio of a firm should be
determined with reference to two basic objectives - maximizing the wealth of
the firm's owners and providing sufficient funds to finance growth. These
objectives are interrelated.
2. Stability of dividends: Dividend stability refers to the payment of a certain
minimum amount of dividend regularly. The stability of dividends can take any
of the following three forms:
a. Constant dividend per share: A company may follow a policy of paying a
certain fixed amount per share as dividend. For example, on a share of
face value of Rs 200, firm may pay a fixed amount say Rs 10 as dividend.
This will be paid year after year irrespective of level of earnings.
b. Constant dividend payout ratio: Under this policy a firm pays a constant percentage
of net earnings as dividend to the shareholders. In each dividend period. Corporate Finance : 213
Dividend Decision c. Constant dividend per share plus extra dividend: Using this policy, a firm
usually pay affixed dividend to the shareholders and in a year of good
performance, an additional or extra dividend is paid over and above the
regular dividend.
3. Legal, contractual and internal constraints and restrictions: Legal

NOTES
stipulations do not require a dividend declaration but they specify the conditions
under which dividends must be paid. Such conditions pertain to capital
impairment, net profits and insolvency. Important contractual restrictions may
be accepted by the company regarding payment of dividends when the company
obtains external funds. These restrictions may cause the firm to restrict the
payment of cash dividends until a certain level of earnings has been achieved
or limit the amount of dividends paid to a certain amount or percentage of
earnings. Internal constraints are unique to a firm and include liquid assets,
growth prospects, and financial requirements, availability of funds, earnings
stability and control.
4. Owner's considerations: The dividend policy is also likely to be affected by

the owner's considerations of the tax status of the shareholders, their opportunities
of investment and the dilution of ownership. This is an external factor as
companies cannot control what investors want or expect from their industry.
5. Capital market considerations: The extent to which the firm has access to
the capital markets, also affects the dividend policy. In case the firm has easy
access to the capital market, it can follow a liberal dividend policy. If the firm
has only limited access to capital markets, it is likely to adopt a low dividend
payout ratio. Such companies rely on retained earnings as a major source of
financing for future growth.
6. Inflation: With rising prices due to inflation, the funds generated from
depreciation may not be sufficient to replace obsolete equipments and machinery.
So, they may have to rely upon retained earnings as a source of fund to replace
those assets. Thus, inflation affects dividend payout ratio in the negative side.
13.4.4 Practical Considerations in Dividend Policy

There are certain practical considerations that affect the dividend policy followed
by the firm. These can be stated as follows:
a. Financial Needs of the company: Sometimes, there are companies that do
not have significant reinvestment opportunities. More precisely we say the
reinvestment rate of the company is lesser than the reinvestment rate of
shareholders. In such cases, obviously, it is better to pay earnings out than to
retain them. As the classic theories of impact of dividends on market value of
a share suggest, or what is anyway intuitively understandable, retention of
earnings makes sense only where the reinvestment rate of the company is
higher than that of shareholders.
b. Tax disparities between current dividends and growth: In our discussion Dividend Decision
on indifference between current dividends and share price appreciation, we
have assumed that taxes do not play a spoilsport. In fact, quite often, they do.
For example, if a company distributes dividends, the same may be taxed (either
as income in the hands of shareholders, or by way of tax on distribution - like
dividend distribution tax in India). Alternatively, if the shareholders have a NOTES
capital appreciation, which they encash by partial liquidation of holdings,
shareholders have a capital gain. Taxability of a capital gain may not be the
same as that of dividends. Hence, taxes may differentiate between current
dividends and share price appreciation.
c. Desire of Shareholders: Investors such as retired persons and widows view
dividends as the regular source of funds to meet their current living expenses.
Such expenses are constant from period to period and hence these investors
prefer a constant and regular dividend policy from the companies.
d. Entities requiring minimum distribution: There might also be situations
where entities are required to do a minimum distribution under regulations. For
example, in case of real estate investment trusts, a certain minimum distribution
is required to attain tax transparent status. There might be other regulations or
regulatory motivations for companies to distribute their profits. These regulations
may impact our discussion on relevance of dividend policy on price of equity
shares.
e. Unlisted companies: Finally, one must also note that discussion above on
the parity between distributed earnings and retained earnings - the latter leading
to market price appreciation - will have relevance only in case of listed firms.
Technically speaking, in case of unlisted firms too, retained earnings belong to
the shareholders, as shareholders after all are the owners of the residual wealth
of the company. However, that residual ownership may be a myth as companies
do not distribute assets except in event of winding, and winding up is a rarity.
13.5 Dividend Policy Analysis of Indian Companies

There are a number of compelling reasons why companies do not and should not
pay dividends.
For the majority of Indian investors, dividends are inconsequential. An obsessive
attention to capital appreciation is all that matters. In essence, the most important
objective of a rational investor is to maximize 'total return' over the intended holding
period. Therefore, both dividends and capital appreciation count. In a bullish market
cycle, it is natural to pay little heed to dividends.
Dividends are a definitive statement about the ability of management to achieve
profit growth on a sustainable basis. Most companies earn considerably more than
they pay out to shareholders. Retained earnings are a fundamental basis of financing
Dividend Decision future growth without having to resort to leverage. However, it is a delicate matter
for companies to cut their dividends, and very few do. So, an increase in dividends is
a signal of confidence in the future. In effect, the signal is that earnings are likely to
grow fast enough to more than compensate for the higher payout.
NOTES 13.5.1 Factors favoring Higher and Lower Dividend
• Higher Dividend: There are factors that make higher dividends beneficial.
For example, higher dividends tend to decrease an agency's costs. This occurs
because the more dividends management needs to pay out, the more external
financing the firm will require. The external financing increases the scrutiny
that management actions have to undergo and, therefore, decreases the agency
problem and agency costs. It is also suggested that for investors to sell current
stock to obtain income equivalent to dividends is not the same psychologically
than receiving dividends. It is harder psychologically to sell stock to obtain
income than to use dividends to obtain income. Therefore, it is argued, that
these two actions cannot be viewed as substitutes, as proposed by the dividend
irrelevance theory. The above point suggests that shareholders who need income
that comes from dividends are psychologically more comfortable with receiving
dividends than with selling part of their shares.
Another argument for the benefits of higher dividends is Time Value refers to the
fact that Rs 1 of dividends received now cannot be seen as equivalent to Rs 1 of
future dividends or stock appreciation to be received at some point in the future.
• Lower dividend : Transactions costs often make lower dividends more
beneficial for stockholders and for the firm. It is more beneficial for a stock
holder if an investor intends to reinvest dividends in stock. This occurs because
there are transactions costs that investor have to incur to buy stock such as
brokerage fees.
The firm will benefit from paying lower dividends in the case where external
financing is required. This is because external financing results in costs such as
flotation costs. If firm just uses retained earnings available instead of paying
out dividends then the costs of external financing will be avoided or decreased.
Tax that investors have to pay on capital gains is generally lower than tax that
they have to pay on dividends. Also, if investors want to reinvest dividends by
buying more stock, investors still lose money by paying taxes on dividends.
Therefore, an argument made by dividend irrelevance theory suggesting that
investors can reinvest dividends by buying more stock and therefore obtaining
the same result as by funds being reinvested is irrelevant as soon as assumptions
of a perfect world (which includes the assumption that there are no taxes) is no
longer hold.

Dividend Decision
13.6 Forms of Dividend
A dividend is generally considered to be a cash payment to the holders of company
stock. However, there are several types of dividends, depending upon the form in
which they are paid to the shareholders. The dividend types are:
NOTES
10.6.1 Cash dividend
The cash dividend is by far the most common of the dividend types used. On the
date of declaration, the board of directors resolves to pay a certain dividend amount
in cash to those investors holding the company's stock on a specific date. The date
of record is the date on which dividends are assigned to the holders of the company's
stock. On the date of payment, the company issues dividend payments. The cash
dividend can be the Regular Dividend or the Interim dividend.
Regular dividend is the dividend paid annually, proposed by the board of
directors and approved by the shareholders in general meeting. It is also known as
final dividend because it is usually paid after the finalization of accounts. It is generally
paid in cash as a percentage of paid up capital, say 10 % or 15 % of the capital.
Sometimes, it is paid per share. On the other hand, interim dividend is paid only if
Articles of Association (AOA) so permit. It is generally declared and paid when
company has earned heavy profits or abnormal profits during the year and directors
which to pay the profits to shareholders. Such payment of dividend in between the
two Annual General meetings before finalizing the accounts is called Interim Dividend.
13.6.2. Stock dividend

A stock dividend is the issuance by a company of its common stock to its common
shareholders without any consideration. If the company issues less than 25 percent
of the total number of previously outstanding shares, it is treated as a stock dividend.
If the transaction is for a greater proportion of the previously outstanding shares,
then it is treated as stock split. The stock dividend is recorded by transferring the
from retained earnings to the capital stock and additional paid-in capital accounts an
amount equal to the fair value of the additional shares issued. The fair value of the
additional shares issued is based on their fair market value when the dividend is
declared.
13.6.3 Property dividend

A company may issue a non-monetary dividend to investors, rather than making a
cash or stock payment, like the assets or property owned by the company. The
distribution is recorded at the fair market value of the assets distributed. Since the
fair market value is likely to vary somewhat from the value of the assets, the company
will likely record the variance as a gain or loss.

Dividend Decision 13.6.4 Scrip dividend
A company may not have sufficient funds to issue dividends in the near future, so
instead it issues a scrip dividend, which is essentially a promissory note (which may
or may not include interest) to pay shareholders at a later date. This dividend creates
a note payable.
NOTES
13.6.5 Liquidating dividend
When the board of directors wishes to return the capital originally contributed by
shareholders as a dividend, it is called a liquidating dividend, and may be an indication
to closing down the business. The accounting for a liquidating dividend is similar to
the entries for a cash dividend, except that the funds are considered to come from
the additional paid-in capital account. The various types of dividend, its payment and
the accounting treatment is given below
Example 13.4
Cash Dividend
On February 1, 2014 ABC International's board of directors declares a cash dividend
of $0.50 per share on the company's 2,000,000 outstanding shares, to be paid on
June 1 to all shareholders of record on April 1, 2014. On February 1,2014 the company
records this entry:
Debit Credit
Retained earnings 1,000,000
Dividends payable 1,000,000
On June 1, 2014 ABC pays the dividends, and records the transaction with this
entry:
Debit Credit
Cash 1,000,000
Stock Dividend
ABC International declares a stock dividend to its shareholders of 10,000
shares. The fair value of the stock is $5.00, and its par value is $1. ABC records the
following entry:
Debit Credit
Retained earnings 50,000
Common stock, $1 par value 10,000
Additional paid-in capital 40,000

Property Dividend Dividend Decision
ABC International's board of directors elects to declare a special issuance of 500

identical, signed prints by Pablo Picasso, which the company has stored in a vault
for a number of years. The company originally acquired the prints for $500,000, and
they have a fair market value as of the date of dividend declaration of $4,000,000.
NOTES
ABC records the following entry as of the date of declaration to record the change
in value of the assets, as well as the liability to pay the dividends:
Debit Credit
Long-term investments - artwork 3,500,000
Gain on appreciation of artwork 3,500,000
Debit Credit
Retained earnings 4,000,000
On the dividend payment date, ABC records the following entry to record
the payment transaction:
Debit Credit
Long-term investments - artwork 4,000,000
Scrip Dividend
ABC International declares a $250,000 scrip dividend to its shareholders that has a
10 percent interest rate. At the dividend declaration date, it records the following
entry:
Debit Credit
Retained earnings 250,000
Notes payable 250,000
The date of payment is one year later, so that ABC has accrued $25,000 in Check Your Concept
interest expense on the notes payable. On the payment date (assuming no prior
6. What are the different
accrual of the interest expense), ABC records the payment transaction with this forms of stable dividend?
entry:
7. What is optimum
Debit Credit dividend payout ratio?
Notes payable 250,000 8. Differentiate between

cash and stock dividend?
Interest expense 25,000
9. What is stock buy back?
Cash 275,000
Dividend Decision Liquidating Dividend
ABC International's board of directors declares a liquidating dividend of
INR 1,600,000. It records the dividend declaration with this entry:
Debit Credit
NOTES Additional paid-in capital 1,600,000
On the dividend payment date, ABC records the following entry to record
the payment transaction:
Debit Credit
Cash 1,600,000
13.7 Bonus Shares

Bonus share is also referred as stock dividend. It involves payment to existing owners
of dividend in the form of shares. It is an integral part of dividend policy of a firm to
use bonus shares and stock splits. Bonus shares may be issued to satisfy the existing
shareholders in a situation where cash position has to be maintained. Thus when the
additional shares are allotted to the existing shareholders without receiving any
additional payment from them, it is known as issue of bonus shares. Bonus shares
are allotted by capitalizing the reserves and surplus.
Issue of bonus shares results in the conversion of the company's profits into
share capital. Therefore it is termed as capitalization of company's profits. Since
such shares are issued to the equity shareholders in proportion to their holdings of
equity share capital of the company, a shareholder continues to retain his / her
proportionate ownership of the company. Issue of bonus shares does not affect the
total capital structure of the company. It is simply a capitalization of that portion of
shareholders' equity which is represented by reserves and surpluses. It also does
not affect the total earnings of the shareholders. Issue of Bonus Shares is more or
less a financial gimmick without any real impact on the wealth of the shareholders.
Still firms issue bonus shares and shareholders look forward to issue of bonus shares.
13.7.1 Reasons for issuing Bonus Shares

The bonus issue tends to bring the market price per share within a more reasonable
range.
1. It increases the number of outstanding shares. This promotes more active trading.
2. The nominal rate of dividend tends to decline. This may dispel the impression of
profiteering.
3. Share capital base increases and the company may achieve a more spectacular Dividend Decision
size in the eyes of the investing company.
4. Shareholders regard a bonus issue as a strong indication that the prospects of
the company have brightened and they can reasonably look for an increase in
total dividend.
NOTES
5. It improves the prospects of raising additional funds.
13.7.2. Stock Splits

In a stock split the face value per share is reduced and the number of shares is
increased proportionately. A stock split is similar to a bonus issue from economic
point of view. But there are some differences from the accounting point of view.
The difference between Bonus Issue and Stock Split is given below.
Bonus Issue Stock Split

1. The par value of share is unchanged. 1. The par value of share is reduced.
2. A part of the reserves is capitalized. 2. There is no capitalization of reserves.
13.7.3 Advantages of bonus shares to Company

Following are the important advantages of bonus issue to the company.
1. Conservation of Cash: Issue of bonus shares does not involve cash outflow.
The company can retain earnings as well as satisfy the desire of the shareholders
to receive dividend.
2. Keeps the EPS at a reasonable level: A company having high EPS may face
problems both from employees and consumers.
Employees may feel that they are underpaid. Consumers may feel that they are
being charged too high for the company's products. Issue of bonus shares
increases the number of shares and reduces the earning per share.
3. Increases the marketability of company's shares: Issue of bonus
shares reduces the market price per share. The price of the share may come
within the reach of ordinary investor. This increases the marketability of shares.
4. Enhances prestige of the company: By issuing bonus shares, the
company increases its credit standing and its borrowing capacity. It reflects
financial strength of the company.
5. It helps in financing its projects: By issuing bonus shares, the expansion and
modernization programmes of a company can be easily financed. The company
need not depend on outside agencies for finances.
6. Retention of managerial control: Any new issue of shares has a danger of
dilution of managerial control over the company. Since, bonus shares are issued Corporate Finance : 221
Dividend Decision to the existing shareholders in proportion to their current holdings; there is no
threat of dilution of managerial control over the company.
13.7.4 Advantages of Bonus Issue to shareholders

1. Tax benefits: When a shareholder receives dividend in cash, it adds to his
NOTES total income and is taxed at usual income tax rates. From this point of view the
bonus shares increase the wealth of shareholders. In case the shareholder
requires cash he can sell his additional shares.
2. Indication of higher future profits: Issue of bonus shares is generally an
indication of higher future profits.
This is because a company declares a bonus issue only when its earnings are
expected to increase.
3. Increase in future dividend: The shareholder will get more dividends in the
future even it the company continues to offer existing cash dividend per share.
4. High psychological value: Issue of bonus shares is usually perceived positively
by the market. This tends to create greater demand for the company's shares.
In fact, always the share prices rise at the declaration of bonus shares.
13.7.5 Limitations of Bonus Issues to the Company

1. Issue of bonus shares leads to an increase in the capitalization of the company.
The increased capitalization can be justified only if there is increase in the
earning capacity of the company.
2. After the issue of the bonus shares the shareholders expect the existing rate of
dividend per share to continue. It is really a challenging task for the company to
retain the existing rate of dividend per share.
3. Issue of bonus shares prevents new investors from becoming the shareholders
of the company (no doubt they can buy the shares in the secondary market).
13.8 Key Terms

• Stock dividend: Payment of a dividend in the form of stock rather than cash. A
stock dividend comes from treasury stock, increasing the number of shares
outstanding, and reduces the value of each share.
• Stripped common shares: Entitle shareholders to receive either all the dividends
from one or a group of well-known companies or an installment receipt that
packages any capital gain in the form of a call option.
• Stock split: The increase in the number of outstanding shares of stock while
making no change in shareholders' equity.
• Homemade dividends: An individual investor can undo corporate dividend
policy by reinvesting excess dividends or selling off shares of stock to receive a Dividend Decision
desired cash flow.
• Ex-dividend date: Date four business days before the date of record for a
security. An individual purchasing stock before its ex-dividend date will receive
the current dividend.
NOTES
• Declaration date: Date on which the board of directors passes a resolution to
pay a dividend of a specified amount to all qualified holders of record on a
specified date.
• Dividend payout ratio: The dividend payout ratio measures the percentage of
a company's net income that is given to shareholders in the form of dividends.
• Qualified Dividend: A type of dividend to which capital gains tax rates are
applied. These tax rates are usually lower than regular income tax rates.
• Dividend yield: A financial ratio that shows how much a company pays out in
dividends each year relative to its share price. In the absence of any capital
gains, the dividend yield is the return on investment for a stock.
• Clientele Effect: The theory that a company's stock price will move according
to the demands and goals of investors in reaction to a tax, dividend or other
policy change affecting the company. The clientele effect assumes that investors
are attracted to different company policies, and that when a company's policy
changes, investors will adjust their stock holdings accordingly. As a result of this
adjustment, the stock price will move.
13.9 Summary
• Dividend is the portion of profit which is distributed amongst its shareholders on
the recommendation of board of directors. It can either be paid in cash or in the
form of shares.
• The Dividend Decision, in corporate finance, is a decision made by the directors
of a company about the amount and timing of any cash payments made to the
company's stockholders. The Dividend Decision is important as it may influence
its capital structure and stock price of any company.
• On the basis of impact of dividend payout on firm value, there are two different
and conflicting schools of thought: relevance and irrelevance dividend theories.
According to one school of thought the dividends are irrelevant and the amount
Check Your Concept
of dividends paid does not affect the value of the firm while the other theory
considers that the dividend decision is relevant to the value of the firm. 10. Differentiate between
bonus issue and stock
• According to Modigliani and Merton Miller value of the firm is determined by split?
the basic earning power, the firm's risk and not by the distribution of earnings.
11. Why companies issue
The value of the firm therefore depends on the investment decisions and not
bonus shares.
the dividend decision.
• The Walter approach is based on the cost of equity and the rate of return on Corporate Finance : 223
Dividend Decision reinvestment. In case of higher reinvestment rate compare to cost of capital,
firm value can be increased by retaining the profit. In opposite situation, firm
should prefer the higher pay out for increasing firm value.
• Gordon approach based on bird-in-the-hand theory advocate that shareholders
are risk-averse and prefer to receive dividend payments rather than future
NOTES capital gains. That is why market price of shares of high-payout companies will
command premium.

1. A company earns 10% against a required rate of return of 8%. The EPS is Rs
8 with a 60% dividend pay-out ratio. Find the value of its share using:
a. Walter's model; and
b. Gordon's model.
2. EPS is Rs 20. Capitalization rate is 12.5%. IRR is 14%. Determine the pay-
out ratio and the price of shares at this pay-out ratio based on Walter's theory.
3. If a share of a company is selling for Rs 100. The company is going to declare
dividend for Rs 7 per share. The capitalization rate is 10%. Find the
shareholders' wealth in case of dividend/no dividend.
4. A company has Rs 50,000 shares. Its earnings and investment requirements
are as follows:
Year Earnings (Rs) Investment (Rs)

1 100000 120000
2 100000 110000
3 100000 60000
4 100000 40000
Find dividend per share based on the residual theory of dividend.

5. What are the factors that affect dividend policy? Briefly describe each of
them.
6. What are the different pay out methods? Explain effect of different pay out
methods on shareholders.
7. Explain the advantages and disadvantages of Bonus shares.
8. Why do firms issues stock dividends? Also explain the other mode of dividend
payment.
9. What do you mean by share buy-back? Is it related to the dividend policy?
10. Critically evaluate the MM's dividend irrelevance hypothesis. Also explain its
underline assumption.
Dividend Decision
13. 11 Further Readings and And References
Books:
TMH Publication.
NOTES
Publication.
Publication
Ltd, New Delhi.
Web resources:
1. Bhattacharya, S. (2012). 'Why Companies Do and Do Not Pay
Dividends', Forbes India. Available at http://forbesindia.com/column/
column/why-companies-do-and-do-not-pay-dividends/33650/1
2. DeAngelo, H., DeAngelo, L, Stulz, R. (2006). "Dividend policy and
the earned/contributed capital mix: a test of the life-cycle theory",
Journal of Financial Economics 81, pp. 227-254.
3. Feldstein, Martin, and Jerry Green. 1983. Why do companies pay
dividends? American Economic Review Issue, 73, No.1, pp. 17-30.
4. Dividend Policy: Its Impact on Firm Value (Harvard Business School
Press, Boston, Massachusttes).
5. Malkawi, H., Raffery, M., Pillai, R., (2010). Dividend Policy: A Review
of Theories and Empirical Evidence, International Bulletin of Business
Administration, Issue 9.

Working Capital Management
UNIT 14 : WORKING CAPITAL MANAGEMENT
Structure
14.0 Introduction
14.1 Unit Objectives NOTES
14.2 Concepts of Working Capital
14.2.1 Gross Working Capital
14.2.2 Net Working Capital
14.3 Importance of Working Capital
14.3.1 The Dangers of Excessive Working Capital
14.3.2 The Dangers of Inadequate Working Capital
14.4 Operating and Cash Conversion Cycle
14.5 Determinants of Working Capital
14.6 Estimating Working Capital Needs
14.6.1 Conservative Approach
14.6.2 Components Approach
14.6.3 Operating Cycle Approach
14.6.4 Ratio of Current Assets to Fixed Assets
14.6.5 Current Assets Holding Period
14.7 Financing of Working Capital
14.7.1 Principles of Working Capital Finance
14.7.2 Approaches for Financing Working Capital
14.7.3 Sources of Working Capital Finance
14.8 Key Terms
14.9 Summary
14.0 Introduction
The assets and liabilities of a business can be classified on the basis of the duration
as fixed assets and current assets and as long-term liabilities and short-term or
current liabilities. The fixed assets are retained in the business to earn profits during
the life of these assets and are not for sale. Examples of fixed assets are land,
building, machinery, long term investments, etc. Short -term assets or current assets
on the other hand are the liquid assets of the company, which are held either in cash
or other forms which can be easily converted into cash within one accounting period,
usually a year. Similarly the long term liabilities are the obligations of the company
Working Capital Management which are repayable over the period greater than the accounting period like the
share capital, debentures, long-term loans, etc. Short -term liabilities or current liabilities
have to be paid within the accounting period and includes sundry creditors, bills
payable, outstanding expenses, short-term loans, etc. Short-term, or current, assets
and liabilities are collectively known as working capital. Table 11.1 show the structure
NOTES of the current assets and current liabilities commonly present.
Table 14.1: Structure of Current Assets and Liabilities
The investment in working capital is the investment in short term assets of

the firm, thus working capital management is the process of planning and controlling
the level and mix of current assets of the firm as well as financing these assets.
Specifically, Working Capital Management requires financial managers to decide
what quantities of cash, other liquid assets, accounts receivables and inventories,
the firm will hold at any point of time. Management of working capital is important
for the business because of two reasons, firstly, the fixed assets can be used at the
optimal level only when they are supported by sufficient working capital and secondly,
the working capital involves investment of funds of the business. If the working
capital is not managed properly it may either end up in unnecessary blocking of the
funds or result in scarce resources that may even lead to insolvency of the firm. The
main aim of this unit is to explore the concept of working capital management, its
importance and various determinants of working capital management.

After studying this unit you should be able to:
• Explain the concept of working capital
• Understand the components of working capital.
• Understand the importance of working capital management in a firm
• Know the concept of operating and cash conversion cycle
• Understand the determinants of working capital
• Understand how the firm estimates its working capital needs
• Explain various sources of financing the working capital. Working Capital Management
14.2 Concepts of Working Capital

There are two concepts of working capital viz. Gross working capital or quantitative
NOTES
and Net Working capital or qualitative.
14.2.1 Gross Working Capital (GWC)

In the broad sense, the term working capital refers to the Gross Working Capital and
represents total amount of funds invested in Current Assets. Gross Working Capital
is the capital invested in total Current Assets of the enterprise. Although Current
Assets vary from industry to industry, they constitute between 50 to 60 per cent of
the total assets of manufacturing concerns. Thus, gross working capital is the total
of all the current assets held by the company and that is why it is also known as
quantitative concept.
Gross Working Capital = Total current Assets
14.2.2 Net working Capital (NWC)

Net Working Capital refers to the difference between Current Assets and Current
Liabilities. It is the excess of total current assets over the total current liabilities. If
the total current assets are more than total current liabilities then the difference is
known as positive net working capital and if the current liabilities are more than the
current assets, the difference is known as negative working capital. The NWC is
termed as the qualitative concept because it indicates the liquidity position of the
firm and also reflects the extent to which the current assets are financed by long
term sources of funds.
Net Working Capital = Total current Assets- Total Current liabilities
The gross working capital is financial or going concern concept while net
working capital is an accounting concept of working capital. These two concepts of
working capital are not exclusive. The net working capital may be suitable only for
proprietary form of organizations such as sole-trader or partnership firms. The gross
concept of working capital, on the other hand, is suitable to the company form of
organization where there is diverse between ownership, management and control.
The task of the financial manager is to keep the working capital at the
efficient level so that there is sufficient liquidity in the firm and the long term sources
of funds are not over invested in current assets. The liquidity of the business is
measured by the ability of the firm to meet its short term obligations when they
become due. The three basic measures of liquidity are:
a. Current Ratio: current assets/current liabilities.
b. Acid -Test (Quick Ratio): Quick Assets / current liabilities
Working Capital Management c. Net working Capital : Current Assets - Current liabilities
Normally the current ratio at the level of 2:1, quick ratio at the level of 1:1
and positive net working capital are considered as good level of working capital.
However, it may change form industry to industry. The concept of gross working
capital and net working capital can be understood form the following example:
NOTES
Example 14.1: Calculation of Working Capital Measurements
Current Assets (in Rs lakhs) Current Liabilities (in Rs lakhs)
Particulars Amount Particulars Amount
Cash 203 Short - term loans 132
Short term financial Accounts payable 356
investments 138
Accounts receivable 470 Accrued income taxes 67
Inventories 455 Current due on long term
debt 83
Other current assets 264 Other current liabilities 575
Total 1530 Total 1214
Solution:
Gross working capital = Total Current Assets = Rs.1,530
Net working capital = Total current Assets - Total Current Liabilities = Rs.1,530 -
Rs.1,214 = Rs.316
Current ratio = current Assets/ Current Liabilities = 1,530 / 1,214 = 1.26
Quick Ratio = (current assets - Inventory- other current assets)/ current liabilities
=Rs 811/1214
= 0.67
14.2.3 Concept of Working Capital on basis of Time

Working Capital, on the basis of time can be categorized as:
A. Permanent or Fixed Working Capital
B. Temporary or Variable Working Capital
A. Permanent Working Capital

Permanent or fixed working capital is minimum amount which is required to ensure
effective utilization of fixed facilities and for maintaining the circulation of current
assets. Every firm has to maintain a minimum level of raw material, work- in-process,
finished goods and cash balance. This minimum level of current assets is called
Corporate Finance : 230 permanent or fixed working capital as this part of working is permanently blocked in
current assets. As the business grow the requirements of working capital also Working Capital Management
increases due to increase in current assets. It is further be classified as regular
Working Capital and reserve Working Capital. Regular Working Capital, as the name
implies, refers to the Working Capital required for regular conduct of operations.
Reserve Working Capital is the excess over the requirements for regular Working
Capital, which may be provided for contingencies, such as strikes and rise in prices. NOTES
B. Temporary or Variable Working Capital

Temporary or variable working capital is the amount of working capital
which is required to meet the seasonal demands and some special exigencies. The
variable working capital can further be classified as seasonal working capital and
special working capital. The capital required to meet the seasonal need of the
enterprise is called seasonal working capital. Special working capital is that part of
working capital which is required to meet special exigencies such as launching of
extensive marketing for conducting research, etc. The requirements of the permanent
and temporary Working Capital are shown in figure below.
Figure 14.1: Working Capital Requirements
14.3 Importance of Working Capital

Working capital requirement of a firm keeps on changing with the change in the
business activity and hence the firm must be in a position to strike a balance between
them. The financial manager should know where to source the funds from, in case
the need arise and where to invest in case of excess funds. The management of
Check Your Concept
working capital is important because the excess of working capital as well as deficit
working capital both can be dangerous for the organization. 1. Difference between
gross and net working
14.3.1 The dangers of excessive working capital capital.
The excessive working capital is the result of over investment in the various 2. Explain the different
components of working capital, i.e. the current assets, like the excess inventory, measures of liquidity.

Working Capital Management long standing debtors. Following are the dangers or drawback of excessive working
capital :
1. It results in unnecessary accumulation of inventories. Thus, the chances
of inventory mishandling, waste, obsolescence, theft and losses increase.
NOTES 2. Excess working capital is an indication of defective credit policy and

slack collection period. Consequently, higher incidences of bad debts
may arise which can adversely affects the profits.
3. It reflects an imbalance between liquidity and profitability.
4. It means funds are idle and when funds are idle no profit is earned. The
rate of return on its investments goes down.
5. It leads to greater production, which may not have matching demand.
6. The excess of working capital may lead to carelessness about cost of
production. It makes the management complacent which degenerates
into managerial inefficiency.
14.3.2 The dangers of inadequate working capital

1. It results in stagnation of growth because it becomes difficult for the
firms to undertake profitable projects due to non-availability of the funds.
2. It becomes difficult to implement operating plans and achieve the firms
profit targets
3. Operating inefficiencies creep in when it becomes difficult even to meet
day-to-day commitments.
4. Fixed assets are not efficiently utilized. Thus the rate of return on
investment slumps.
5. Due to inadequate working capital, the firm will be unable to avail attractive
credit opportunities etc.
6. The firm loses its reputation when it is not in position to honor its short-
term obligations. This may result into tight credit terms the firm.
14.4 Operating and Cash Conversion Cycle

Sales are foremost requirement for any business to earn profits. Sales provide the
business with the cash which is used to carry out the various activities of the business.
However, the sale does not get converted into cash immediately and there is time
lag between the sales of goods and services and the receipts of cash. The working
capital need arises to manage the current assets resulting form the lag between
sales and realization of cash. This time lag is referred to as the operating cycle.
Thus the operating cycle is the time duration starting from the procurement of the
goods and raw materials and ending with the realization of cash from sales. While
the operating cycle is the time period from inventory purchase until the receipt of
cash, the cash cycle is the time period from when cash is paid out, to when cash is
received. Though, the operating cycle and cash cycle are at time used
interchangeably. The working capital requirement of the firm depends to a large
NOTES
extent upon the operating cycle and cash cycle of the firm. The operating cycle and
cash cycle of a manufacturing company involves three phases.
1. Conversion of cash into inventory: Acquisition of resources such as raw
materials, labor, power and fuel.
2. Conversion of inventory into receivables: Manufacture of the product,
which includes conversion of raw materials into work-in-progress, work-
in-progress into finished goods and then into sales.
3. Conversion of sales/ receivables into cash: Sale may be either for Cash
or on credit. Credit sales create accounts receivable for collection.
Figure 14.2: Operating Cycle

(Source: Ravi M. Kishore, "Financial Management", Taxmann publication)
The control of working capital is ensuring that the company has enough cash in its
bank. This will save on bank interest and charges on overdrafts. The company also
needs to ensure that the levels of inventories and trade receivables is not too great, as
this means funds are tied up in assets with no returns (known as the opportunity cost).
The working capital cycle therefore should be kept to a minimum to ensure efficient
and cost effective management. Operating cycle for a trade is calculated as:
Net Operating cycle =ICP (Inventory conversion Period)

+DCP (Debtors Conversion Period)- DP(Days Payable)
a. Inventory Conversion Period (ICP)

It is the total time needed for producing and selling the product which includes
Working Capital Management raw materials conversion period (RMCP), work-in-progress conversion period
(WIPCP) and finished goods conversion period (FGCP). Raw Material
Conversion Period refers to the period in which the raw materials are generally
kept in stores before they are issued for manufacturing to production department.
Work-in-Progress Conversion Period refers to the period for which the raw
NOTES material remains in the manufacturing process before it is taken out as finished
product. Finished Goods Conversion Period refers to the period for which finished
products remain in stores before being sold to a customer.
Inventory conversion period (in days) = Inventory/ (Cost of Sales/365) = 365/
Inventory Turnover
b. Debtors Conversion Period (DCP)

It is the time required to collect the outstanding amount from customers.
Debtors conversion Period (in days) = Receivables/ (Sales/365) = 365/
Receivables Turnover
c. Days Payable (DP)

The Payable Deferred Period (PDP) is the length of time the firm is able to
delay payments on various resource purchases.
Days Payable (in days) = Accounts Payable / (Purchases/365) = 365/Payables
Turnover
The total of inventory conversion period and debtors' conversion period is referred
to as Operating Cycle (OC) and symbolically represented as:
Operating Cycle (OC) = RMCP + WIPCP + FGCP + DCP
The difference between operating cycle and the payable period is Cash Cycle (CC).
Cash cycle is also termed as net operating cycle, asset conversion cycle, working
capital cycle or cash conversion cycle. Thus,
Cash Cycle (CC) = OC - CDP
The various terms in the orating cycle are calculated as under:
Average Stock of Raw materials

RMCP =
Raw materials consumption per day
Average Stock of Work-in-progress

WIPCP =
Total cost of production per day
Average Stock of Finished Goods

FGCP =
Total cost of Sales per day

Average Accounts Receivable Working Capital Management
DCP =
Net Credit Sales per day
Average Payments
CDP =
Net Credit Purchases per day NOTES
Where;
RMCP = Raw Material Conversion Period
WIPCP = Work- in- Progress Conversion Period
FGCP = Finished Goods Conversion Period
DCP = Debtors Conversion Period
CDP= Creditors Deferral Period
Example 14.2
DX had the following balances in its trial balance at 31 March 2010. You are required
to calculate the length of DX's working capital cycle.
Trial balance extract at 31 March 2010
Sales Revenue 2,40, 000
Cost of sales 1,40, 000
Purchases in the year 1,60,000
Inventories 36, 000
Trade receivables 29,000
Trade payables 19,000
Cash and cash equivalents 9,500
Solution
Check Your Concept
a. Inventory Conversion Period (ICP) = (Inventory/ Cost of sales ) x365 =
(36,000/140000)x 365 = 93.86 days
between temporary
b. Debtors Conversion Period (DCP) = (Trade receivables / credit sales) x and permanent working
365 days = (29,000/240,000)x365 = 44.10 days capital?
c. Creditors Payable Period (CDP) = (Trade payables / purchases) x 365 4. What are the
days = (19,000/160,000)x365 = 43.44 days disadvantages of excess
Operating Cycle = ICP (Inventory conversion Period) +DCP (Debtors working capital?
Conversion Period) = 93.86 days + 44.10 days = 137.96 = 138 days 5. Explain the components
Cash Conversion Cycle =ICP (Inventory conversion Period) +DCP of operating cycle.
(Debtors Conversion Period) - CDP (Creditors Payable Period) = 93.86
Working Capital Management days + 44.10 days - 43.44 days = 94.52 = 95 days
From the above example it is clear that it takes 95 days to the company
from procurement of its raw material to finally realize the cash on sales
of goods.
NOTES 14.4.1 Length of the operating and Cash Cycle

The shorter operating and cash cycles are considered better than longer cycles
because, the shorter the cycle, the better it is for the company as it means:
a. Inventories are moving though the organization rapidly. The risk of
wastage, obsolesce of inventory and theft are reduced.
b. Trade receivables are being collected quickly. The risk of bad debt
reduces.
c. The organization is taking the maximum credit possible from suppliers.
The firm can utilize cash for a longer period.
d. The shorter the cycle, the lower the company's reliance on external
supplies of finance like bank overdrafts which is costly.
Excessive working capital means too much money is invested in inventories
and trade receivables. This represents lost interest or excessive interest paid and
lost opportunities (the funds could be invested elsewhere and earn a higher return.
The longer operating and cash cycle means the investment of more funds in working
capital and hence more working capital is required to finance it.
14.5 Determinants of Working Capital

The management of current assets, current liabilities and inter-relationship between
them is termed as working capital management. In other words, working capital
management is concerned with problems that arise in attempting to manage the
current assets, the current liabilities and the inter-relationship that exist between
them". The two aspects of working capital management are: (a) to determine the
magnitude of current assets or "level of working capital" and (b) to determine the
mode of financing or "hedging decisions."
In practice, there is no set of universally acceptable rules to ascertain the
working capital needs of a business organization. The following is the description of
factors, which generally influence the working capital requirements of firms.
a. Nature of Business
The working capital requirements of a firm basically depend upon the nature
of its business. The two relevant features in the nature of the business are
the cash nature of the business that is cash sale and the sale of services
instead of commodities. Public utility undertakings like electricity, water supply
and railways need very limited working capital because they offer only cash Working Capital Management
sales and supply services. As such no funds are tied up in inventories and
receivables. Similarly, the working capital needs will be eats in the hotels,
restaurants and eating houses. On the other hand, trading and financial firms
require less investment in fixed assets, but have to invest large amount in
Current Assets like materials, receivables and cash. The manufacturing firms NOTES
also require sizable working capital along with fixed investments.
b. Size of Business/Scale of Operation
Generally, the greater the size of a business unit, the larger will be the
requirements of working capital. Though, in some cases a smaller concern
may also need more working capital due to high overhead charges, inefficient
use of available resources and other economic disadvantages of small size.
c. Production Policy
The working capital needs are affected by the production policy. For example,
in certain business lines the demand is subject to wide fluctuations due to
seasonal variations, and the requirement of working capital depends upon the
production policy. Production could be kept either steady by accumulating
inventories during slack periods with a view to meet high demand during the
peak season or the production could be curtailed during the slack season and
increased during the peak season. If the policy is to keep production steady
by accumulating inventories it will require higher working capital.
d. Length of Production Cycle
The production cycle refers to the time involved in the manufacture of goods.
It covers the time period from procurement of the raw materials and completion
of the manufacturing process leading to the production of finished goods.
The requirement of working capital increases in direct proportion to the length
of manufacturing process. The longer the process period of manufacture, the
greater will be the amount of working capital required.
e . Availability of Raw Materials
In certain industries raw materials are not available throughout the year.
They have to buy raw materials in bulk during the season to ensure an
uninterrupted flow and process it during the entire year. A huge amount is
blocked in the form of material inventories during such season which gives
rise to more working capital requirements. This uncertainty leads to the
business having larger working capital requirements in the busy season than
in the slack season.
f. Working Capital Cycle
In a manufacturing concern the working capital cycle starts with the purchase
of raw materials and ends with the realization of cash from the sale of finished
products. The speed with which the working capital completes one cycle Corporate Finance : 237
Working Capital Management determines the requirement of working capital. The larger the period of cycle,
the greater will be the requirement of working capital.
g. Rate of Stock Turnover
There is a high degree of inverse relationship between the quantum of working
NOTES capital and the velocity or speed with which the sales are affected. A firm
having a high rate of stock turnover will need lower amount of working capital
as compared to a firm having a low rate of turnover.
h. Credit Policy
In some firms most of the sale is at cash and even it is received in advance
while, in other sales is at credit and payments are received only after a month
or two. In former case less working capital is needed than the later. The
credit terms depend largely on norms of industry but enterprise some flexibility
and discretion. The credit policy affects the requirements of working capital
in two ways: (1) through credit terms granted by the firm to its customers/
buyers of goods and services and (2) credit terms available to the firm from
its creditors. In order to ensure that unnecessary funds are not tied up in book
debts, the enterprise should follow a rationalized credit policy based on the
credit standing of the customers and other relevant factors.
i. Business Cycle
Business cycle refers to alternate expansion and contraction in general business
activity. The period of boom or upward phase, the larger amount of working
capital is required. On the contrary, in times of depression or downswing
phase firms the demand is less and the sale tends to fall and the need for
working capital declines.
j. Growth Rate
The working capital requirements of a concern increases with the growth
and expansion of its business activities. In a fast growing concern large amount
of working capital is required even though the relationship between the growth
in the volume of business and the growth in the working capital is difficult to
determine. The critical fact, however, is that the need for increased working
capital funds does not follow growth in business activities but precedes it. It
is clear that advance planning is essential for a growing concern.
k. Earning Capacity and Dividend Policy
The levels of profits differ from one enterprise to another. The net profit is
the source of working capital to the extent it is earned in cash. Thus, the high
profit margins improve the prospects of generating more internal funds and
contributing to the working capital pool. Firms with high earning capacity
may generate cash profits from operations and contribute to the working
capital. Likewise, the payment of dividend has also the bearing on the working
capital. The payment of dividend requires cash and affects the working capital
Corporate Finance : 238 to that extent. Thus a firm that maintains a steady high rate of cash dividend,
irrespective of its quantum of profits, had less funds available for working Working Capital Management
capital and its working capital investment is reduced.
l. Price Level Changes
Generally the rising prices will require the firm to maintain larger amount of
Working Capital as more funds will be required to maintain the same Current NOTES
Assets. Some firms may be affected much while some others may not be
affected at all by the rise in prices.
m. Taxation Rate
Taxes are the first appropriation of profits and the management has no
discretion in this respect. The payment of taxes is often made in advance and
the firm needs to make provisions for taxation in advance. Since the tax
liability is short term liability and paid in cash, if the tax liability increases, it
leads to the increase in working capital requirements and vice versa.
n. Management ability
Proper co-ordination in production and distribution of goods may reduce the
requirement of working capital, as minimum funds will be invested in absolute
inventory, non-recoverable debts, etc.
o. Other factors
Certain other factors such as operating efficiency, management ability,
irregularities of supply, import policy, assets structure, importance of labor
and banking facilities, depreciation policy followed by the firm also influence
the requirements of Working Capital.
14.6 Estimating Working Capital Needs

There are various approaches which have been applied in practice for estimating
the working capital needs of a firm, some of them in brief are explained as follows:
14.6.1 Conservative Approach

The conservative approach states that the proportion of current assets to current
liabilities should be kept at 2:1. If this proportion is to be kept the firm would be able
to meet its obligations on time and hence its financial solvency would not be in
trouble. However, the limitation of this approach is that it suggests only quantitative
measure. It does not suggest as to what type of assets are to be included in current
assets. If the current assets contain stock, which is outdated or receivable which
are not collectable, than the amount of current assets has no meaning. Further, in the
present scenario no firm maintains this ratio, as it's too difficult for them to maintain
such a high level of current assets

Working Capital Management 14.6.2. Components Approach
In this method, firm use one of the planning models of working capital to estimate
working capital. The method adopted here attempts at estimation of working capital
and its components by taking into account, the period for which the various items
remain as stock or as outstanding, the cost structure of production and annual
NOTES
production. It assumes even production and even sales, throughout and what is
produced is completely sold.
14.6.3. Operating Cycle Approach

As referred earlier also that working capital is also known as revolving capital. That
is, a circular path of conversion/re-conversion takes place. Once complete processing
is done, company get finished goods. Until these goods are sold, they remain in
stock. Sales may be for cash and/or on credit basis. Firm need to wait a little to
realize cash from the credit customers. The realized cash is used to pay creditors.
Firm need to maintain a cash balance for day-to-day transactions as well as for
meeting sudden spurt in payment obligations accompanied by sluggish cash collections
from debtors. Thus, a revolution or cycle from cash to raw materials to Work in
Progress (WIP), to finished goods, to debtors, and back to cash is taking place. This
revolution or cycle is known as operating cycle.
Working Capital Requirement = (Estimated cost of goods sold x Operating

Cycle) + Desired Cash Balance
14.6.4 Ratio of Current Assets to Fixed Assets

The financial manager should determine the optimum level of current assets so that
the wealth of shareholders is maximized. In a business enterprise both fixed and
current assets are needed to support a particular level of output. However, to support
the same level of output, the firm can have different levels of working capital. Thus
the level of current assets can be measuring the current assets to fixed assets i.e. by
measuring the ratio of current assets to fixed assets. Dividing current assets by
fixed assets gives the ratio of Current Assets to Fixed Assets. From the viewpoint of
this ratio, there are three types of approaches:
• Conservative approach: Many firms maintain a high ratio of current
assets to fixed assets so that they may not have any difficulty even in
crisis. It suggests greater liquidity and lower risk. Risk adverse firms
mainly adopt this approach.
• Aggressive approach: Many firms maintain low ratio of current assets
to fixed assets, so that their funds may not block idle and they can be
used for some profitable purpose. It involves higher risks and smaller
liquidity.
• Moderate Capital approach: Most of the firms maintain their current
level between these two extreme levels. This is a moderate capital
Corporate Finance : 240 approach. This involves moderate liquidity and moderate risk.
NOTES
Figure 14.3: Investment in working capital

(Source: http://www.mbaknol.com/financial-management/estimation-of-
working-capital-requirements/2/)
14.6.5 Current Assets Holding Period

In this method the working capital requirements are to be estimated on the basis of
average holding period of current assets and relating them to costs based on the
firm's experience in the previous years. This method is essentially based on the
operating cycle concept. A modified version of this method is also used by various
firms, in which the current assets are carefully estimated and at the same time the
current liabilities are also to be estimated. The difference between two gives a
rough idea about the net working capital requirements of the firm. The various
components of current assets and current liabilities are to be estimated for estimating
the working capital requirements are estimated as under:
1. Stock of Raw Materials = No. of Units Produced × Per Unit Cost of
Raw materials × Average holding period of raw materials
2. Work in Progress =
i. Materials : No. of Units Produced × Per Unit Cost of Raw materials
× Average period of Raw materials in process
ii. Labor : No. of Units Produced × Per Unit Cost of Labor ×Average
of period of Labor in process
iii. Overheads: No. of Units Produced × Per Unit Cost of Overheads×
Average of period of Overheads in process
Generally, the WIP is to be taken as half a month's raw material
cost and one month's labor and variable cost. Check Your Concept
3. Finished Goods = No. of Units Produced × Per Unit Total Cost 6. Advantages and
disadvantages of conser-
4. Sundry Debtors = No. of Units Sold ×Period of credit given to debtors × vative approach?
Total Cost of Production
Profit is not to be considered for calculating the outstanding debtors. On credit deferral period?
the same way only the sales which are made on credit are to be 8. Explain the factos
considered. Thus the cash sales are to be deducted before estimating affecting working
capital requirement.
the debtors.
5. Sundry Creditors = No. of Units Produced × Per unit cost of raw materials
× Credit period allowed by the suppliers Corporate Finance : 241
Working Capital Management 6. Outstanding Wages and Overheads = No. of Units Produced × per unit
cost of Wages and Overheads × Time lag in payment of Wages and
Overheads.
After estimating the components of current assets and current liabilities a
Statement Showing the Working Capital Requirement is to be prepared as
NOTES under:
Table 14.2 Statement Showing Requirement of Working Capital
Particulars Rs. Rs.
Current Assets :
1. Stock of Raw Materials
2. Stock of Work in progress :
3. Material Cost
4. Wages
5. Overheads
6. Stock of Finished Goods (at cost of production)
7. Debtors
8. Minimum Cash required
9. Advance Payments
Total Current Assets (A)
Current Liabilities :
Creditors for purchases
Outstanding wages and overheads
Advance received from customers
Total Current Liabilities (B)
Total Working Capital Requirement (A - B)
Example 14.3
ABC Company is new business which wants to know its working capital requirements for
next year. The following information is available about the projections for the current year:
Per unit
Elements of cost: (Rs.)
Raw material 40
Direct labor 15
Overhead 30
Total cost 85
Profit 15
Sales 100
Other information Working Capital Management
Raw material in stock: average 4 weeks consumption, Work - in progress (completion

stage- 50 per cent) on an average half a month. Finished goods in stock: on an
average, one month. Credit allowed by suppliers is one month. Credit allowed to
debtors is two months. Average time lag in payment of wages is 1½ weeks and 4
NOTES
weeks in overhead expenses. Cash in hand and at bank is desired to be maintained
at Rs. 50,000. All Sales are on credit basis only. You are required to prepare statement
showing estimate of working capital needed to finance an activity level of 96,000
units of production. Assume that production is carried on evenly throughout the year,
and wages and overhead accrue similarly. For the calculation purpose 4 weeks may
be taken as equivalent to a month and 52 weeks in a year.
Solution
Calculation of Working Capital Requirement
(A) Current Assets Rs. Rs.
i. Stock of material for 4 weeks (96,000 x 40 x 4/52) 2,95,385
ii. Work in progress for ½ month or 2 weeks
Material (96,000 x 40 x 2/52) x 0.5 73,846
Labor (96,000 x 15 x 2/52) x 0.5 27,692
Overhead (96,000 x 30 x 2/52) x0.5 55,385 1 56,923
iii. Finished stock (96,000 x 85 x 4/52) 6,27,692
iv. Debtors for 2 months (96,000x 85 x 8/52) 12,55,385
Cash in hand or at bank 50,000
Investment in Current Assets 23, 85,385
(B) Current Liabilities
i. Creditors for one month (96,000 x 40 x 4/52) 2,95,385

ii. Average lag in payment of expenses
Overheads (96,000 x 30 x 4/52) 2, 21,538
Labor (96,000 x 15 x 1.5/52) 41,538 2, 63,076
Current Liabilities 5,58,461
Net working capital requirement (A - B) 18, 26,924

14.7 Financing of Working Capital
Financing of working capital is another important aspect of working capital
management. After determination of working capital requirement, company need to
make arrangement of financing. There are various sources of financing the working
NOTES capital and so the management is required to decide the mix of sources that result in
least cost of financing the working capital and are sufficient to finance it.
14.7.1 Principles of Working Capital Finance

a. Principle of Risk Variation
Risk variation refers to an ability of a firm to maintain sufficient Current
Assets to pay for its obligations. If Working Capital varied in relation to
sales, the amount of risk that a firm assumes is also varied and the opportunity
for gain or loss is increased. It means that there is a definite relationship
between the degree of risk and the rate of return.
b. Principle of Equity Position
The amount of Working Capital invested in each component should be
adequately justified by a firm's equity position. Every paisa contributed in the
Working Capital must contribute the Net Working Capital of the firm.
c. Principle of Cost of Capital
It emphasizes the different sources of finance and each source has a different
cost of capital. The cost of capital moves inversely with risk. As such
additional risk capital results in the decline in the cost of capital.
d. Principle of Maturity of Payments
A firm should make every attempt to relate maturities of payments to its
flow of internally created funds. The failure to meet such a match of generation
to outside demand would accentuate the risk.
14.7.2 Approaches for financing working capital

Depending on the mix of short and long term financing, there are three basic
approaches.
a. Matching or Hedging Approach
The term hedging is very often used in the sense of risk reducing investment
strategy involving transactions of a simultaneous but opposing nature so that
the loss arising out of one transaction is likely to offset in the other due to the
financing mix. The term hedging can be said to refer to the process of matching
maturities of debt with the maturities of financial needs. That is why it is
called matching approach. According to this approach, the maturity of the
sources of funds should match the nature of the assets to be financed. For
analytical purpose current assets can be broadly classified into:
i. Those, which require certain amount for given level of operation and Working Capital Management
hence do not vary over time.
ii. Those, which fluctuates over time.
This approach suggests that long-term funds should be used to finance
the fixed portion of Current Assets requirements as spelt out in a manner
NOTES
similar to the financing of fixed assets. The purely temporary requirement
that is the seasonal variation over and above the permanent financing
needs should be appropriately financed with short-term funds or Current
Liabilities.
Figure14.4: Matching/Hedging Approach of Working Capital Management
b. Conservative Approach
The financing policy of the firm is said to be conservative when it depends
more on long-term funds for financing needs. Under this approach, the firm
finances its permanent assets and also a part of temporary Current Assets
with long-term financing. In the periods when the firm has no need for
temporary Current Assets, the idle long-term funds can be invested in tradable
securities to conserve liquidity.
Figure 14.5: Conservative approach of Working Capital Management

c. Aggressive Approach
A firm may be said to be adopting an aggressive policy when it used more of
short-term financing than warranted by the matching plan. Under this
approach, the firm finances a part of its permanent Current Assets with Corporate Finance : 245
Working Capital Management short-term financing. Some extremely aggressive firms may even finance a
part of their fixed assets with short-term financing. Relatively more the use
of short-term financing makes the firm more risky.
NOTES
Fig.14.6: Aggressive Approach of Working Capital management
14.7.3 Sources of Working Capital Finance

The working capital can be financed using the long terms sources as well as current
sources.
Sources of financing Permanent or Fixed Working Capital
• Shares: The most important source for the permanent or long-term
working capital is the issue of equity, preference and deferred shares.
• Debentures: Another important source for raising the permanent
working capital is the issue of debentures, which means a debt where
the debenture holder is considered as the creditor of the company.
• Retained Earnings: Otherwise called ploughing back of profits. It
means the reinvestment by the company's surplus earnings in its business.
• Loans from Financial Institutions: Financial institutions such as
Commercial banks, Life Insurance Corporation of India, Industrial
Finance Corporation of India, State Finance Corporation, Industrial
Development Bank of India, etc., also provide term loans for working
capital needs.
• Public Deposits (Fixed): These deposits are fixed in nature and are
accepted by a business enterprise directly from the public.
Sources of financing temporary or variable or short-term Working Capital
• Commercial Banks: The major portion of working capital needs is
provided by the commercial banks. The different forms of credit offered
by banks are loans and advances, cash credits, overdrafts and purchasing,
factoring, forfeiting key Cash credit, transit receipt and discounting bills.
• Indigenous Bankers: Private moneylenders and other country bankers
are also used to be a source of finance prior to the establishment of
Corporate Finance : 246 commercial banks. Even now, some business houses depend upon them.
• Trade credit: It refers to the credit extended by the suppliers of goods Working Capital Management
in the normal course of business. It may also take the form of an open
account or bills payable.
• Installment credit: Under this source the assets are purchased and
possession of goods is taken immediately but the payment is made in
NOTES
installment over a period of time.
• Advances: Receiving of payment in advance from customers and agents
against order of goods.
14.8 Key Terms

• Aggressive Policy: An aggressive policy with regard to the level of
investment in working capital means that a company chooses to operate
with lower levels of inventory, trade receivables and cash for a given
level of activity or sales.
• Cash Cycle: cash cycle is the time period from when cash is paid out,
to when cash is received.
• Conservative Policy: A conservative and more ?exible working capital
policy for a given level of turnover would be associated with maintaining
a larger cash balance, perhaps even investing in short-term securities,
offering more generous credit terms to customers and holding higher
levels of inventory.
• Current Assets: The assets that will be converted into cash within the
accounting period which is one year.
• Current Liabilities: The liabilities which are payable within the
accounting period which is one year.
• Factoring: Factoring entails the sale of accounts receivable to another
firm, called the factor, who then collects payment from the customer.
• Line of Credit: A line of credit is an open-ended loan with a borrowing
limit that the business can draw against or repay at any time during the
loan period. This arrangement allows a company flexibility to borrow
funds when the need arises for the exact amount required.
• Matching Approach: A loan whose purpose is finance everyday
operation of a business.
• Moderate Policy: A moderate policy would tread a middle path between Check Your Concept
the aggressive and conservative approaches. 9. What is the matching
approach of working
• Operating Cycle: the time duration starting from the procurement of
capital management?
the goods and raw materials and ending with the realization of cash
from sales. Also known as working capital cycle.
Working Capital Management • Overdraft: An overdraft is an agreement by a bank to allow a company
to borrow up to a certain level.
• Permanent Working Capital: The permanent working capital
investment provides an ongoing positive net working capital position,
that is, a level of current assets that exceeds current liabilities.
NOTES
• Term Loan: A term loan is a form of medium-term debt in which
principal is repaid over several years, typically in 5 to 15 years.
• Working Capital: It is the amount of Capital that a Business has available
to meet the day-to-day cash requirements of its operations
14.9 Summary
• Working Capital is the difference between resources in cash or readily
convertible into cash (Current Assets) and organizational commitments
for which cash will soon be required (Current Liabilities). It refers to the
amount of Current Assets that exceeds Current Liabilities.
• Objectives of Working Capital Management are to decide the optimum
Level of Investment in various WC Assets, decide Optimal Mix of Short
Term and Long Term Capital and decide appropriate means of Short
Term Financing. Two Steps involved in the Working Capital Management
are (i) Forecasting the Amount of Working Capital (ii) Determining the
Sources of Working Capital.
• Working Capital Management is important because Working Capital is
the Life Blood of the Business. Fixed Assets (Long Term Assets) can
be purchased on Lease/Hire Purchase but Current Assets cannot be.
Both the excess and deficit working has disadvantages to the firm. Thus
the firm has to strike balance between Liquidity and Profitability
• Gross Concept of working capital means total Current Assets. This is
knows as Quantitative aspect of Working Capital (Focus is on (i) Optimum
Investment in Current Assets and (ii) Financing of Current Assets).
• Net Concept of working capital means difference between Currents
Assets & Current Liabilities. This is knows as Qualitative aspect of
Working Capital. (Focus is on (i) Liquidity Position of the Firm and (ii)
WC Amount that can be financed by Permanent sources of Funds)
• Operating cycle/ working capital cycle is Cash -> Raw-Materials ->
Work-in-Process -> Finished Goods -> Cash.
• Factors affecting Working Capital/ Determinants of Working Capital
are - Nature of Business/Industry; Size of Business/Scale of Operations;
Growth prospects; Business Cycle; Manufacturing Cycle; Operating
Cycle & Rapidity of Turnover; Operating Efficiency; Profit Margin;
Profit Appropriation; Depreciation Policy; Taxation Policy; Dividend Working Capital Management
Policy and Government Regulations.
• The various methods of estimating Working capital needs are
Conservative Approach, Components Approach, Operating Cycle
Approach, Ratio of Current Assets to Fixed Assets and Current Assets
NOTES
Holding Period.
• Working capital financing requires the selection the right mix of long
trams as well as short term sources of funds.
• The principles that guide the financing of working capital are the principle
of Risk Variation, principle of Equity Position, principle of cost of capital
and the principle of maturity of payment.
• Various approaches to finance the working capital are the Hedging/
Matching approach, Conservative Approach and the aggressive approach.

1. Distinguish between (a) Gross working capital and Net working capital,
(b) permanent and temporary working capital.
2. Define the operating cycle and cash cycle.
3. What are the various determinants of working capital? Explain how
each affects the working capital requirements.
4. Why working capital management is important? What if the working
capital is in excess or insufficient?
5. What are various approaches to estimate the working capital needs?
Which approach you feel is most appropriate?
6. What the guiding principles when making decision on financing of working
capital?
7. What are the three approaches of financing the working capital? If the
firm as Constant funds requirements, which of the three financing
methods is preferable.
8. What is the basic premise of the hedging approach of financing the
working capital? What are the effects of this approach on profitability
and risk?
9. Explain the profitability- liquidity trade off in working capital
management?
10. What are sources of financing the permanent and temporal working
capital requirements?
11. Explain how a manufacturing company could control its working capital
levels, and the impact of the suggested control measures. Corporate Finance : 249
Working Capital Management 12. MN Ltd. is commencing a new project for manufacture of electric toys.
The following cost information has been ascertained for annual production
of 60,000 units at full capacity:
Amount per unit
Rs.
NOTES
Raw materials 20
Direct labor 15
Manufacturing overheads:
Rs.
Variable 15
Fixed 10 25
Selling and Distribution overheads:
Rs.
Variable 3
Fixed 1 4
Total cost 6 4
Profit 1 6
Selling price 8 0
In the first year of operations expected production and sales are 40,000
units and 35,000 units respectively. To assess the need of working capital, the following
additional information is available:
(i) Stock of Raw materials………………………...3 months consumption.
(ii) Credit allowable for debtors…………………………..…1½ months.
(iii) Credit allowable by creditors……………………………4 months.
(iv) Lag in payment of wages………………………………..1 month.
(v) Lag in payment of overheads…………………………..½ month.
(vi) Cash in hand and Bank is expected to be Rs. 60,000.
You are required to prepare a projected statement of working capital

requirement for the first year of operations. Debtors are taken at cost.
13. AB has the following balances under current assets and current liabilities:
Current assets Rs. Current liabilities Rs.

Inventory 50,000 Trade payables 88,000
Trade receivables 70,000 Interest payable 7,000
Bank 10,000
Calculate AB's current ratio and quick ratio.

[Ans: Current ratio = 1.37, Quick ratio = 0.84] Working Capital Management
14. During January 20X4, Gazza Ltd made credit sales of Rs.30,000, which
have a 25% mark up. It also purchased Rs.20,000 of inventories on
credit. Calculate by how much the working capital will increase or
decrease as a result of the above transactions?
NOTES
[Hint: Increase in trade receivables Rs. 30,000 ; Increase in trade payables
(Rs.20,000) ; Inventories - increase due to purchases Rs. 20,000 ;
Inventories - Decrease due to sales (i.e. COS) {30,000 x 100 / 125}
(Rs.24,000) ]
[Ans: Increase in WC by Rs. 6,000]
15. Agile Ltd has an annual turnover of Rs.18m on which it earns a margin
of 20%. All the sales and purchases are made on credit and it has a
policy of maintaining the following levels of inventories, trade receivables
and payables throughout the year.
Inventory = Rs.2 million
Trade receivable = Rs. 5 million
Trade payable = Rs. 2.5 million
You are required to calculate Agile Ltd's cash cycle to the nearest day?
[Ans: 89 Days]
Books:
TMH Publication.
Publication.
Publication
Ltd, New Delhi.
Working Capital Management 9. Maheshwari S.N., "Financial Management: Principles and
Practices", Sultan Chand & Sons.
Web resources:
1. "Concept of Working Capital Management". Available at http://
NOTES bbi.co.in/concept-of-working-capital-management/
2. Mathur, S.N. (2010). "Working Capital Management". Available at
http://shodhganga.inflibnet.ac.in/bitstream/10603/703/7/07_chapter1.pdf
3. http://www.caalley.com/art/WorkingCapitalManagement.pdf

Inventory Management
UNIT 15 : INVENTORY MANAGEMENT
Structure
15.2 Concept of Inventories
15.3 Costs Associated With Inventories
15.4 Motives of Holding Inventories
15.5 Inventory Management
15.6 Inventory Management Techniques
15.6.1 Economic Order Quantity
15.6.2 Reorder Level
15.7 Inventory Control Systems
15.7.1 ABC Analysis
15.7.2 VED Analysis
15.7.3 Just-in-Time
15.8 Key Terms
15.9 Summary
15.0 Introduction
Inventory is the stock of any item or resource used in an organization. An inventory
system is the set of policies and controls that monitor levels of inventory and determine
what levels should be maintained, when stock should be replenished, and how large
orders should be. Inventories occupy the most strategic position in the structure of
working capital of most business enterprises. It constitutes the largest component of
current asset in most business enterprises. Over inventory or under inventory both
have an effect on financial health of the business as well on business opportunities.
Inventories are the most important part of working capital in most of the business
because of its large contribution to current assets. Due to huge funds tied up with
inventories, a proper management of inventories is very much desirable for the
success of any business. That is the reason why Inventor manager has to achieve
the optimum level of inventory and ensure that the business has the right goods on
Inventory Management hand to avoid stock-outs and to prevent spoilage. The basic purpose of inventory
analysis, whether in manufacturing, distribution, retail, or services, is to specify (1)
when items should be ordered and (2) how large the order should be. Many firms
are tending to enter into longer-term relationships with vendors to supply their needs
for perhaps the entire year. This changes the "when" and "how many to order" to
NOTES "when" and "how many to deliver." This unit explore the concept of inventory,
techniques of managing inventories and how to finance inventory in any organization.
15.1 Unit Objcetives

• Understand the need and the nature of inventory
• Explain cost associated with inventories
• Calculate the appropriate order size when a one-time purchase must be made
• Learn about various types of inventory policies
• Describe what the economic order quantity is and how to calculate it
• Get familiar with mathematical models of inventory analysis
• Describe the appropriateness of different inventory control techniques
15.2 Concept of Inventory

Inventory constitutes one of the important items of current assets, which permits
smooth operation of production and sale process of a firm. Inventory can be refers
to the goods or materials used by any organization for manufacturing as well as
sales purpose. It also includes the items, which are used as supportive materials to
facilitate production. It is a usable but idle resource. The levels of these kinds of
inventories differ from firm to firm based on the nature of business. Inventories
mainly consist of raw material, work-in-process and finished goods and spare parts
which are held by a business in ordinary course of business, either for sale or for the
purpose of using them in the process of producing goods and services.
• Raw Material: Raw material is a type of inventory which acts as the basic
constituent of a product. For example cotton is raw material for cloth
production and plastic is raw material for production of toys. Raw material is
usually held by manufacturing companies because they have to manufacture
goods from raw material.
• Work-In-Process: Work in process is a type of inventory that is in the
process of production. This means that work-in-process inventory is in the
middle of production stage and it is partly complete. Work-in-process account
is used by manufacturing companies.
• Finished Goods: Finished goods are a type of inventory which comes into
existence after the production process in complete. Finished goods are ready
for sale inventory.
l Spare parts Inventory Management
Spare part inventories are mainly held for purpose of coping up with untimely
breakdowns in machinery and facilities. This may form a minor part of the
inventory, however are as necessary as holding raw materials inventory.
NOTES
15.3 Cost Associated with Investories
Inventory is very much essential and major contributor to corporate profitability of
every business. That is why management must carefully determine when various
items should be ordered, how much to order each time, and how often to order to
meet customer needs so that overall cost of inventory can be minimized. Broadly
following cost are associated with inventory.
1. Holding or Carrying cost

They are expenses such as storage, handling, insurance, taxes, obsolescence,
theft, and interest on funds financing the goods. These charges increase as
inventory levels rise. To minimize carrying costs, management makes frequent
orders of small quantities. Holding costs are commonly assessed as a percentage
of unit value, rather than attempting to derive monetary value for each of these
costs individually. This practice is a reflection of the difficulty inherent in deriving
a specific per unit cost, for example, obsolescence or theft.
2. Ordering costs
Ordering costs are those fees associated with placing an order, including expenses
related to personnel in purchasing department, communications, and the handling
of related paper work. Lowering these costs would be accomplished by placing
small number of orders, each for a large quantity. Unlike carrying costs, ordering
expenses are generally expressed as a monetary value per order.
3. Stock-out costs
They include sales that are lost, both short and long term, when a desired item
is not available; the costs associated with back ordering the missing item; or
expenses related to stopping the production line because a component part has
not arrived. These charges are probably the most difficult to compute, but
arguably the most important because they represent the costs incurred by
customers when an inventory policy falters. Failing to understand these expenses
can lead management to maintain higher inventory levels than customer
requirements may justify
15.4 Motives of Holding Investories

Whether a business actually manufactures its goods, simply resells them or provides
a service, maintaining optimum inventory levels is a critical aspect of serving
customers and remaining viable Inventories are needed because demand and supply
cannot be matched for physical and economical reasons. There are several other Corporate Finance : 255
Inventory Management reasons for carrying inventories in any organization. These reasons mainly categories
as follows:
• Transaction Motive
The Companies hold inventory to facilitate the smooth and uninterrupted flow
of production and sale operations. It may not be possible for the company to
NOTES
procure the raw material whenever necessary. There may be a time lag between
the demand for the material and its supply. Hence it is needed to hold the raw
material inventory.
• Precaution Motive
In addition to the requirement to hold the inventory for routine transactions, the
company may hold them to safeguard against risk of unpredictable changes in
demand and supply forces. Companies often hold inventories to cope up with
delay in the supply of raw material due to factors like strike, transport, disruption,
short supply, lengthy processes involved in import of raw material etc.
• Speculative Motive
Inventories may also be held so that advantage can be taken of price fluctuations.
For instance, if the price of a particular raw material in expected to go up
rather steeply, an enterprise may decide to hold a larger than necessary stock
of this item.
15.5 Inventory Management

Inventory management is the process of efficiently managing the constant flow of
inventories into the business processes. This process usually involves controlling the
transfer of units in order to prevent the inventory from becoming too high, or too
less. Because excessive investment in inventory results into more cost of fund being
tied up so that it reduces the profitability, inventories may be misused, lost, damaged
and hold costs in terms of large space and others. At the same time, insufficient
investment in inventory creates stock-out problems, interruption in production and
selling operation. Investment in inventory should neither be excessive nor inadequate.
It should just be optimum. Maintaining optimum level of inventory is the main aim of
inventory management.
• Maintain sufficient stock of raw material in the period of short supply
and anticipate price changes.
• Ensure a continuous supply of material to production department
Check Your Concept
facilitating uninterrupted production.
1. What is inventory?
• Minimize the carrying cost and time.
2. Explain the different • Maintain sufficient stock of finished goods for smooth sales operations.
types of inventory.
• Ensure that materials are available for use in production and production
services as and when required.
• Ensure that finished goods are available for delivery to customers to Inventory Management
fulfil orders, smooth sales operation and efficient customer service.
• Minimize investment in inventories and minimize the carrying cost and
time.
NOTES
15.6 Inventory Management Techniques
The primary objective of inventory management is to minimize the overall cost of
inventory so that profitability of firm can be maximized. It can be achieved through
maintaining the optimum level of inventory all the time. Optimum level of inventory
can be managed by answering two basic questions.
• What should be the size of order?
• When should it be ordered?
First question can be answered by determining Economic Order Quantity (EOQ)
and second question by determining Re-order Level.
15.6.1. Economic Order Quantity (EOQ)

The most common inventory problem faced by manufacturers, retailers, and
wholesalers is that stock levels are depleted over time and then are replenished by
the arrival of a lot of new units. At the time of placing a order for new lot, manager
faces a problem of determining the size of order. EOQ model helps managers to
determine optimum size of lot to be ordered. Simply, EOQ is the optimum size of the
order for a particular item of inventory calculated at point where the total inventory
cost is minimized. Optimum order quantity can be determined by the trade-off of
inventory holding and ordering cost because total inventory cost is calculated by
adding up total ordering and total holding cost. Normally holding and ordering costs
involving the following costs.
(A) Ordering Cost

Also known as purchase cost or set up cost, this is the sum of the fixed costs that
are incurred each time an item is ordered. These costs are not associated with the
quantity ordered but primarily with physical activities required to process the order.
It includes the following:
• Preparation of purchase order
• Cost of receiving goods
• Documentation processing cost
• Transport cost
• Intermittent cost of chasing orders
Inventory Management (B) Holding Cost
Also called carrying cost, is the cost associated with having inventory on hand. It is
primarily made up of the costs associated with the inventory investment and storage
cost. Below are the primary components of carrying cost.
• Storage cost
NOTES
• Store staffing cost
• Material handling cost
• Obsolescence and deterioration cost
• Opportunity cost of money tied up with inventory
• Inventory insurance cost
Figure15.1: Determination of Economic order Quantity

S o u r c e : h t t p : / / k f k n o w l e d g e b a n k . k a p l a n . c o . u k / K F K B / Wi k i % 2 0 P a g e s /
Economic%20Order%20Quantity%20(EOQ).aspx
Economic order quantity can also be calculated by using mathematical model which
is known as Wilson EOQ Model or Wilson Formula. The model was developed by F.
W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively. EOQ is
essentially an accounting formula that determines the point at which the combination
of order costs and inventory carrying costs are the least. The result is the most cost
effective quantity to order. In purchasing this is known as the order quantity, in
manufacturing it is known as the production lot size.
Assumptions of EOQ model
• Demand is known and constant.

• Lead time is Known and constant
• Only one item is involved
• The stock is replenished instantaneously.
• There is known constant price per unit
• Stock-outs do not occur.
• Stock is monitored on a continuous basis and an order is made when the NOTES
stock level reaches a re-order point
Maximum Inventory
Re-order point
Lead time Time
Figure 15 2: Stock movements under EOQ Model
Source : http://www.transtutors.com/homework-help/management/supply-chain-opeations-
anagement/inventroy-management-control/fixed-time-period-models/
(A) Trial and Error Approach

This is an analytical approach for the determination of optimum lot size. In this
method number of different lot size is determined and then total inventory cost is
calculated for each option. Option at which, total inventory cost is minimum that is
considered to be Economic order quantity. In this method total cost of inventor is
calculated as follow:
Total inventory cost = total purchase cost + Total ordering cost + Total holding cost
Total Purchase cost = D x P
Total Ordering Cost = (D x Co)/Q
Check Your Concept
Total Holding Cost = (Q/2) CH
3. Why should inventory
Where : be held?
A = annual demand 4. Explain reorder point.
Co = Cost of ordering per order 5. Differentiate between
holding and ordering.
CH = Cost of Holding per unit
Q = Size of an order
Inventory Management (B) Mathematical approach
Under this model EOQ can be determined by using following mathematical formula:
2 × D × CO
NOTES CH
where
A = Annual Demand of Inventory
CO = Ordering Cost Per order
CH = Holding Cost Per Unit
Example15.1
An auto parts supplier sells Hardy-brand batteries to car dealers and auto mechanics.
The annual demand is approximately 1,200 batteries. The supplier pays Rs.28 for
each battery and estimates that the annual holding cost is 30 percent of the battery's
value. It costs approximately Rs.20 to place an order (managerial and clerical costs).
You are required to :
a. Determine the economic order quantity (EOQ).
b. How many orders will be placed per year using the EOQ?
c. Determine the ordering, holding, and total inventory costs for the EOQ.
Solution :

15.6.2. Reorder Level Inventory Management
The reorder level is that level of stock at which a purchase requisition is initiated by
the storekeeper for replenishing the stock. This level is set between the maximum
and the minimum level in such a way that before the material ordered for is received
into the stores, there is sufficient quantity on hand to cover both normal and abnormal
NOTES
circumstances. The fixation of ordering level depends upon two important factors
viz, the maximum delivery period and the maximum rate of consumption. In designing
reorder point subsystem, three items of information are needed as inputs to the
subsystem.
• Usage rate
This is the rate per day at which the item is consumed in production or sold
to customers. It is expressed in units. It may be calculated by dividing annual
sales by 365 days. If the sales are 50,000 units the usage rate is 50,000/365
= 137 Units per day.
• Lead time
This is the amount of time between placing an order and receiving goods.
This information is usually provided by the purchasing department. The time
to allow for an order to arrive may be estimated from a check of the company's
record and the time taken in the past for different suppliers to fill orders.
• Safety stock
The minimum level of inventory may be expressed in terms of several days'
sales. The level can be calculated by multiplying the usage rate and time in
the number of days that the firm wants to hold as a protection against
shortages.
Re-order level = (Lead Time * Consumption rate) + Safety stock.
Example 12.2
You are required to calculate the re-order level of raw material for Bharat limited,
manufacturer of furniture from the following in formations:
Annual Consumption(360 days) 12000 units
Cost per unit Rs.1
Normal Lead Time 15 Days
Safety Stock 30 Days Consumption
Solution :
Given
Annual Consumption = 1200 unit
Lead Time = 15 Days
Inventory Management Safety Stock = 30 days Consumption
Re-Order Level = (Lead time x Consumption Rate) + Safety Stock
NOTES
= 15 × 33.3 + 1000
= 500 + 1000
= 1500 units
15.7 Inventory Control

Inventory control is concerned with the acquisition, storage, handling and use of
inventories so as to ensure the availability of inventory whenever needed, providing
adequate provision for contingencies, deriving maximum economy and minimizing
wastage and losses. Hence Inventory control refers to a system, which ensures the
supply of required quantity and quality of inventory at the required time and at the
same time prevent unnecessary investment in inventories. It is one of the most vital
phase of material management. Reducing inventories without impairing operating
efficiency frees working capital that can be effectively employed elsewhere.
Following techniques can be used for proper inventory control:
• ABC Analysis
• VED Analysis
• Just-in-Time
15.7.1. ABC Analysis

ABC Analysis is one of the important techniques which is based on the grading of
inventory according to the importance. This method is popularly known as Always
Better Control. The ABC grouping items according to annual issue value, (in terms
of money), in an attempt to identify the small number of items that will account for
most of the issue value and that are the most important ones to control for effective
inventory management. The emphasis is on putting effort where it will have the
Check Your Concept most effect. ABC classifications allow the inventory manager to assign priorities for
6. What is lead time? inventory control. Strict control needs to be kept on A and B items, with preferably
7. What is selective low safety stock level. Taking a lenient view, the C class items can be maintained
control of inventory? with looser control and with high safety stock level. The ABC concept puts emphasis
8.How does one on the fact that every item of inventory is critical and has the potential of affecting,
determine EOQ for a adversely, production, or sales to a customer or operations. The categorization helps
firm? in better control on A and B items.

• A category (High Value Materials) Inventory Management
A category items are goods which annual consumption value is the

highest. The top 70-80% of the annual consumption value of the company
typically accounts for only 10-20% of total inventory items.
• B Category (Medium Value Materials) NOTES
B category items are the interclass items, with a medium consumption
value of 15-25% of annual consumption value typically accounts for
30% of total inventory items.
• C Category (Low Value Materials)
C category items are, on the contrary, items with the lowest consumption
value. The lower 5% of the annual consumption value typically accounts
for 50% of total inventory items.
Figure 15. 3: ABC Classification of Inventory

Source: http://johanneswoe.wordpress.com/2010/05/23/abc-analysis/
Advantages of ABC Analysis

• Close and strict control is facilitated on the most important items which
help in overall inventory valuation or overall material consumption.
• Proper regulation of investment in inventory which will ensure optimum
utilization of available funds.
• Helps in maintaining a high inventory turnover rates.
15.7.2 VED Analysis

This analysis attempts to classify items into three categories depending upon the
consequences of material stock out when demanded. As stated earlier, the cost of
Inventory Management shortage may vary depending upon the seriousness of such a situation. VED Analysis
is very useful to categorize items of spare parts and components. In fact, in the
inventory control of spare parts and components it is advisable, for the organization
to use a combination of ABC and VED Analysis. Such control system would be
found to be more effective and meaningful.
NOTES
• Vital: Vital category items are those items without which the production
activities or any other activity of the company, would come to a halt, or at
least be drastically affected.
• Essential: Essential items are those items whose stock - out cost is very
high for the company.
• Desirable: Desirable items are those items whose stock-out or shortage
causes only a minor disruption for a short duration in the production schedule.
The cost incurred is very nominal
15.7.3 Just-in- Time (JIT)

Just-in-time also known as JIT inventory is a inventory management strategy that is
aimed at monitoring the inventory process in such a manner as to minimize the costs
associated with inventory control and maintenance. To a great degree, a just-in-time
inventory process relies on the efficient monitoring of the usage of materials in the
production of goods and ordering replacement goods that arrive shortly before they
are needed. This simple strategy helps to prevent incurring the costs associated with
carrying large inventories of raw materials at any given point in time.
Many purchasing departments employ a JIT inventory for such key items
as raw materials and machine parts. This means that records are kept that make it
possible to place a new order for a given component when the number of units on
hand decreases to a pre-determined point. In times past, this type of inventory control
often was accomplished by maintaining a flip card inventory, such as the old Kardex
system. Today, this same type of component usage is often managed with purchasing
and inventory control software.
15.8 Key Terms

• Backorder: Occurs when a customer demand cannot be met from stock,
but the customer waits for the item to come into stock
• Consumables: Stocks of materials needed to support operations, but
which do not form part of the ?nal product, such as oil, paper, cleaners,
etc.
• Economic Order Quantity: Also known as EOQ is the order quantity
that minimizes total inventory holding costs and ordering costs. It is one
of the oldest classical production scheduling models.

• Inventory Management: It is a science primarily about specifying the Inventory Management
shape and percentage of stocked goods.
• Inventory Credit: refers to the use of stock, or inventory, as collateral to
raise finance
• Inventory: Inventory or stock refers to the goods and materials that a
NOTES
business holds for the ultimate purpose of resale.
• Kanban: Card (either physical or electronic) that passes a message
backwards through the supply chain to trigger JIT operations
• Lean strategy: A business strategy that aims at doing every operation
using the least possible resource - people, space, stock, equipment, time,
etc
• Lost sales: When customer demand cannot be met, and the customer
withdraws their demand (perhaps moving to another supplier)
• Lot Size: The quantity of an inventory item management either buys
form a supplier or manufacturers using internal processes
• Replenishment: Putting materials into stock to replace units that have
been used
• Safety stock: A reserve of materials that is not normally needed, but is
held to cover unexpected circumstances
• Stock Rotation: Stock Rotation is the practice of changing the way
inventory is displayed on a regular basis. This is most commonly used in
hospitably and retail - particularity where food products are sold.
• Time between Orders (TBO): The average elapsed time between
receiving (or placing) replenishment orders of Q units for a particular lot
size.
15.9 Summary
• Inventories occupy the most strategic position in the structure of working
capital of most business enterprises. It constitutes the largest component
of current asset in most business enterprises.
• The key decision in manufacturing and retail businesses is how much
inventory to keep on hand. Inventory decisions involve a delicate balance
between three classes of costs: ordering costs, holding costs, and shortage
costs.
• Costs of inventories are very closely related to size of inventories, so the
manager should decide precisely about the quantity to order and at what
time these order should be placed.
• EQO represent the point where total ordering cost is equal to total holding
cost and total cost of inventory is minimum.
• Fixation of various inventory levels such as Re-order level, minimum Corporate Finance : 265
Inventory Management stock level, maximum stock level and safety stock level helps in proper
inventory management.
• Proper inventory management can only be achieved through proper
monitoring for that purpose various techniques like JIT, ABC analysis
are used.
NOTES
15.10 Questions And Excercises
1. Define Inventory and its types. Also discuss the concept of Inventory
Management.
2. Explain various reasons for holding inventory in any organization.
3. What do you understand by Economic Order Quantity (EOQ) ? Explain
the procedure of calculating EOQ.
4. Explain the selective control of inventory? Why is it needed?
5. What are the various cost associated with inventory?
6. Imagine that you work for Game World and you have been asked to
decide on the best inventory control policy for the computer game 'Aliens'.
You are told that the demand is fairly constant at 5000 units' p.a. and it
costs Rs.14.40 to place an order. You are also told that the storage cost
of holding one unit of the game per annum is Rs.5. determine the EOQ
for the Game World.
7. A firm uses 1,100 units of a raw material per annum, the price of which
is Rs 1,500 per unit. The order cost per order is Rs 150 and the carrying
cost of the inventory is Rs 200 per unit. Find the EOQ and the number of
orders that are to be made during the year.
8. Total demand for a commodity is 1000 tonnes in time T. The carrying
cost is Rs 20 per tonne of stock during time T, and the order cost is Rs 2
per order. Find out:
a. The EOQ and the number of orders. How long will a particular order of
inventory last?
b. The EOQ if the order cost comes down to Re 1.
9. EOQ is 14.1421 tonnes with a total demand for the stock being 1000
tonnes, order cost being Rs 2 per order and carrying cost being Rs 20
per tonne. The supplier provides discount at the rate of Re 0.10 each
tonne if the purchase amount is at least 20 tonnes. Should the firm place
an order for 20 tonnes in order to avail of the discount?
10. X Ltd. uses 1,000 electric drills per year in our production process. The
ordering cost for these is Rs.100 per order and the carrying cost is
assumed to be 40% of the unit cost. In orders of less than 120, drills cost
Rs.78 per unit; for orders of 120 or more the cost drops to Rs.50 per
unit. Should company take advantage of the quantity discount?
Books:
TMH Publication.
2. Brealey, Myers & Allen, "Principles of Corporate Finance", TMH NOTES
Publication.
Publication
Ltd, New Delhi.
Web resources:
1. Motives of Holding Inventories, available at: http://
www.insidebusiness360.com/index.php/reasons-for-holding-inventories-
13860
http://spiffyd.hubpages.com/hub/Management-accounting-Reasons-for-
holding-inventory
2. Concept and types of inventories, available at:
file:///C:/Documents%20and%20Settings/Administrator/Desktop/
essentials_of_inventory_management.pdf
3. Objectives of inventory Management, available at:
file:///C:/Documents%20and%20Settings/Administrator/Desktop/
1560523611pv.pdf
4. Economic order quantity, available at:
http://digitalcommons.calpoly.edu/cgi/viewcontent.cgi? article=1006 &
context = imesp
5. Reorder level, available at:
http://dosen.narotama.ac.id/wp-content/uploads/2013/02/Chapter-14-
Materials-Inventory-Control.pdf
6. ABC Analysis, available at:
http://www.materialsmanagement.info/inventory/abc-inventory-
analysis.htm

Cash Management
UNIT 16 : CASH MANAGEMENT
Structure
16.2 Motives for Holding Cash
16.3 Objectives of Cash Management
16.4 Factors Affecting the Cash Requirements
16.5 Determination of Cash Needs
16.6 Cash Management Strategies
16.7 Cash Management Techniques
16.8 Cash Management Practices in India
16.9 Key Terms
16.10 Summary
16.12 Practical Problems
16.0 Introduction
Cash is considered as one of the most important areas of working capital management
because of its liquidity. The question arises, "Why Cash is so important?" - The
answer is "Because of its liquidity". Cash is the ready currency to which all the
current assets can be reduced. Cash is the lifeblood of the business and is important
for the short-term stability and long-term survival of the firm. Cash management
also includes cash equivalents. Cash equivalents are the near cash assets like the
deposits in banks and marketable securities because of their ease with which they
can be converted into cash. The cash equivalents fulfill the cash requirements when
in need. Cash management is important to meet the cash expenditure needs of the
business and reduce the additional blockage of funds in cash and cash equivalents.
The unit explains the significance of cash management and the process used in
management of cash.

After studying this unit you should be able to understand :
• Why cash management is so important for the survival of any business?
• What are the motives of the business behind holding cash balances?
NOTES
• How the cash needs are determined by the business and what factors
affects the cash needs of a business?
• The various techniques and processes used to manage cash.
• The practices followed by companies in India to manage cash.
16.2 Motives for Holding Cash

Cash is vital for the continuation of the business but irrespective of the form in which
it may be held, cash when kept as asset has no earning power and instead reduces in
value due to inflation. The question arises that if the cash does not earn any return then
why any business organization needs to hold cash. The motives behind holding and
maintaining cash balances can be divided into four categories as follows:
a. Transaction Motive
This motive refers to the need of holding cash to meet regular cash expenditure
requirements of the business. The requirements are for the transactions that
are carried out in the ordinary course of business. A firm frequently involves in
purchase and sales of goods or services. A firm should make payment in terms
of cash for the purchase of goods, payment of salary, wages, rent, interest, tax,
insurance, and dividend etc. A firm also receives cash in terms of sales revenue,
interest on loan, return on investments made outside the firm and so on. If
these receipts and payments were perfectly synchronized, a firm would not
have to hold cash for transaction motive. But in real, cash inflows and outflows
cannot be matched exactly and therefore need for holding cash known as
transaction motive.
b. Precautionary Motive
The motive refers to unpredicted or unanticipated cash needs that may arise in
business at short notice period. The needs may be due to some disaster like the
flood, strikes, delay in collection from customers, bill presented earlier for
payment, cancellation of some order. These emergencies also bound a firm to
hold certain level of cash.
c. Speculative Motive
The motive refers to the desire of the organization to take advantage of the
opportunities which arise unexpected and are out of the regular course of
business activities. These opportunities arise in conditions, when price of raw
material is expected to fall, when interest rate on borrowed funds are expected
to decline and purchase of inventory occurs at reduced price on immediate
Corporate Finance : 270 cash payment.
d. Compensating Motive Cash Management
The motive refers to hold cash to compensate banks for providing certain
services and loans. Banks provide a variety of services to business and charge
commission or fee for the services. The bank also charge indirect compensation
which requires the client to maintain a minimum cash balance at the bank
account. This balance cannot be utilized by the business for transaction purposes NOTES
and the bank can only use the amount to earn a return. Such balances are
referred to as compensating balances.
16.3 Objectives of Cash Management

After getting familiar with the motives behind holding the cash balance, we should
know the objectives that govern the process of cash management. The cash
management is done with two basic objectives: (a) To meet the payment schedule
and (b) To minimize Funds as cash balance.
a. To meet payment Schedule
The firms are required to make regular payments in regular course of business
to suppliers of goods, employees, for expenses, etc. Simultaneously, there are
cash inflows also in form of collections from customers. Cash management
serves the objective of making cash available to meet the payment schedule
in case the inflows are less than the outflows. So, the firm keeps adequate
cash balances to fulfill the objectives. Thus, the maintenance of adequate
cash balance to meet the payment schedule is important for following reasons:
i. Avoids bankruptcy that may arise due to inability of the firm to meet its
obligations.
ii. The relations with the suppliers, creditors and the bank are not strained
and there repayments are made timely.
iii. The firm can avail Cash discounts by making the payments within the
due dates.
iv. Provides strong credit rating to the firm enabling to get favorable terms
in credit transactions in purchase of goods and bank loans.
v. The firm is in the position to meet the contingencies and unexpected
cash expenditures easily.
vi. Firms can take advantages of opportunities that may be available.
b. To minimize fund committed as Cash Balance
The other core objective of cash management is to minimize the cash balances.
Since, it is clear that cash when held as asset do not earn any returns, it is
important for the firm to maintain the cash balances which reduces over
investment of funds in cash balance while fulfilling the transaction needs as
discussed above. While the high cash balance ensures prompt payment and
increases credibility of the firm, the large funds kept as cash balance results
in idle funds and the firm will have to forego profits. A very low level of cash
may on the other side lead to failure to meet the payments schedule. Thus,
the objective of cash management is to have an optimal cash balance. Corporate Finance : 271
16.4 Factors Affecting The Cash Requirements
The factors that determine the cash requirement of a firm are as follows:
a. Cash Cycle
NOTES It is the length of the time between the payment for purchase of raw material
& receipt of sales revenue. So, the cash cycles refer to the time that elapsed
from the point when the firm makes an outlay to purchase raw material to the
point when cash is collected from the sale of finished goods produced using
that raw material.
Figure 16.1: Cash Cycle

(Source: http://www.smeworld.org/story/money/factoring-alternative-source-of-wc.php)
The longer cash cycle means large cash needs of the firm because the time
difference between the cash outflows and inflows is more and so the firm will
have to maintain sufficient cash balance to meet the payments schedule for
the period. The smaller cash cycle means that the time difference between
the cash outflows and inflows is less and so the firm will have to maintain
small cash balance to meet the payments schedule for the smaller period.
b. Synchronization of Cash Inflows & Cash Outflows
Every firm has to maintain cash balance because its expected inflows &
outflows rates are not always synchronized. The timings of cash inflows may
not always match the timings of the outflows. Therefore a cash balance is
required to fill up the gap arising out of difference in timings & quantum of
inflows and outflows. If the inflows are appearing just at the time when cash
is required for payment, then no cash balance will be required to be maintained
by the firm.
c. Cost of Cash Balance
Another factor to be considered while determining the minimum cash balance
is the cost of maintaining excess cash or of meeting shortage of cash. If the
firm is maintaining excess cash then it is missing the opportunities of investing
these funds in a profitable way. Similarly, if the firm is maintaining inadequate
cash balance then it may be required to arrange funds on an emergency basis
to meet any unexpected shortage. Even if the shortage is expected to continue
Corporate Finance : 272 only for a short period, yet the funds are to be arranged & there will always
be a cost (may be more than normal cost) of raising fund. If the cash shortage Cash Management
cost is lower than the excess cash balance cost, the firm tends to maintain
large balances and vice versa.
d. Other Considerations
In addition to the above factors, there may be some other considerations also NOTES
affecting the need for cash balance. There may be several subjective
considerations such as uncertainties of a particular trade, staff required for
cash management activities etc., which will have a bearing on determining the
cash balance required by a firm.
16.5 Determination of Cash Needs

The next step in the process of cash management after identifying the factors affecting
the cash needs of the firms is to determine the cash need in absolute amount. The
optimal cash balance for a firm can be determined using the two approaches, namely,
(a) Cash management or Conversion models and (b) Cash budget.
16.5.1 Cash Management/ Conversion Models

The three commonly used cash management models are as follows:
i. Baumol Model : The model determines the minimum cost that the manager
will have to incur in converting securities to cash considering the cost of
conversion and the counter balancing cost of keeping the idle cash balances
which would otherwise would have been invested in marketable securities.
The conversion of securities to cash has two cost elements being the cost of
converting the securities to cash and the opportunity lost on converted securities.
Baumol model of cash management trades off between opportunity cost or
carrying cost or holding cost & the transaction cost. As such firm attempts to
minimize the sum of the holding cash & the cost of converting marketable
securities to cash.
Assumptions of Baumol Model
There are certain assumptions or ideas that are critical with respect to the
Baumol model of cash management:-
Check Your Concept
• The particular company should be able to change the securities that
they own into cash, keeping the cost of transaction the same. Under 1. Why cash is so
normal circumstances, all such deals have variable costs and fixed costs. important?
• The company is capable of predicting its cash necessities. They should 2. Explain the reasons of
be able to do this with a level of certainty. The company should also get holding cash.
a fixed amount of money. They should be getting this money at regular
3. Explain the stages of
intervals.
cash conversion
• The company is aware of the opportunity cost required for holding cash. cycles.
It should stay the same for a considerable length of time.

• The company should be making its cash payments at a consistent rate
over a certain period of time. In other words, the rate of cash outflow
should be regular.
The Optimal Cash Balance using Baumol Model can be calculated as below:
• Optimal Cash balance ( C) = .................. Eq.16.1
NOTES
• Holding Cost = i(C/2)
• Transaction Cost = X/ C *B
• Total Cost = k(C/2) + X(B/C)
Where, B is the total fund requirement, C is the cash balance, i is the
opportunity cost & X is the cost per transaction.
Limitations of the Baumol model:
• It does not allow cash flows to fluctuate.
• Overdraft is not considered.
• There are uncertainties in the pattern of future cash flows.
Example 16.1
Fictitious Corporation has determined that its operating circumstances are quite
suitable for use of the Baumol Cash Management Model. The company consistently
earns a five percent annual rate of return on its marketable securities and requires a
total of Rs 2, 00,000 in cash each year to maintain its production. Transactions costs
are Rs 50 each time company liquidates marketable securities. Determine the
following for the Fictitious Corporation:
Solution
2 x 50 x 200,000
I. Optimum cash order quantity = c* = .05
= 20,000
II. Optimum average cash balance = 20,000/2 = 10,000

III. Optimum number of securities liquidations for cash per year = x/c =
200,000/ 20,000 = 10
IV. Optimum number of days between orders for cash = 365/10 = 36.5
V. Total annual transactions cost incurred by using the optimum cash order
quantity (Transaction Cost) = x/C * B = 10 * 50 = 500
VI. Annual foregone returns cost (Holding cost)= 20,000/2 *.05 = C*/2*
i = 500
VII. Minimum total cost associated with obtaining and maintaining cash
balances = 500 + 500 = 1000
ii. Miller-Orr Model
This model assumes that the cash flows are uncertain but has the upper limit
and lower limit within which it normally fluctuates. Under this model, the firm
allows the cash balance to fluctuate between the upper control limit and the
Cash Management
lower control limit, making a purchase and sale of marketable securities only
when one of these limits is reached. The assumption made here is that the
net cash flows are normally distributed with a zero value of mean and a
standard deviation. This model provides two control limits - the upper control
limit and the lower control limit as well as a return point. The process can be
explained using the figure 16.2 as under:- NOTES
Figure 16.2: Miller- Orr Model
(Source: http://www.themanagementor.com/enlightenmentorareas/finance/cfa/miller.htm)
When the firm's cash limit fluctuates at random and touches the upper limit,
σ the firm buys sufficient marketable securities to come back to a normal
level of cash balance i.e. the return point. Similarly, when the firm's cash
flows wander and touch the lower limit, it sells sufficient marketable
securities to bring the cash balance back to the normal level i.e. the return
point.
The lower limit is set by the firm based on its desired minimum "safety stock"
of cash in hand. The objective of cash management, according to Miller-Orr
(MO) is to determine the optimum cash balance level which minimizes the
cost of cash management. The upper control limits and return path are than
calculated by the Miller-Orr Model using spread which is the distance between
upper limit and lower limit.
Spread = (Upper Limit - Lower Limit) = 3Z

(Upper limit - Lower limit) = (3/4 x Transaction Cost x Cash Flow Variance/
1/3
Interest Rate)
2 1/3
Z = (3/4 × b × /i)
Where, σ 2 is the variance of daily changes in cash balances
If the transaction cost is higher or cash flows shows greater fluctuations,
than the upper limit and lower limit will be far off from each other. As the interest
rate increases, the limits will come closer. There is an inverse relation between the
Z and the interest rate. The upper control limit is three times above the lower control
limits and the return point lies between the upper and lower limits. Hence,
NOTES
Upper Limit = Lower Limit + 3Z
Return Paint = Lower Limit + Z
So, the firm holds the average cash balance equal to:
Average Cash Balance = Lower Limit + 4/3 Z
The Miller-Orr Model is more realistic as it allows variation in cash balance within
the lower and upper limits. The lower limit can be set according to the firm's liquidity
requirement.
Example 16.2
Jain private limited want to maintain a minimum cash balance of Rs. 500,000. The
estimated variance of the daily cash flows is Rs. 1,200,000 per day and the cost for
each transaction of buying and selling marketable securities is fixed at Rs. 10,000.
The marketable securities yield 3% per year. You are required to calculate the
desired cash balance of the firm using Miller- Orr model.
Solution:
= Rs. 47,356
Return Point = Lower Limit + Z = 500,000 + 47,356 = Rs. 547,356
Upper limit = Lower limit + 3Z = 500,000 + 3* 47,356 = Rs. 642,068
Thus, the Jain private limited must perform cash management as follows:
• The desired cash balance at Rs 547,356.

• When the cash balance reaches the upper limit of Rs 642,068, Sweets
Ltd. has too much cash. It then should use its cash to buy Rs 94,712 (Rs
642,068 - Rs547, 356) marketable securities in order to bring the cash
balance back to its desired cash level (i.e. Rs 547,356).
• When the cash balance hits the lower limit of Rs 500,000, the company
lacks cash. It then sells Rs 47,356 (Rs 547,356 - Rs 500,000) of its
securities in order to bring the cash balance back to its desired cash
level (i.e. Rs 547,356). Cash Management
• If the cash balance lies between the upper and lower limits (i.e. between
Rs 500,000 and Rs 642,068), there will be no transaction in securities.
iii. Orgler's Model
This model provides for integration of cash management with production and NOTES
other aspects of the firm. According to this model, an option cash management
strategy can be determined through the use of multiple linear programming
models. The construction of the model comprises three sections:
1. selection of the appropriate planning horizon,
2. selection of the appropriate decision variables and
3. Formulation of the cash management strategy itself.
The advantage of linear programming model is that it enables coordination
of the optimal cash management strategy with the other operations of the firm
such as production and with less restriction on working capital balances. The
model basically uses one year planning horizons with twelve monthly periods
because of its simplicity. It has four basic sets of decisions variables which
influence cash management of a firm and which must be incorporated into the
linear programming model of the firm. These are:
1. payment schedule
2. short-term financing
3. purchase and sale of marketable securities
4. cash balance itself
Orgler's objective function is to minimize the horizon value of the net
revenues from the cash budget over the entire planning period. Using the
assumption that all revenues generated are immediately reinvested and that
any cost is immediately financed, the objective function represents the value
of the net income from the cash budget at the horizon "by adding the net
returns over the planning period". Thus, the objective function recognizes each
operations of the firm that generates cash inflows or cash outflows as adding
or subtracting profit opportunities from the firm from its cash management
operations. An example for the linear programming model is as follows.
Objective function:
Maximize profit = a1x1 + a2×2
The important feature of the model is that it allows the financial managers to
integrate cash management with production and other aspects of the firm.
16.5.2 Cash Budgets

The cash budgets are also used widely by the firms to determine the cash balances
that the firm needs to hold. The preparation of cash budgets requires the identification Corporate Finance : 277
of the period over which the budgets are made and forecasting of the production
and financial activities and the cash flows from each of them. All the cash receipts
and payment are forecasted and if the budget shows any surplus cash, the firm
plans the investment of cash on securities and if the budget shows the shortage of
cash, the firm plans for the borrowing of the cash.
NOTES
16.6 Cash Management Strategies
The cash management strategies aims at minimizing the operating cash balance
requirements of the firm. Thus the strategies help in reducing the cash cycle and
increasing the cash turnover. The basic four strategies that can be employed for
cash management are:
a. Stretching accounts payables
This process follows the simple strategy of delaying the payment for accounts
payables. Thus the firm must try to delay the payment of accounts payables
as late as possible without affecting the credibility of the firm. However, in
case there are cash discounts available on prompt payment, the firm must not
hesitate to take advantage of these.
b. Efficient Inventory- Production Management
Cash is blocked in high level of inventory. Thus another method of reducing
the cash investment is managing the inventory. This can be done by increasing
the inventory turnover, reducing the production cycle and by increasing the
finished goods turnover. All these activities require better production planning
and forecasting of the sales of the products.
c. Speeding collection of Accounts Receivables
The other strategy for cash management is the management of accounts
receivables. The firm should try to collect accounts receivables as quickly as
possible. However, this should not be done at the cost of loss of future sales or
loss of customers. The credit period can be reduced by changing the credit
terms, credit standards and collections policies. The credit standards lay down
the criteria that determine the customers who should be allowed the credit.
d. Combined cash management policies
Instead of using the above strategies independently, the firm can use the
combination of these strategies to get the maximum benefit. Thus the firm
must see that there should not be too much delay in payment of accounts
payables so that the credit standing is maintained and the purchases are done
at desirable prices. The inventory must not be too low to result in stock out
and the credit policy must not be too strict to keep away the customers and
affect the sales negatively. The combined strategies, requires the liquidity
management, working capital management, risk management and financial
Corporate Finance : 278 management simultaneously by the company.
Cash Management
16.7 Cash Management Techniques
Some techniques that can be used to implement the cash managements strategies
discussed above are follows.
• Collect Quickly
NOTES
The best form of cash management is to collect payments as quickly as
possible. Making sure that all payments are processed on time and that
customers with credit get their invoices well ahead of the bill due date is
always a good idea. Don't wait until the end of the month to send out invoices;
it is a fact that the longer you go without contacting a customer, the less
chance you have of collecting the debt. The only way to maintain your working
capital is make sure the cash flow is steady and on time.
• Monitoring Costs and Inventory
Keeping an eye on how much you are paying to suppliers should be at the
front of your business mind at all times. It doesn't hurt to shop around for a
better deal; even if you can't get a better price than your current supplier,
maybe you can get more agreeable payment options that leave you with
more cash in hand at the end of every month. Also monitory your inventory
closely; paying attention to what is selling and what is not. Try to keep your
inventory as lean as possible so you aren't tying up too much of your working
capital.
• Concentration Banking
The system involves decentralized collection of accounts receivables by the
firm which have large number of branches at different locations.
Concentration Banking is system whereby customers make payments to a
regional collection center which transfers the funds to at the principal bank.
An example of a concentration bank can be a company which has multiple
chain stores across the country and each store deposits its cash into local
banks. The company can set it up so that these funds can be concentrated or
deposited into one account, usually called a concentration account, at a
concentration bank. The concentration banking results in saving of time of
collection, and hence results in better cash management. However, the
selection of collection centers must be based on the volume of billing / business
in a particular geographical area. It may be noted that the concentration Check Your Concept
banking also involve a cost in terms of minimum cash balance required with 4. What do you mean by
a bank or in the form of normal minimum cost of maintaining a current cash budget?
account.
5. What is lock box
• Lockbox System system of cash
This technique involves setting up post office lock Box at important collection management?
centers and helps speed up posting of customers' payments to your bank
account. Payments are mailed to a P.O. Box directly accessible by the bank, Corporate Finance : 279
which processes receipts daily. Thus one doesn't have to go to the bank (or
send a subordinate) and stand in line to make deposits. Deposited checks
don't sit in a teller's drawer all day; they are taken directly to the processing
department. If your bank is regional or national you can set up lock-box
accounts near your biggest customers, eliminating days of postal travel time
NOTES for checks they mail to you.
• Float
The cash balance shown in the company's Ledger may not be the same as
the available balance in its bank account. The difference is the net float.
When the firm has written large number of cheques awaiting clearance, the
available balance will be larger than the ledger balance. When the firm has
just deposited large number of Cheques, which have not been collected by
the bank, the available balance will be smaller.
The amount of Cheque issued but not presented for payment is known as
the disbursement float. For example, suppose that ABC Company has a
book balance as well as available balance of Rs 4 Lac with its bank, State
Bank of India, as on March 31. On April 1 it pays Rs 1 Lac by Cheque to
one of its suppliers and hence reduces its book balance by Rs. 1 Lac.
The amount of Cheque deposited in the banks, but not yet cleared, is known
as the collection float. For example, suppose that XYZ Company has book
balance as well as available balance of Rs 5 Lac as on April 30. On May 1
XYZ Company receives a Cheque for Rs. 1.5 Lac from a customer which
it deposits in the Bank. It increases its book balance by Rs. 1.5. Lac. However,
this amount is not available to ABC Company until its bank presents the
Cheque to the customer's bank on, say, May 5. So, between May 1 and May
5 ABC Company has a collection float of (-) Rs. 1.5 Lac.
The net float at a point of time is simply the overall difference between the
firm's available bank balance and the balance shown by the ledger account
of the firm. If the net float is positive, i.e., payment float is more than receipt
float, and then the available bank balance exceeds the book balance. However,
if the available bank balance is less than the book balance, then the firm has
net negative float. If a firm has positive net float (i.e. the payment float is
more than the receipt float), it can issue more Cheque even if the net bank
balance shown by the books of account may not be sufficient. A firm with a
positive net float can use it to its advantage and maintain a smaller cash
balance than it would have in the absence of the float.
• Electronic Data Interchange (EDI)
It refers to direct, electronic exchange of information between various parties.
Financial EDI or FEDI, involves electronic transfer of information and funds
between transacting parties. FEDI leads to elimination of paper invoices,
Corporate Finance : 280 paper cheques, mailing handling and so on. Under FEDI, the seller sends the
bill electronically to the buyer, the buyer electronically authorizes its bank o Cash Management
make payment, and the bank transfers funds electronically to the account of
the seller at a designed bank. The net effect is that the time required to
complete a business transaction is shortened considerably thereby virtually
eliminating the float.
NOTES
16.8 Cash Management Practices in India
Cash management has changed significantly during last two decades in India for
two reasons. First, from the early 1970s to the late 1980s, there was an upward
trend in interest rate that increased the opportunity cost of holding cash. This
encouraged financial manager to search for more efficient ways of managing cash.
Second, technological developments, particularly computerized electronic funds
transfer mechanism changed the way cash is managed. Most cash management
activities are performed jointly by the firm and its banks. Effective cash management
encompasses proper management of cash inflow, and outflows, which entails (1)
improving forecasts of cash flows, (2) synchronizing cash inflows and outflows, (3)
using floats, (4) accelerating collections, (5) getting available funds to where they
are needed, and (6) controlling disbursement. Most businesses are conducted by
large firms, many sources and make payments from a number of different cities or
even countries.
For example, companies such as IBM, General Motors, and Hewlett-Packard
have manufacturing plants all around the world, even more sales offices, but most of
the payments are made from the cities where manufacturing occurs, or else from
the head office. Thus a major corporation might have hundreds of bank accounts,
and since there is no reason to think that inflows and outflows will balance in each
account, a system must be in place to transfer funds from where they come into
where they are needed, to arrange loans to cover net corporate shortfalls, and to
invest net corporate surpluses without delay.
Cash management by MNCs is far more daunting task than the domestic
companies. Unilever for example manufactures and sells all over the world. To
operate effectively Unilever has numerous bank accounts so that some banking
transactions can take place near to the point of business transaction can take place
near to the point of business. Sales receipts from America will be paid into local
banks there; likewise many operating expenses will be paid for with funds drawn
from those same banks. The problem for Unilever is that some of those bank accounts
will have high inflows and others high outflows, so interest could be payable on one
while funds are lying idle or earning a low rate of return in another. Therefore, as
well as taking advantage of the benefit of having local banks carry out local
transactions, large firms need to set in place a co-coordinating system to ensure that
funds are transferred from where there is surplus to where they are needed.

16.9 Key Terms
• Cash Cycle: Cash conversion cycle is the time it takes a company to
convert its resource inputs into cash. It measures how effectively a
company is managing its working capital. Cash Conversion Cycle =
NOTES Operating Cycle ? Days Payables Outstanding.
• Cash Holding: This ratio indicates the proportion of current assets which
are held as cash. Generally, the financial manager will want to keep this
figure at the safe minimum to be able to service immediate current
outflows. The ratio is measured as: cash/ current asets.
• Cash Turnover: The cash turnover ratio indicates the number of times
that cash turns over in a year. Cash Turnover Ratio = 365/ cash cycle.
• Concentration Banking: opening collection centers (banks) in different
parts of the country to save the postal delays.
• EDI: Electronic data interchange (EDI) is the direct, electronic exchange
of funds between various parties.
• NEFT: National Electronic Funds Transfer (NEFT) NEFT is electronic
funds transfer system, which facilitates transfer of funds to other bank
accounts in branches across the country.
• Lockbox System: A lockbox collection system allows companies to quickly
process payments from customers. Customers send payments to one or
more post office lockboxes.
• Float: Difference between the cash balance shown in the company's
Ledger and the amount available balance in its bank account.
• Precautionary Motive: Keeping cash to meet the unforeseen
contingencies and unplanned activities.
• Speculative Motive: Keeping money to take advantage of the opportunities
which arise unexpected and are out of the regular course of business
activities.
• Transaction Motive: Keeping money to meet their day-to-day expenses
during the period between the receipt and spending of their money.
16.10 Summary
• Cash management is the key areas in working capital management. The
four motives behind holding cash are: (i) transaction motive, (ii)
precautionary motive, (iii) speculative motive and (iv) compensating
motive.
• The transaction motive refers to the need of holding cash to meet regular
Corporate Finance : 282 cash expenditure requirements of the business. The precautionary motive
refers to unpredicted or unanticipated cash needs that may arise in Cash Management
business at short notice period. The speculative motive refers to the
desire of the organization to take advantage of the opportunities which
arise unexpected and are out of the regular course of business activities.
The compensating motive refers to hold cash to compensate banks for
providing certain services and loans. NOTES
• The two basic objective of cash management contradictory in nature
being, to meet the payment schedule and to minimize the funds kept as
cash balances.
• The factors that determine the cash balances needed are: (i) cash cycles,
(ii) synchronization of cash flows, (iii) cost of cash balance, and (iv)
other considerations like uncertainties of a particular trade, staff required
for cash management activities etc.
• The cash needs can be determined either using the cash determination
models or the cash budgets.
• The Baumol model was developed by William Baumol can determine
the optimum amount of cash for a company to hold under conditions of
certainty. The objective is to minimize the sum of the fixed costs of
transactions and the opportunity cost of holding cash balances that do
not yield a return. This is similar to the EOQ model used in inventory
management.
• When the cash payments are uncertain, Miller-Orr model can be used.
This model places upper and lower limits on cash balances. When the
upper limit is reached, a transfer of cash to marketable securities is
made; when the lower limit is reached, a transfer from securities to cash
is made. As long as the cash balance stays within the limits, no transaction
occurs.
• According to the Orgler's model, the optimal cash management strategy
can be determined through the use of a multiple linear programming
model. It is a model that provides for integration of cash management
with production and other aspects of the firm.
• Cash forecasting & budgeting is very important in managing cash because
it enables the firm to maintain short-term liquidity. After preparing cash
budgets, if there is excess cash available, it can be invested productively
in short-term marketable securities or short-term investments.
• The cash management strategies aims at minimizing the operating cash
balance requirements of the firm. The commonly used strategies are
stretching the accounts payables, efficient management of Inventory
and production, speedy collection of accounts receivables and the
combination of various strategies.
• There are various techniques available to implement the cash management
strategies. Some of the commonly used techniques are quick collection,
monitoring of cast and inventory, concentration banking, use of lock-box
system, EDIs, etc.
NOTES 16.11 Questions and Exercises

1. What are the principle motives for holding cash?
2. What are the objectives of cash management? Explain with suitable
examples.
3. Explain briefly the factors that determine the cash needs of the firm.
4. Explain the use and importance of cash budgets in cash management?
5. Define some of the basic strategies of efficient cash management?
6. Explain the three commonly used cash management models?
7. Define some techniques that can be used to manage the cash.
8. What do you understand by Concentration banking? Do you think is
beneficial? Explain.
9. Explain the benefits of utilizing Float in cash management.
10. What is the importance of speedy collection of accounts receivables?
What are its fallouts?
11. Determine the cash needs using the Baumol Model:
12. A Company estimates a cash requirement of $2,000,000 for a 1 month
period. The opportunity interest rate is 6% per annum, which works out
to 0.5 percent per month. The transaction cost for borrowing or
withdrawing funds is $150.
13. Determine cash needs using the Miller-Orr model:
Fixed cost of a securities transaction = $5
Variance of daily net cash flows = $25
Daily interest rate on securities = 0.0003 (10% per annum, so 10%/360
days = 0.0003 daily).
14. Company K has receivables turnover ratio of 12, inventory turnover
ratio of 10 and payable turnover ratio of 8. Find the cash conversion
cycle.
15. Let us assume that X Ltd. has a ledger balance and bank available
balance of Rs.1, 00,000 as on 1st March. On 2nd March, it issues a
cheque for Rs.30, 000 to one of its suppliers. This consequently reduces
the ledger balance to Rs.70, 000. The bank, however, will not debit X
Ltd. till the cheque is presented for payment. Say, the suppliers present
the cheque on 7th March only. So, till this happens, the available balance
is greater than the book balance by Rs30, 000. Calculate disbursement
float?

16. Let us assume that X Ltd. has a ledger balance and bank available
balance of Rs.100,000 as on 1st March. On 2nd March, it receives a Cash Management
cheque for Rs. 20,000 from one of its accounts receivables. This will
increase the ledger balance by Rs.20,000. But this amount will not be
available to the company till its bank presents the cheque for collection.
Say, the cheque is collected on 7th March. So, between those periods,
the available balance will be lower than the book balance by Rs. 20,000. NOTES
What is the Collection float?

Books:
TMH Publication.
Publication.
Publication
Ltd, New Delhi.
Web References:
1. Motives for holding cash, available at: http://accountlearning.blogspot.in/
2012/05/motives-for-holding-cash.html
2. Cash Management Techniques, available at:
http://www.treasury.nl/files/2007/05/550.pdf
3. Float - a useful tool, available at:
http://www.icai.org/post.html?post_id=2935
4. Working Capital and Cash management, available at: https://

www.icsa.org.uk/assets/files/pdfs/BusinessPractice_and_IQS_docs/
studytexts/cfm2/o_CFM_6thEd_StudyText_Chapter10.pdf.

Receivable Management
UNIT 17 : RECEIVABLE MANAGEMENT
Structure
17.2 Concept of Receivable
17.3 Cost Associated with Receivable
17.4 Receivable Management
17.5 Credit Policy
17.5.1 Types of Credit Policy
17.4.2 Optimum Credit Policy
17.6 Credit Standard and Analysis
17.7 Credit Terms
17.8 Collection Policy and Procedures
17.9 Factoring
17.9.1. Type of Factoring
17.10 Key Terms
17.11 Summary
17.0 Introduction
Management of Receivables also known as management of trade credit is one of
three primary components of working capital, the other being inventory and cash.
Receivables occupy second important place after inventories and thereby constitute
a substantial portion of current assets in several firms. The capital invested in
receivables is almost of the same amount as that invested in cash and inventories.
Receivables thus, form about one third of current assets in India. Trade credit is an
important market tool. As, it acts like a bridge for mobilization of goods from production
to distribution stages in the field of marketing. Since real profit only occurs when an
invoice is paid, but in a modern "trade credit" economy, in order to keep customers
and grow your business you need to offer credit terms. Even with the buyer's
agreement on when payment is supposed to be due, payments will often lag, putting
a dent in your cash flow or worse, forcing you to increase borrowing to maintain
Receivable Management operations. Poor accounts receivable practices equal poor cash flow, so proper
management of these account receivable is critical for the success of any business.
The main objective of this unit is to explore the concept of receivables management,
its importance and various strategies or methods of receivables management.
NOTES 17.1 Unit Objectives

• Explain the concept of Receivable
• Understand the concept credit sales and receivable arising out of it
• Understand the need and objectives of an effective credit policy
• Explain optimum credit policy
• Determine the process of credit analysis
• Know the benefits of factoring
17.2 Concept of Receivables
When a firm sells goods for cash, payments are received immediately and, therefore,
no receivables are credited. However, when a firm sells goods or services on credit,
the payments are postponed to future dates and receivables are created. Accounts
receivables constitute a significant portion of the total currents assets of the business
next after inventories. They are direct consequences of "trade credit" which has
become an essential marketing tool in modern business. When goods and services
are sold under an agreement permitting the customer to pay for them at a later date,
the amount due from the customer is recorded as accounts receivables. Receivables
are assets accounts representing amounts owed to the firm as a result of the credit
sale of goods and services in the ordinary course of business.
Accounts receivables are amounts owed to the business enterprise,

usually by its customers. Sometimes, it is broken down into trade accounts
receivables; the former refers to amounts owed by customers, and the latter
refers to amounts owed by employees and others.
...… Robert Anthony
17.3. Cost Associated with Receivables

Many businesses extend credit to their customers as a matter of course without
evaluating the cost and consequences of doing so. Maintaining receivables bears
cost which includes:

• Opportunity Cost Receivable Management
This is the cost of funds being tied up in receivables, which would

otherwise have not been incurred if all sales were in cash.
• Administrative cost
It include labour and direct expenses (such as paper and postage) NOTES
associated with billing your customers, collecting past due invoices and
processing payments.
• Bad Debt Losses
This is the loss due to default customers. Extension of credit to low
quality-rate customers results into increase in bad debt losses.
• Financing Costs
The size of your accounts receivable balance drives the size of your
financing costs. There are interest costs if you have to borrow to get the
operating cash represented by these receivables.
• Cash Discount
It is the cost incurred to induce the customer for early payments of their
accounts. A firm can offer cash discount to its customers to reduce the
average collection period, bad debt losses, and the cost of investment in
receivables.
17.4 Receivable Management

The purpose of any commercial enterprise is earning profits, credit in itself is utilized
to increase sale, but sales must return a profit. The primary objective of management
or receivables should not be limited to expansion of sales but should involve
maximization of overall returns on investment. Management of receivables is a
process under which decisions to maximise returns on the investment blocked in
receivables are taken. In order that the credit sales are properly managed it is
necessary to determine following factors:
• The terms of credit granted to customers deemed creditworthy.
• The policies and practices of the firm in determining which customers
are to be granted credit.
• The paying practices of credit customers.
• The vigour of the sellers, collection policies and practice.
• The volume of credit sales

17.5 Credit Policy
Credit is one of the important and vital factors that influence the demand for a firm's
product or services. In today's competitive environment it is becoming an essential
marketing tool for growth. Although, the degree of granting credit is different in
NOTES different organizations based on market size, nature of product and services, industry
norms and management approach. .The discharge of the credit function in a company
includes a number of activities for which the policies have to be clearly laid down.
Such a step will ensure consistency in credit decisions and actions. A credit policy
thus, establishes guidelines that govern grant or reject credit to a customer, what
should be the level of credit granted to a customer etc. A credit policy can be said to
have a direct effect on the volume of investment a company desires to make in
receivables. All companies should have, and follow, written credit policies.
17.5.1 Types of Credit Policy
• Loose or Expansive Credit Policy

In this type of credit policy firms grand credit to customers very liberally.
Credits are granted even to those whose credit worthiness is not proved, not
known and are doubtful. This type of credit policy always results in higher
sales but at the same time cost of bad debt and credit management tend to
increase.
• Tight or Restrictive Credit Policy
In this policy credit standard and control are very high and firms are very
selective in extending credit. They sell on credit, only to those customers who
had proved credit worthiness and fulfil the entire credit standards established
by the organization. This type of policy minimizes the cost of bad debt but at
the same time restrict the sales volumes.
17.5.2 Optimum Credit Policy

Credit policy of every company is at large influenced by two conflicting objectives
irrespective of the native and type of company. They are liquidity and profitability.
When firm has a liberated credit policy, it will result in increased sale. However risk
will also rise with rising of sale. When we sell the good to such debtors whose
capability to pay is not good, and then it is possible that a few amounts will become
bad debts. On other hand, when company's credit policy is strict, then it will raise
liquidity and security, however decrease the profitability. Therefore, finance manager
must make credit policy at optimum level where profitability and liquidity will be
equivalent. Figure 14.1 show the concept of optimum credit policy.

NOTES
Figure 17.1: Graphical Representation of Optimum Credit Policy

(Source: http://www.tutorsglobe.com/homework-help/financial-management/
elements-of-debtors-management-73993.aspx)
In reality, it is rather a different task to establish an optimum credit policy as
the best combination of variables of credit policy is quite difficult to obtain. The
important variables of credit policy should be identified before establishing an optimum
credit policy. Three important decisions variables of credit policy are:
• Credit Standards and analysis
These are the criteria on the basis on which company decide the types
of customers to whom goods could be sold on credit.
• Credit terms
These are the negotiated terms such as the monthly and total credit
amount, maximum time allowed for repayment, discount for cash or
early payment, and the amount or rate of late payment penalty.
• Collection policy
Collection policy refers to the procedures adopted by a firm (creditor) Check Your Concept
collect the amount of from its debtors when such amount becomes due 1. What is receivable?
after the expiry of credit period.
2. What do mean by cash
17.6 Credit Standards and Analysis discount?
3. Explain the different
cost associated with
17.6.1 Credit Standards
receivables
Credit standards refers to the minimum criteria adopted by a firm for the purpose of
short listing its customers for the purpose of extension of credit during a period of
time The nature of credit standard followed by a firm can determine changes in Corporate Finance : 291
Receivable Management sales and receivables. A liberal credit standard always tends to increase the sales
through credit grant to more customers as a results, firm would have to expand
receivables investment along with sustaining costs of administering credit and bad-
debt losses.
On the other hand, strict credit standards would mean extending credit to
NOTES
financially sound customers only. This saves the firm from bad debt losses and the
firm has to spend lesser by a way of administrative credit cost. But, this reduces
investment in receivables besides depressing sales. In this way profit sacrificed by
the firm on account of losing sales amounts more than the cost saved by the firm.
Thus the choice of optimum credit standards involves a trade-off between the
incremental returns and incremental costs.
17.6.2 Credit Analysis

It is not enough just to establish credit standards; in addition to that a firm
should also develop a procedure for evaluating the customers for credit grant. These
procedures set by company come under credit analysis. It involves collecting credit
information and proper evaluation of this information to determine the creditworthiness
of a customer. Credit analysis process involves following two steps:
17.6.2.1 Obtaining Credit Information

For the proper credit analysis firstly information about the credit history of
any customer is required. Theses information can be obtain from various sources.
These sources are:
• Financial Statements
A firm can ask a customer to supply financial statements. Rules of thumb
based on calculated financial ratios can be used.
• Credit reports on customer's payment history with other firms
Many organizations sell information on the credit strength of business
firms. Firms such as Experian, Equifax and Dun & Bradstreet provide
subscribers with credit reports on individual firms.
• Banks references
Banks will generally provide some assistance to their business customers
in acquiring information on the creditworthiness of other firms.
• Payment History of Customer With the Firm
The most obvious way to obtain an estimate of a customer's probability
of non-payment is whether he or she has paid previous bills
17.6.2.2 Analysis of Credit Information

Once the credit information has been collected from different sources, it should be
analysed to determine credit worthiness of the applicant. Although there is no
Corporate Finance : 292 established procedures to analyse the information still firm can adopt any suitable
method. Firm can adopt credit scoring methods in which it gives score on different
parameters and calculate the overall score to determine whether or not credit should
be grant. Parameters for credit analysis can be
• Character: The customer's willingness to meet credit obligations.
• Capacity: The customer's ability to meet credit obligations out of operating NOTES
cash flows.
• Capital: The customer's financial reserves.
• Collateral: A pledged asset in the case of default.
• Conditions: General economic conditions.
On the basis of overall score customers can be classified into:
• Good Accounts
Good accounts refer to customers with strong credit creditworthiness and the
chance of default is nominal.
• Bad Account
These customers are financially very weak and having a strong probability of
default.
• Marginal Account
These are the customers with moderate financial health. Risks of default of
these customers are between the good and bad accounts.
17.7 Credit Terms

Credit terms refer to the conditions recognized by the firms for making credit sale of
the goods to its buyers. In other words, credit terms mean the terms of payments of
the receivables. A firm is required to consider various aspects of credit customers,
approval of credit period, and acceptance of sales discounts. There are two important
components of credit terms which are:
• Credit Period
The credit period is the time length for which seller agrees to provide credit to
the buyers. It varies according to the practice of trade and varies between 15
to 60 days. In some cases for an early payment pre-agreed discount is given
to induce buyer make an early payment.
• Cash Discount Terms
One of the most common credit terms is the amount of days before full payment
is due. For example, an invoice may have credit terms of two ten net 30. This
implies that full payment is due within 30 days from the date the invoice was
printed. If payment is received within ten days from the date the invoice was
printed, a two percent discount will be deducted from the full balance.

17.8 Collection Policy and Procedures
Even the most profitable venture won't stay afloat if they can't collect cash. A
healthy cash flow allows businesses to pay unexpected expenses and take part in
last-minute investment opportunities. In order to collect on receivables, a company
NOTES should have a clear and understandable collection policy. These policies refer to the
procedures adopted by a firm (creditor) collect the amount of from its debtors when
such amount becomes due after the expiry of credit period.The firm usually employs
the following procedures for customers that are overdue:
• Send a delinquency letter informing the customer of the past-due status
of the account.
• Make a telephone call to the customer.
• Employ a collection agency.
• Take legal action against the customer.
17.9 Factoring
Factoring is a financial technique where a specialized firm (factor) purchases from
the clients accounts receivables that result from the sales of goods or the provision
of services to customers. In this way, the customer of the client firm becomes the
debtor of the factor and has to fulfil its obligations towards the factor directly. The
factoring agreement usually assumes that the whole credit risks as well as the
collection of the accounts are taken by the factor. Factoring offers enterprises,
Check Your Concept particularly small and medium ones, a means of financing their need for working
4. What is optimal credit capital, but also an instrument of collection of receivables and default risk hedging.
policy? Factoring is often used synonymously with accounts receivable funding. Factoring
is a form of commercial funding whereby a business sells its accounts receivable (in
5. What are the sources
the form of invoices) at a discount. Effectively, the business is no longer dependent
of obtaining credit
on the conversion of accounts receivable to cash from the actual payment from
information?
their customers, which takes place on typical 30 to 90 day terms. Businesses benefit
6. What is the difference from the acceleration of cash flow.
beetween recourse
and non-recousrse 17.9.1 Types of Factoring
factoring
There are a number of types of factoring in both theory and practice. They depend
on the relation between the main actors in the factoring operation. Some basic data
on factoring are given below:
• Recourse Factoring
In recourse factoring, the factor turns to the client (seller), if the receivables
become bad, i.e. if the customer does not pay on maturity. The risk of bad
receivables remains with the client, and the factor does not assume any risk
Corporate Finance : 294 associated with the receivables. The factor provides the service of receivables
collection, but does not cover the risk of the buyer failing to pay the debt. The Receivable Management
factor can recover the funds from the seller (client) in the case of such
default. The seller assumes the risks associated with the credit and the buyer's
creditworthiness. The factor charges the seller for the management of
receivables and debt collection services, while also charging interest on the
amount advanced to the client (seller). NOTES
• Non-recourse Factoring
In non-recourse factoring, the factor assumes the risk of non-payment by the
client's customers. The factor cannot demand any outstanding amount from
the client (seller). The commission or fees charged for non-recourse factoring
services are higher than for recourse factoring. The factor assumes the risk
of non-payment on maturity and consequently takes an additional fee called a
"del credere commission".
17.10 Key Terms

• Accounts Receivables: Amounts owed to a business for goods or services
rendered that it expects to receive.
• Aging: A process where accounts receivable are sorted out by age (typically
current, 30 to 60 days old, 60 to 120 days old, and so on.) Aging permits
collection efforts to focus on accounts that are long overdue.
• Bank Reference: The information returned as a result of a written request
which is sent to the applicant's bank asking for its opinion regarding the financial
standing of the applicant.
• Cash Discount: An incentive that a seller offers to a buyer in return for
paying a bill owed before the scheduled due date. The seller will usually
reduce the amount owed by the buyer by a small percentage.
• Collection Charges: Fees added to accounts receivable for outside collection
efforts, including administration costs, penalties and interest.
• Credit account: An account that allows buyers to obtain goods or services
without paying for them until a later date.
• Credit Memo: It is a document issued by a company to a customer to
offset all or part of an invoice, to correct accounts receivable and make good
to the customer for such issues as damaged or return goods, lack of delivery,
incorrect prices or freight charges, or other such problems. The company
usually applies the credit memo against the customer's outstanding balance,
or issues a check to the customer.
• Credit Report: Confidential report on a consumer's payment habits as
reported by their creditors to a consumer credit reporting agency. The agency
provides the information to credit grantors who have a permissible purpose
under the law to review the report.
Receivable Management • Credit Scoring: Tool used by credit grantors to provide an objective
means of determining risks in granting credit. Credit scoring increases
efficiency and timely response in the credit granting process. Credit
scoring criteria is set by the credit grantor.
• Creditor: An individual or organization to whom money is owed.
NOTES
• Default Risk: The event in which companies or individuals will be unable
to make the required payments on their debt obligations. Lenders and
investors are exposed to default risk in virtually all forms of credit
extensions.
• Factor: A company that purchases accounts receivable from a client,
then collects payment for the invoices.
• Factoring: A financial transaction whereby a business sells its accounts
receivable at a discount. The purchasing organization assumes the
responsibility of collecting the invoices
• Trade Credit: An agreement where a customer can purchase goods
on account (without paying cash), paying the supplier at a later date.
Usually when the goods are delivered, a trade credit is given for a specific
amount of days.
17.11 Summary
• Receivables arise out of credit sales for which payment has not yet
received. This process of credit sales involves costs such finance cost,
opportunity cost and time cost that is why its management is very
important. To maximize the value of the firm, these costs must be
controlled and managed properly.
• Volume of receivable depends on the extent of credit sales, credit policy
and the collection efforts of a firm.
• Effective receivable management can be done by determining the trade-
off between the cost of receivable and profitability of additional credit
sales.
• Credit terms refer to the conditions recognized by the firms for making
credit sale of the goods to its buyers. In other words, credit terms mean
the terms of payments of the receivables.
• Collection policy of firm should focus on the acceleration of credit
collection and reduction of bad debt. Cash discount policy can be used
for seed up repayment of credit sales.
• Factoring can be used for accounts receivable funding. Factoring is a
form of commercial funding whereby a business sells its accounts
receivable at a discount. Effectively, the business is no longer dependent
on the conversion of accounts receivable to cash from the actual payment Receivable Management
from their customers, which takes place on typical 30 to 90 day terms.
Businesses benefit from the acceleration of cash flow.
17.12 Questions and Exercises NOTES
1. What is trade debt? What are the costs involved in extension of credit to
the customers?
2. Effective management of receivable is essential for achieving
organizational objectives. Do you agree? Discuss the statement in the
light of effect of receivable management on firm value.
3. Explain the importance of Receivable management.
4. Taking an example of Cement industry, comment on the receivable
management policies of the Top 5 plays in the Cement Industry.
5. Explain the objectives of credit policy? What is an optimum credit policy?
6. What is factoring? Explain the difference between factoring and bill
discounting.
7. Explain the process of credit analysis in detail.
8. Discuss the role of credit rating in receivables management.
9. Taking an example of Service industry, comment on the credit policy of
the firms operating in this industry.
10. Discuss the various sources of information to be obtained before granting
credit to a customer.
10. Discuss the various sources of information to be obtained before granting
credit to a customer.
11. Differentiate between recourse and non- recourse factoring?
12. How are the five Cs of credit used to perform in-depth credit analysis?
Why this framework is typically used only on high-dollar credit requests?
13. How is credit scoring used in the credit selection process? In what types
of situations is it most useful?
14. What are the key variables to consider when evaluating the benefits and
costs of changing credit standards? How do these variables differ when
evaluating the benefits and costs of changing credit terms?
15. Why should a firm actively monitor the accounts receivable of its credit
customers? Explain with suitable illustrations.

Books:
NOTES Publication.
Publication.
Pearson Education
Publication
Ltd, New Delhi.
Web resources:
1. Concept of receivable management, available at: http://
www.mbaknol.com/business-finance/the-concept-of-receivables-
management/
2. Receivable management, available at: http://shodhganga.inflibnet.ac.in/
bitstream/10603/703/11/11_chapter5.pdf
3. Credit policy, available at: http://www.fecma.eu/Documents/
FECMA%20Credit%20Policy%20chapt%20%201.pdf
4. Factoring, available at:
• http://www.qfinance.com/contentFiles/QF02/g1xtn5q6/12/2/factoring-
and-invoice-discounting-working-capital-management-options.pdf
• http://www.vendorseek.com/what-is-factoring.asp

Derivatives &
UNIT18 : DERIVATIVES & RISK MANAGEMENT Risk Management
Structure
18.0 Introduction
18.1 Unit Objectives NOTES
18.2 Concept of Risk Management
18.3 Types of Financial Risk
18.4 Derivatives
18.5 Types of Derivatives Products
18.5.1 Forward
18.5.2 Future
18.5.3 Options
18.5.4 Swap
17.6 Participants in Derivatives Market
17.7 Key Terms
17.8 Summary
18.0 Introduction
In every business, decision making involves certain amount of risk. This risk can
broadly be classified as business risk and financial risk. These risks have always
been part of financial activities, but after 1990’s risk management has become a key
business function. Now a days due to increased volatility of stock markets forced
managers to pay attention on risk management to reduce the risk. This chapter
describes various financial instruments that help financial institutions in managing
risk in a better way. These instruments, called financial derivatives, have payoffs
that are linked to previously issued securities and extremely useful risk reduction
tools.
In this chapter, we mainly focus on most important financial derivatives like
future, forward, option and swaps. We will also look in to the functioning of these
instruments and try to understand that how these instruments reduce the financial risk.

• Explain the concept of risk
• Understand the need of risk management Corporate Finance : 299
Derivatives & • Understand the concept of derivatives
Risk Management
• Know about various derivative instruments
• Determine the role of derivatives in risk management
NOTES 18.2 Concept of Risk Management

Managing risk is important to a large number of individuals and institutions. The
most fundamental aspect of business is a process where we invest, take on risk and
in exchange earn a compensatory return. The key to success in this process is to
manage your risk return trade-off. Managing risk is a nice concept but the difficulty
is often measuring risk. There is a saying “what gets measured gets managed.” To
alter this slightly, “What cannot be measured cannot be managed” Hence risk
management always requires some measure of risk. Risk in the most general context
refers to the chance of loss or an unfavorable outcome associated with an action.
The deregulation of financial markets, the lifting of exchange controls and the
motivation to capture international markets has meant that organisations must operate
within a volatile global environment. These organisations are vulnerable to financial
risk that may result from interest rate, exchange rate or commodity price movements.
The purpose of this segment is to equip you with the necessary skills to assess these
financial risks and manage them strategically with the use of financial instruments.For
an individual farm manager, risk management involves optimizing expected returns
subject to the risks involved and risk tolerance. More specifically risk management
is the process of identifying, analyzing and addressing significant risks on an ongoing
basis. It is a process that can help avoid negative outcomes, and help recognize
emerging opportunities. The outcome for a project team in committing to a risk
management process is the development of an action plan, that when taken, may
help to mitigate the probability of a risk happening and the consequences of a risk
when it happens.
In all projects, there are a number of ways to allocate risks:
• Transferred risks (risks transferred to contracting party)
• Retained risks (risks retained by the public sector agency)
• Shared risks (risks shared between the contracting party and the public
sector)
18.3 Types of Financial Risk

• Interest rate risk: Interest rate risk is the risk of falling bond prices
due to the rise in interest rates. Usually, the longer the maturity, the
greater the degree of price volatility. If you hold a bond until maturity,
you may be less concerned about these price fluctuations (which are
known as interest-rate risk, or market risk), because you will receive the
par, or face, value of your bond at maturity. Various economic forces Derivatives &
Risk Management
affect the level and direction of interest rates in the economy. Interest
rates typically climb when the economy is growing, and fall during
economic downturns. Similarly, rising inflation leads to rising interest
rates (although at some point, higher rates themselves become contributors
to higher inflation), and moderating inflation leads to lower interest rates. NOTES
Inflation is one of the most influential forces on interest rates
• Foreign-Exchange Risk: Foreign-exchange risk is the risk that an
asset or investment denominated in a foreign currency will lose value as
a result of unfavourable exchange rate fluctuations between the
investment’s foreign currency and the investment holder’s domestic
currency. This risk usually affects businesses that export and/or import,
but it can also affect investors making international investments. For
example, if money must be converted to another currency to make a
certain investment, then any changes in the currency exchange rate will
cause that investment’s value to either decrease or increase when the
investment is sold and converted back into the original currency.
• Price Risk: All markets whether it is of commodity or stock, is dynamic
and involves price fluctuations. This continuous changing price causes
the profit of a business enterprise to change. Price risk can be manage
or kept within the acceptable limits with the help of financial instruments
specifically devised for the purpose. Investors can use a number of
relatively conservative decisions such as buying put options, to more
aggressive strategies including short-selling and inverse ETFs
18.4 Derivatives
One of the key features of financial markets is extreme volatility. Prices of foreign
currencies, petroleum and other commodities, equity shares and instruments fluctuate
all the time, and pose a significant risk to those whose businesses are linked to such
fluctuating prices. To reduce this risk, modern finance provides a method called
hedging. Derivatives are widely used for hedging. Of course, some people use it to
speculate as well. A derivative is a financial contract with a value that is derived
from an underlying asset. Derivatives have no direct value in and of themselves -
their value is based on the expected future price movements of their underlying
asset. The underlying asset can be equity, forex, commodity or any other asset. For
example, wheat farmers may wish to sell their harvest at a future date to eliminate
the risk of a change in prices by that date. Such a transaction is an example of a
derivative. The price of this derivative is driven by the spot price of wheat which is
the “underlying”.
In the Indian context the Securities Contracts (Regulation) Act, 1956
(SC(R)A) defines “derivative” to include - Corporate Finance : 301
Derivatives & • A security derived from a debt instrument, share, loan whether secured
Risk Management or unsecured, risk instrument or contract for differences or any other
form of security.
• A contract which derives its value from the prices, or index of prices, of
underlying securities.
NOTES Derivatives are often used as an instrument to hedge risk for one party of a contract,
while offering the potential for high returns for the other party. Derivatives have
been created to mitigate a remarkable number of risks such as fluctuations in stock,
bond, commodity, and index prices; changes in foreign exchange rates; changes in
interest rates; and weather etc.A derivative is traded between two parties – who
are referred to as the counterparties. These counterparties are subject to a pre-
agreed set of terms and conditions that determine their rights and obligations.
Derivatives can be traded on or off an exchange and are known as
• Exchange-Traded Derivatives (ETDs): Standardised contracts traded
on a recognised exchange, with the counterparties being the holder and
the exchange. The contract terms are non-negotiable and their prices
are publicly available.
• Over-the-Counter Derivatives (OTCs): Bespoke contracts traded
off-exchange with specific terms and conditions determined and agreed
by the buyer and seller (counterparties). As a result OTC derivatives
are more illiquid, eg forward contracts and swaps.
18.5 Types of Derivatives Instruments

The past few decades have witnessed a revolution in the trading of derivative securities
in world financial markets. There is wide range of instruments available as derivatives.
Every instrument has its own features and applicability. The most common types of
derivative contracts are forwards, futures, options and swap.
18.5.1 Forward
A forward contract is a private agreement between two parties giving the buyer an
obligation to purchase an asset (and the seller an obligation to sell an asset) at a set
price at a future point in time. The party who agrees to buy the asset is called the
long and the party selling the asset is called the short. The assets often traded in
forward contracts include commodities like grain, precious metals, electricity, oil,
beef, orange juice, and natural gas, but foreign currencies and financial instruments
are also part of today’s forward markets.
These financial instruments were devised to mitigate risk, by the way of

securing buyers today for future produce. Parties involved in a forward contract
have a contractual obligation to buy or sell the asset in question on maturity of the
contract. There are two ways in which this obligation can be met; delivery and cash
settlement.
Corporate Finance : 302 • Delivery: This is the case when the long pays the short the agreed upon
amount, in exchange, the short will deliver the asset to the long. This type of Derivatives &
Risk Management
forward is typically called a deliverable forward.
• Cash settlement: Cash settlement is when the parties agree to calculate the
market value of the position at expiry and a payment is made to the long. A
forward contract involving cash settlement is called a non-deliverable forward.
NOTES
Example : You are a trader of fruits. You enter into a contract with a farmer to
deliver 1000 kilograms of apples at 100 per kilo, 3 months from now. That’s a forward
contract. Here, apples are the specified asset, 100 per kilo is the specified price and
3 months is the specified future date.
18.5.2 Futures
A futures contract is an agreement between two parties - a buyer and a seller - to
buy or sell something at a future date. The contact trades on a futures exchange and
is subject to a daily settlement procedure. Future contracts evolved out of forward
contracts and possess many of the same characteristics. Unlike forward contracts,
futures contracts trade on organized exchanges, called future markets. Future
contacts also differ from forward contacts in that they are subject to a daily settlement
procedure. In the daily settlement, investors who incur losses pay them every day to
investors who make profits. In every futures contract, everything is specified: the
quantity and quality of the commodity, the specific price per unit, and the date and
method of delivery. The “price” of a futures contract is represented by the agreed-
upon price of the underlying commodity or financial instrument that will be delivered
in the future
Essentially a Futures contract has following features
• The buyer of a futures contract, the “long,” agrees to receive delivery;
• The seller of a futures contract, the “short,” agrees to make delivery;
• The contracts are traded on exchanges either by open outcry in specified
trading areas (called pits or rings) or electronically via a computerized
network;
• Futures contracts are marked to market each day at their end-of-day
settlement prices, and the resulting daily gains and losses are passed
through to the gaining or losing accounts;
• Futures contracts can be terminated by an offsetting transaction (i.e., an
equal and opposite transaction to the one that opened the position)
executed at any time prior to the contract’s expiration. The vast majority
of futures contracts are terminated by offset or a final cash payment
rather than by delivery; and
• The same or similar futures contracts can be traded on more than one
exchange in the United States or elsewhere, although normally one
contract tends to dominate its competitors on other exchanges in terms
of trading activity and liquidity.
Derivatives & Difference between futures and forward contracts:
Risk Management
Forward contract Futures contract
Definition A forward contract is an A futures contract is a
agreement between two parties standardized contract, traded
NOTES to buy or sell an asset (which on a futures exchange, to buy
can be of any kind) at a pre- or sell a certain underlying
agreed future point in time at instrument at a certain date in
a specified price. the future, at a specified price.
Structure & Customized to customer needs. Standardized. Initial margin
Purpose Usually no initial payment payment required. Usually
required. Usually used for used for speculation.
hedging.
Transaction Negotiated directly by the Quoted and traded on the
method buyer and seller Exchange
Market regulation Not regulated Government regulated
market (the Commodity
Futures Trading
Commission or CFTC is the
governing body)
Institutional The contracting parties Clearing House
guarantee
Risk High counterparty risk Low counterparty risk
Guarantees No guarantee of settlement Both parties must deposit
until the date of maturity only an initial guarantee
the forward price, based on the (margin). The value of the
spot price of the underlying operation is marked to
asset is paid market rates with daily
settlement of profits and
losses.
Check Your Concept Contract Maturity Forward contracts generally Future contracts may not
1. What is risk? mature by delivering the necessarily mature by
commodity. delivery of commodity.
price risk? Expiry date Depending on the transaction Standardized
3. What do you mean by Method of pre- Opposite contract with same Opposite contract on the
derivatives? termination or different counterparty. exchange.
4. Difference between Counterparty risk remains
Exchange-Traded while terminating with different
Derivatives (ETDs) counterparty.
and Over-the-Counter Contract size Depending on the transaction Standardized
Derivatives (OTCs). and the requirements of the
contracting parties.
Market Primary & Secondary Primary
Derivatives &
18.5.3 Options Risk Management
An options contract is an agreement between a buyer and seller that gives the
purchaser of the option the right, but not the obligation to buy or sell a particular
asset at a later date at an agreed upon price. Options contracts are often used in
securities, commodities, and real estate transactions. It establishes a specific price, NOTES
called the strike price, at which the contract may be exercised, or acted upon.
Contracts also have an expiration date. When an option expires, it no longer has
value and no longer exists.
Option contracts are either put or call options:
• Call Option. The owner of a Call Option has the right to purchase
the underlying good at a specific price, and this right lasts until a
specific date.
• Put Option. The owner of a Put Option has the right to sell the
underlying good at a specific price, and this right lasts until a specific
date.
18.5.3.1 In the money/at the money/out of money
In case of option contract, when the price of the underlying security is equal to the
strike price, an option is at-the-money. A call option is in-the-money if the strike
price is less than the market price of the underlying security. A put option is in-the-
money if the strike price is greater than the market price of the underlying security.
A call option is out-of-the-money if the strike price is greater than the market price
of the underlying security. A put option is out-of-the money if the strike price is less
than the market price of the underlying security.
Example:
Option Strike price Market price Status

(in Rs.) (in Rs.)
Call 35 29 out-of-the-money
Put 45 52 out-of-the-money
Call 25 25 at-the-money
Put 100 100 at-the-money
Call 10 16 in-the-money
Put 40 25 in-the-money
18.5.3.2. Features of an options contract

• The buyer has the right to buy or sell the asset.
• To acquire the right of an option, the buyer of the option must pay a price
to the seller. This is called the option price or the premium.
• The exercise price is also called the fixed price, strike price or just the
strike and is determined at the beginning of the transaction. It is the Corporate Finance : 305
Derivatives & fixed price at which the holder of the call or put can buy or sell the
Risk Management
underlying asset.
• Exercising is using this right the option grants you to buy or sell the
underlying asset. The seller may have a potential commitment to buy or
sell the asset if the buyer exercises his right on the option.
NOTES
• The expiration date is the final date that the option holder has to exercise
her right to buy or sell the underlying asset.
• An American option can be exercised at any time, whereas a European
option can only be exercised at the expiration date.
18.5.3.3 Difference between futures and options contract

• An Option gives the buyer the right but not the obligation while the seller
has an obligation to comply with the contract. In the case of a futures
contract, there is an obligation on the part of both the buyer and the
seller. When you purchase call or put Options you have the right to let
your Option lapse but if you choose to exercise it, the counter-party
(seller) must comply. A futures contract, on the other hand, is binding on
both counter-parties as both parties have to settle on or before the expiry
date
• Purchasing a futures contract requires an upfront margin and normally
involves a larger outflow of cash than in the case of Options, which
require only the payment of premium.
• A futures contract carries unlimited profit and loss potential whereas the
buyer of a Call or Put Option’s loss is limited but the profit potential is
unlimited.
• Futures are a favourite with speculators and arbitrageurs whereas Options
are widely used by hedgers
Check Your Concept 18.5.4 Swaps

5. Advantages of future Swaps are agreements between two companies to exchange cash flows in the
contract? future accordig to a prearranged formula. Swaps, therefore, may be regarded as a
portfolio of forward contra.Swaps are traded on overthecounter derivatives markets
6. Difference beteween
and are most common in interest rates, currencies and commodities. They often
future and forward?
extend much further into the future than exchange contracts. The two commonly
7. What is strike price? used swaps are:
8. Differentiate between • Interest rate swaps: An interest rate swap is an agreement between
American and two parties to exchange one stream of interest payments for another,
Europen options. over a set period of time. In an interest rate swap, the principal amount
is not actually exchanged between the counterparties, rather interest
payments are exchanged based on a ‘notional amount’ or ‘notional
Corporate Finance : 306 principal’.
• Currency swaps: A currency swap is a contract which commits two Derivatives &
Risk Management
counter parties to an exchange, over an agreed period, two streams of
payments in different currencies, each calculated using a different interest
rate, and an exchange, at the end of the period, of the corresponding
principal amounts, at an exchange rate agreed at the start of the contract.
NOTES
18.6 Participants in Derivatives Market

On the basis of their trading motives, participants in the derivatives markets
can be segregated into four categories - hedgers, speculators, margin traders and
arbitrageurs. Let’s take a look at why these participants trade in derivatives and
how their motives are driven by their risk profiles.
• Hedgers: These are investors with a present or anticipated exposure to
the underlying asset which is subject to price risks. Hedgers use the
derivatives markets primarily for price risk management of assets and
portfolios.
• Speculators: These are individuals who take a view on the future
direction of the markets. They take a view whether prices would rise or
fall in future and accordingly buy or sell futures and options to try and
make a profit from the future price movements of the underlying asset.
• Arbitrageurs: They take positions in financial markets to earn riskless
profits. The arbitrageurs take short and long positions in the same or
different contracts at the same time to create a position which can
generate a riskless profit.
• Margin traders: Margin traders are speculators who make use of the
payment mechanism, which is peculiar to the derivative markets. When
you trade in derivative products, you are not required to pay the total
value of your position up front. You are only required to deposit a fraction
(called margin) of the value of your outstanding position. This is called
margin trading and results in a high leverage factor in derivative trades,
i.e., with a small deposit, you are able to maintain a large outstanding
position. This leverage factor is a multiplier, which allows the speculator
to buy three to five times the quantity that his capital investment would
otherwise have allowed him to buy in the cash market.
18.7 Key Terms

• Credit Risk: Credit risk is the risk of loss from counterparty in default
or from a pejorative change in the credit status of a counterparty that
causes the value of their obligations to decrease.

Derivatives & • Hedge: A transaction that offsets an exposure to fluctuations in financial
Risk Management
prices of some other contract or business risk. It may consist of cash
instruments or derivatives.
• Hybrid Security: Any security that includes more than one component.
For example, a hybrid security might be a fixed income note that includes
NOTES
a foreign exchange option or a commodity price option.
• Intrinsic Value: The economic value of a financial contract, as distinct
from the contract’s time value. One way to think of the intrinsic value of
the financial contract is to calculate its value if it were a forward contract
with the same delivery date. If the contract is an option, its intrinsic
value cannot be less than zero.
• Look-Back Options: An option which gives the owner the right to buy
(sell) at the lowest (highest) price that traded in the underlying from the
inception of the contract to its maturity, i.e. the most favourable price
that traded over the lifetime of the contract.
• Margin: A credit-enhancement provision to master agreements and
individual transactions in which one counterparty agrees to post a deposit
of cash or other liquid financial instruments with the entity selling it a
financial instrument that places some obligation on the entity posting the
margin.
• Mark to Market Accounting: A method of accounting most suited for
financial instruments in which contracts are revalued at regular intervals
using prevailing market prices. This is known as taking a “snapshot” of
the market.
• Netting: When there are cash flows in two directions between two
counterparties, they can be consolidated into one net payment from one
counterparty to the other thereby reducing the settlement risk involved
• Premium: The cost associated with a derivative contract, referring to
the combination of intrinsic value and time value. It usually applies to
options contracts. However, it also applies to off-market forward
contracts.
• Strike Price: The price at which the holder of a derivative contract
exercises his right if it is economic to do so at the appropriate point in
time as delineated in the financial product’s contract.
18.8 Summary
• In every business, decision making involves certain amount of risk. This

risk can broadly be classified as business risk and financial risk. These
Corporate Finance : 308 risks have always been part of financial activities, and affect the financial
decisions of a business up to a great extent. Derivatives &
Risk Management
• Therefore risk is critical for the success of any business enterprise. It is
a continuing process to identify, analyze, evaluate, and treat loss
exposures and monitor risk control and financial resources to mitigate
the adverse effects of loss.
NOTES
• Derivatives instruments are become very important tool of risk
management. Basically, derivatives had been introduced in order to hedge
against the price risk (risk of price of asset owned going in an
unfavourable direction). It enabled transfer of risk from those who were
not willing to take it (hedgers) to those who were intentionally willing to
assume it
• A derivative is a financial contract with a value that is derived from an
underlying asset. Derivatives have no direct value in and of themselves
- their value is based on the expected future price movements of their
underlying asset. The underlying asset can be equity, forex, commodity
or any other asset.
• Most common derivative instruments are future, forward, options and
swaps. Every instrument has its own features and applicability.
• A forward contract is a private agreement between two parties giving
the buyer an obligation to purchase an asset (and the seller an obligation
to sell an asset) at a set price at a future point in time. The party who
agrees to buy the asset is called the long and the party selling the asset
is called the short.
• Future contracts evolved out of forward contracts and possess many of
the same characteristics. Unlike forward contracts, futures contracts
trade on organized exchanges, called future markets.
• An Option contract is an agreement in which a seller (writer) conveys
to a buyer (holder) of a contract the right, but not the obligation, to buy or
sell a specific quantity of something at a specified price on or before a
specified date.

1. What do you understand by risk and what are the different ways of
classifying and managing them?
2. What are the different kinds of financial risk?
3. What do you mean by derivatives? Differentiate between exchange
traded and over-the-counter derivatives.

Derivatives & 4. What is a forward contract and how it is different from a future contract?
Risk Management
5. Explain the key specifications parameters of a future contract.
6. What is a currency swap and how it is different from an interest rate
swap?
NOTES 7. What is an option contract? Explain the advantages of option over future
contract.

Books
1. Ross, Westerfield & Jaffe, “Fundamental of Corporate Finance”,
TMH Publication.
2. Chandra, Prasanna, “Investment Analysis and Portfolio
Management”, TMH Publication.
3. Khan, M.Y. and Jain, P.K., “Financial Management- Text, Problems
and cases”, TMH Publication.
4. Srivastava, Rajiv, “Derivatives and Risk Management” ,Oxford
university press.
Web resources
1. Risk Management, available at:,
• http://www.tamu.edu/faculty/rakwater/research/Risk-
Management.pdf
2. Concept of Derivatives, available at:
• h t t p s : / / w w w. j p m o r g a n . c o m / c m / B l o b S e r v e r /
is_napfms2013.pdf_for_pensions_page?blobkey=id&blobwhere=
1320629079768&blobheader=application/
pdf&blobheadername1=CacheControl&blobheadervalue1=
private&blobcol=urldata&blobtable=MungoBlobs
• http://nikhil-barjatya.tripod.com/ncfm/derivative/7-46.pdf
3. Derivatives instruments, available at:
• http://www.oswego.edu/~edunne/340ch9.htm
• http://www.csie.ntu.edu.tw/~lyuu/Capitals/lessons_der.pdf

Merger and Acquisition
UNIT 19 : MERGER AND ACQUISITION
Structure
19.0 Introduction
NOTES
19.2 Merger & Acquisition in India
19.3 Merger
19.3.1. Forms of Merger
19.4 Acquisition
19.5 Difference between Merger and Acquisition
19.6 Strategic rationales for Merger & Acquisition
19.7 Steps in Merger & Acquisition
19.8 Due Diligence
19.9 Regulatory framework for Merger & Acquisition
19.10 Key Terms
19.11 Summary
19.0 Introduction
A business can grow through either internal expansion or external expansion. In
external option, firm can acquire a running business and expend overnight through
the combination of business. These combinations can be in the form of merger,
acquisitions and takeovers. Mergers and acquisitions have now become a prominent,
and permanent, part of the corporate landscape. A glance at any business newspaper
will indicate that mergers and acquisitions are big business and are taking place all
the time. Some sectors, such as finance, oil, pharmaceuticals, telecommunications,
IT and chemicals, have been transformed since 1994 by the occurrence of very
large-scale mergers and acquisitions. Many corporations are using it with a great
effect to improve their competitive positions. And unlike routine capital investments,
merger and acquisition (M&A) deals often strike like lightning, literally changing a
company's strategic and financial characteristics overnight. It has become significantly
popular in India after 1990s, where India entered in to the Liberalization, Privatization
and Globalization (LPG) era.

• Understand the need of M & A
NOTES • Explain the types and form of M & A

• Learn about the process of M & A
• Understand the legal and financial considerations of M & A
• Know about the methods of payment in M & A
19.2 Merger and Acquisitions in India

Most of the mergers and acquisitions are an outcome of the favourable economic
factors like the macroeconomic setting, escalation in the GDP, higher interest rates
and fiscal policies. These factors not only trigger the M & A process but also play an
active role in laying the mergers and acquisition strategies between bidding and
target firms. The history of mergers and acquisitions can be traced back to the 19th
century which has evolved in different phases gradually. But in India in the recent
years has showed tremendous growth in the M&A deal. It has been actively playing
in all industrial sectors. It is widely spreading far across the stretches of all industrial
verticals and on all business platforms. The increasing volume is witnessed in various
sectors like that of finance, pharmaceuticals, telecom, FMCG, industrial development,
automotives and metals. The volume of M&A transactions in India has apparently
increased to about 67.2 billion USD in 2010 from 21.3 billion USD in 2009. At
present the industry is witnessing a whopping 270% increase in M&A deal in the
first quarter of the financial year. This increasing percentage is mainly attributed to
the increasing cross-border M&A transactions. Over that increasing interest of
foreign companies in Indian companies has given a tremendous push to such
transactions. Large Indian companies are going through a phase of growth as all are
exploring growth potential in foreign markets and on the other end even international
companies is targeting Indian companies for growth and expansion. Some of the
major factors resulting in this sudden growth of merger and acquisition deal in India
are favourable government policies, excess of capital flow, economic stability,
corporate investments, and dynamic attitude of Indian companies.
The recent merger and acquisition made by Indian companies worldwide are:
1. Tata Steel's mega takeover of European steel major Corus for $12.2
billion. The biggest ever for an Indian company. This is the first big thing
which marked the arrival of India Inc on the global stage.
2. Vodafone's purchase of 52% stake in Hutch Essar for about $10 billion.
Essar group still holds 32% in the Joint venture.
Corporate Finance : 312 3. Hindalco of Aditya Birla group's acquisition of Novellis for $6 billion.
4. Ranbaxy's sale to Japan's Daiichi for $4.5 billion. Sing brothers sold the Merger and Acquisition
company to Daiichi and since then there is no real good news coming
out of Ranbaxy.
5. ONGC acquisition of Russia based Imperial Energy for $2.8 billion. This
marked the turnaround of India's hunt for natural reserves to compete
with China. NOTES
6. NTT DoCoMo-Tata Tele services deal for $2.7 billion. The second biggest
telecom deal after the Vodafone. Reliance MTN deal if went through
would have been a good addition to the list.
7. HDFC Bank acquisition of Centurion Bank of Punjab for $2.4 billion.
8. Tata Motors acquisition of luxury car maker Jaguar Land Rover for
$2.3 billion. This could probably the most ambitious deal after the Ranbaxy
one. It certainly landed Tata Motors into lot of trouble.
9. Wind Energy premier Suzlon Energy's acquistion of RePower for $1.7
billion.
10. Reliance Industries taking over Reliance Petroleum Limited (RPL) for
8500 crores or $1.6 billion.
19.3 Mergers
The term 'merger' is not defined under the Companies Act, 1956, the Income Tax
Act, 1961 or any other Indian law. Simply put, a merger is a combination of two or
more distinct entities into one; the desired effect being not just the accumulation of
assets and liabilities of the distinct entities, but to achieve several other benefits such
as economies of scale, acquisition of cutting age technology etc. A merger is a
corporate strategy of combining different companies into a single company in order
to enhance the financial and operational strengths of both organizations. In a merger
the owners of separate, roughly equal-sized firms pool their interests in a single firm.
The surviving firm owns the assets and assumes the debts and other liabilities previously
owned or owed by the separate firms. For example, corporation A and corporation
B, of roughly equal size, pool their assets and liabilities into a new corporation AB,
with the shareholders of corporation A holding 40 percent of AB stock and the
shareholders of corporation B holding the remainder, 60 percent of AB stock. Merger
can also be done through absorption, where one firm get absorbed into another firm
and lost its identity. Usually merger occur in a consensual setting, where executives
from the target company help those from the purchaser in a due diligence process to
ensure that the deal is beneficial to both the parties.
19.3.1 Forms of Mergers

There are many types of mergers that redefine the business world with new strategic
alliances and improved corporate philosophies. From the business structure perspective,
some of the most common and significant types of mergers are listed below: Corporate Finance : 313
Merger and Acquisition (1) Horizontal mergers: Horizontal mergers are types of mergers that involve
companies in direct competition with one another. Horizontal mergers
occur when two companies sell similar products to the same markets.
For Example, the merger of ICICI bank and Bank of Madura is a
horizontal merger. Often horizontal mergers are considered hostile, which
NOTES means a larger company "takes over" a smaller one in more of an
acquisition than a merger. The goal of a horizontal merger is to create a
new, larger organization with more market share. Because the merging
companies' business operations may be very similar, there may be
opportunities to join certain operations, such as manufacturing, and reduce
costs.
(2) Vertical mergers: A vertical merger is one of the most common types of
mergers. When a company merges with either a supplier or a customer
to create an extension of the supply chain, it is known as a vertical
merge or integration. An example of a vertical merger may be a steel
company merging with a car manufacturer. The steel company was
previously a supplier to the car manufacturer but after the merger would
be part of the same company.
(3) Co-generic Mergers: These are mergers between entities engaged in
the same general industry and somewhat interrelated, but having no
common customer-supplier relationship. A company uses this type of
merger in order to use the resulting ability to use the same sales and
distribution channels to reach the customers of both businesses.
(4) Conglomerate Merger: A merger of two companies which are involved
in different types of business. There are many ways for this to benefit
the companies, such as sharing of assets and reducing business risk, but
can also become a risk to the company if the new company gets too
large or if it isn't able to successfully blend the two businesses.
19.4 Acquisition
Acquisition is a corporate action in which a company acquire effective control over
the assets or management of other company without any combination of companies.
Therefore in acquisition two or more companies may remain independent but there
may be a change in the control of the companies. Acquisitions are often made as
part of a company's growth strategy whereby it is more beneficial to take over an
existing firm's operations and niche compared to expanding on its own. An acquisition
can be friendly or hostile. In friendly acquisition companies proceed through
negotiations. But in case of hostile acquisition, target company is unwilling bought
without the prior acceptance by the board of target company. An acquisition is not
always results in full legal control. Sometime a company can also have effective
Corporate Finance : 314 control over other company by holding a minority ownership.
19.5 Difference between Merger and Acquistion
Although merger and acquisition are often used as synonymous terms, there is a
subtle difference between the two concepts. In the case of a merger, two firms
together form a new company. After the merger, the separately owned companies
become jointly owned and obtain a new single identity. When two firms merge, NOTES
stocks of both are surrendered and new stocks in the name of new company are
issued. Generally, mergers take place between two companies of more or less same
size. In these cases, the process is called Merger of Equals. However, with acquisition,
one firm takes over another and establishes its power as the single owner. Generally,
the firm which takes over is the bigger and stronger one. The relatively less powerful,
smaller firm loses its existence, and the firm taking over, runs the whole business
with its own identity. Unlike the merger, stocks of the acquired firm are not
surrendered, but bought by the public prior to the acquisition, and continue to be
traded in the stock market.
19.6 Reasons for Merger and Acquisition

• Growth: Increasing a company's growth is the most common reason
behind merger. Growth can be achieved through investing in capital
projects internally or externally by buying out the assets of outside
companies. Empirical studies show that the faster growth rates are
achieved through external growth by means of mergers and acquisitions.
• Market Power: One of the main motives of a merger is to increase the
share of a firm in the market. It means to increase the size of the firm
and also leading to the monopoly power, hence the firm gets an opportunity
to set prices at levels that are not sustainable in a more competitive
market. There are three sources by which market power can be achieved.
They are product differentiation, overcoming entry barriers and improving
market share.
• Corporate Tax Savings: Although tax savings may not be a primary
motivation for a combination, it can sweeten the deal. When a purchase Check Your Concept
of either the assets or common stock of a company takes place, the
1. What is a merger?
tender offer less the stock's purchase price represents a gain to the
target company's shareholders. Consequently, the target firm's 2. What are the advantages
shareholders will usually experience a taxable gain. However, the of vertical merger?
acquiring company may reap tax savings depending on the market value 3. What do you mean by
of the target company's assets when compared to the purchase price. conglomerate merger?
The acquiring company can write up the target company's assets by the 4. Differentiate between
amount that the market value exceeds the net book value of the target merger and acquisition.
company's assets. This difference can then be charged off to depreciation
with resultant tax savings. This differs from goodwill in that goodwill is
Merger and Acquisition never tax deductible. Depending on the method of corporate combination,
further tax savings may accrue to the owners of the target company.
• Acquire Needed Resources: One firm may simply wish to purchase
the resources of another firm or to combine the resources of the two
firms. These resources may be tangible resources such a plant and
NOTES
equipment, or they may be intangible resources such as trade secrets,
patents, copyrights, leases, etc. , or they may be talents of the target
company's employees. One reason given for the mergers in the petroleum
industry is that companies wish to acquire the leases of their competitors.
If acquiring a company for its talent seems strange, consider that Cisco
Systems CEO John T. Chambers said, "Most people forget that in a
high-tech acquisition, you are really only acquiring people . We are not
acquiring current market share. We are acquiring futures". It emphasize
that often the reasons for mergers and acquisitions are quite similar to
the reasons for buying any asset. Both firms and individuals purchase an
asset for its utility.
• Diversification: Diversification is another frequently cited reason for
mergers. Actually, it was the reason during the conglomerate merger
wave. The idea was to circumvent regulatory restrictions on horizontal
and vertical mergers by going outside a company's industry into new
markets and to achieve growth there. International mergers provide
diversification both geographically and also by product line. When various
economies are not correlated, then the international mergers reduce the
earning risk, inherent in being dependent on a single economy. Thus
international mergers reduce systematic and unsystematic risk.
• Economies of scale: arise when increase in the volume of production
leads to a reduction in the cost of production per unit. This is because,
with merger, fixed costs are distributed over a large volume of production
causing the unit cost of production to decline. Economies of scale may
also arise from other indivisibilities such as production facilities,
management functions and management resources and systems. This is
because a given function, facility or resource is utilized for a large scale
of operations by the combined firm.
• Operating economies: Operating economies arise because a
combination of two or more firms may result in cost reduction due to
operating economies. In other words, a combined firm may avoid or
reduce over-lapping functions and consolidate its management functions
such as manufacturing, marketing, R&D and thus reduce operating costs.
For example, a combined firm may eliminate duplicate channels of
distribution, or crate a centralized training center, or introduce an integrated
planning and control system.
• Synergy: Synergy implies a situation where the combined firm is more Merger and Acquisition
valuable than the sum of the individual combining firms. It refers to
benefits other than those related to economies of scale. Operating
economies are one form of synergy benefits. But apart from operating
economies, synergy may also arise from enhanced managerial capabilities,
creativity, innovativeness, R&D and market coverage capacity due to NOTES
the complementarily of resources and skills and a widened horizon of
opportunities.
19.7 Process of Merger & Acquisition

Merger and acquisition process is the most challenging and most critical one when it
comes to corporate restructuring. One wrong decision or one wrong move can
actually reverse the effects in an unimaginable manner. It should certainly be followed
in a way that a company can gain maximum benefits with the deal. The process of
merger and acquisition has the following steps:
1. Preliminary assessment or business valuation: In this first step of Merger
and Acquisition Process, the market value of the target company is assessed.
In this process of assessment not only the current financial performance of
the company is examined but also the estimated future market value is
considered. The company which intends to acquire the target firm engages
itself in a thorough analysis of the target firm's business history. The products
of the firm, its' capital requirement, organizational structure, brand value
everything are reviewed strictly.
2. Proposal Phase: Proposal phase is a phase in which the company sends a
proposal for a merger or an acquisition with complete details of the deal including
the strategies, amount, and the commitments. Most of the time, this proposal
is send through a non-binding offer document.
3. Exit planning: When a company decides to buy out the target firm and the
target firm agrees, then the latter involves in Exit Planning. The target firm
plans the right time for exit. It considers all the alternatives like Full Sale,
Partial Sale and others. The firm also does the tax planning and evaluates the
options of reinvestment.
4. Structured Marketing Process: This is merger and acquisition process involves
marketing of the business entity. While doing the marketing, selling price is
never divulged to the potential buyers. Serious buyers are also identified and
then encouraged during the process. Following are the features of this phase.
• Seller agrees on the disseminated materials in advance. Buyer also needs
to sign a Non-Disclosure agreement.
• Seller also presents Memorandum and Profiles, which factually showcases
the business.
Merger and Acquisition • Database of prospective buyers are searched.
• Assessment and screening of buyers are done.
• Special focuses are given on the personal needs of the seller during
structuring of deals.
NOTES • Final letter of intent is developed after a phase of negotiation.

5. Buyer Due Diligence: This is the phase in the merger and acquisition process
where seller makes its business process open for the buyer, so that it can make
an in-depth investigation on the business as well as its attorneys, bankers,
accountants, tad advisors etc.
6. Stage of Integration: This stage includes both the company coming together
with their own parameters. It includes the entire process of preparing the
document, signing the agreement, and negotiating the deal. It also defines the
parameters of the future relationship between the two.
7. Operating the Venture: After signing the agreement and entering into the
venture, it is equally important to operate the venture. This operation is attributed
to meet the pre-defined expectations of all the companies involved in the
process. The M&A transaction after the deal include all the essential measures
and activities that work to fulfil the requirements and desires of the companies
involved.
19.8 Due Diligence

Before you acquire another business, it is essential to carefully assess the selling
company's representations about its earnings, assets and liabilities. Due diligence in
a broad sense refers to the level of judgement, care, prudence, determination, and
activity that a person would reasonably be expected to do under particular
circumstances. In corporate law, due diligence is the process of conducting an
intensive investigation of a corporation as one of the first steps in a pending merger
or acquisition. In a company acquisition, due diligence would include fully
understanding all of the obligations of the company: debts, pending and potential
lawsuits, leases, warranties, long-term customer agreements, employment contracts,
distribution agreements, compensation arrangements, and so forth. The process of
due diligence process needs to cover the following aspects of the target company:
• The organizational structure and management style
• The operational aspects, which include production technology, processes
and systems
• The financial aspects, which include operating performance information
and potential tax liabilities
• The human resource environment
• Various legal aspects
• The information system
19.9 Regulatory Framework Related to Merger &
Acquisition
The primary regulators governing M&A activity in India are the Securities and
Exchange Board of India ("SEBI"), the Reserve Bank of India ("RBI") the Foreign
NOTES
Investment Promotion Board ("FIPB") and the Competition Commission of India
("CCI"). Although, it would be a rather herculean task to list all the laws dealing with
M&A, the following is an indicative list of the legislation primarily governing M&A.
• Companies Act, 2013 ("Companies Act"): The Companies Act is
the statute primarily governing all matters relating to companies
incorporated in India. Among other things, the Companies Act specifically
provides for the manner in which mergers, demergers, amalgamations
and/or arrangements may take place pursuant to an Indian court
sanctioned scheme.
• SEBI Takeover Code 1994: SEBI Takeover Regulations permit
consolidation of shares or voting rights beyond 15% up to 55%, provided
the acquirer does not acquire more than 5% of shares or voting rights of
the target company in any financial year. [Regulation 11(1) of the SEBI
Takeover Regulations] However, acquisition of shares or voting rights
beyond 26% would apparently attract the notification procedure under
the Act. It should be clarified that notification to CCI will not be required
for consolidation of shares or voting rights permitted under the SEBI
Takeover Regulations. Similarly the acquirer who has already acquired
control of a company (say a listed company), after adhering to all
requirements of SEBI Takeover Regulations and also the Act, should be
exempted from the Act for further acquisition of shares or voting rights
in the same company.
• The Competition Act, 2002 (the "Competition Act"): The Competition
Act as amended by the Competition (Amendment) Act, 2007, inter alia
provides for control over M&A activity and abuse of dominant position
in the market. Prior approval of the CCI is required for mergers and
acquisitions above specified thresholds. The CCI has extra territorial
jurisdiction as regards mergers or combinations taking place outside India.
• Income Tax Act, 1961 (the "Income Tax Act") and indirect taxation:
Any M&A transaction requires detailed evaluation of the tax
consequences. The Income Tax Act governs all direct taxation within
India and grants or withdraws certain benefits in the case of change of
control/shareholdings subject to certain conditions. Indirect taxation may
be in the form of value added tax, excise, etc. and is governed by various
state and central statutes. Under the present taxation system in India,
taxes vary for each method of acquisition. For example, an asset transfer
by way of slump sale may result in higher income for the seller and
higher value added.
Merger and Acquisition • Foreign Exchange Management Act,1999: The foreign exchange laws
relating to issuance and allotment of shares to foreign entities are
contained in The Foreign Exchange Management (Transfer or Issue of
Security by a person residing out of India) Regulation, 2000 issued by
RBI vide GSR no. 406(E) dated 3rd May, 2000. These regulations provide
NOTES general guidelines on issuance of shares or securities by an Indian entity
to a person residing outside India or recording in its books any transfer
of security from or to such person. RBI has issued detailed guidelines on
foreign investment in India vide "Foreign Direct Investment Scheme"
contained in Schedule 1 of said regulation.
19.10 Key Terms

• Hostile Takeover: Is defined as an "unfriendly takeover". Such actions
are usually revolted against by the managers and executives of the target
firm.
• Reverse Merger: A reverse merger refers to an arrangement where

private company acquires a public company, usually a shell company, in
order to acquire the status of a public company. Also known as a reverse
takeover, it is an alternative to the traditional initial public offering (IPO)
method of floating a public company.
• Dilution: The reduction of earnings, or the value of a stock, that can

occur in a merger when more shares are issued; or with conversion of
convertible securities into common stock.
• Holding company: The holding company would have more than 50%
of the total voting power and has the control on the other company.
• Takeover bid: It is the intention of the acquirer reflected in the action
of acquiring the shares of the Target Company.
• Tender offer: The acquirer pursues takeover (without consent of the
acquiree) by making a tender offer directly to shareholders of the target
company to sell their shares. This offer is often made for cash.
• Swap ratio: This is an exchange rate of the shares of the companies
that would undergo a merger. This is calculated by the valuation of various
assets and liabilities of the merging companies.
• Liquidation Value: The amount which is available if the assets of the
business are sold off and converted to cash
• Amalgamation: It is blending of two or more companies. The
shareholders of each company become the shareholders of the company
which is undertaking the activity. It is similar to a merger.

19.11 Summary
• Merger, acquisition, business alliances and corporate restructuring activities

are increasingly commonplace in both developed and emerging economies.
• Mergers and acquisitions (M&A) is the area of corporate finances, NOTES

management and strategy dealing with purchasing and/or joining with other
companies.
• In a merger, two organizations join forces to become a new business, usually

with a new name. Because the companies involved are typically of similar
size and stature, the term "merger of equals" is sometimes used.
• In an acquisition, on the other hand, one business buys a second and generally
smaller company which may be absorbed into the parent organization or run
as a subsidiary. A company under consideration by another organization for a
merger or acquisition is sometimes referred to as the target.
• Strong companies will act to buy other companies to create a more

competitive, cost efficient company. The companies will come together hoping
to gain a greater market share or to achieve greater efficiency.
• The primary regulators governing M&A activity in India are the Securities
and Exchange Board of India ("SEBI"), the Reserve Bank of India ("RBI")
the Foreign Investment Promotion Board ("FIPB") and the Competition
Commission of India ("CCI").

1. What drives M&A activities? What are its key facilitators in India?
2. What do you mean by term merger? What are the different forms of merger?
3. What are the important steps in a Merger Transaction?
4. Explain the various legislations governing M&A transaction in India.

Books:
4. Pandey, I.M, "Financial Management", Vikas Publication House Pvt. Ltd,
New Delhi.
5. Kapil, S. "Financial Management", Pearson Education. Corporate Finance : 321
Merger and Acquisition Web resources:
1. Introduction to Merger and acquisitions , available at:
• http://www.nishithdesai.com/fileadmin/user_upload/pdfs/
Research%20Papers/Mergers%20%26% 20Acquisitions% 20in%20
India.pdf
NOTES • http://shodhganga.inflibnet.ac.in/bitstream/10603/1949/5/
05_chapter%202.pdf
2. Reasons for merger and acquisition, available at:

• http://www.indianmba.com/Faculty_Column/FC799/fc799.html
• http://www.bain.com/publications/articles/strategic-leader.aspx
3. Process of merger and acquisition,, available at:
• http://www.mergersandacquisitions.in/process-of-merger-and-
acquisition.htm
• http://business.mapsofindia.com/finance/mergers-acquisitions/
process.html
4. Regulatory framework , available at:
• file:///C:/Documents%20and%20Settings/Administrator/
My%20Documents/Downloads/INDIA%20-%20Negotiated%
20M&A% 20Guide% 202011% 20(3).pdf

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FMG 301

MBA : SECOND YEAR

Unit 1 : Introduction to Corporate Finance 01

Prof. Vinay. K. Nangia

Instructional Technology Editing & Programme Co-ordinator

Dr. Satish Kumar

UNIT 1 : INTRODUCTION TO CORPORATE FINANCE

UNIT 2 : LONG TERM SOURCES OF FINANCE

UNIT 3 : SHORT TERM SOURCES OF FINANCE

UNIT 4 : VALUATION: BASIC CONCEPTS

UNIT 5 : VALUATION OF SHARES AND BONDS

UNIT 7 : PORTFOLIO THEORY

UNIT 8 : ASSETS PRICING

UNIT 9 : CAPITAL BUDGETING DECISION- I

UNIT 10 : CAPITAL BUDGETING DECISION- II

UNIT 11 : THE COST OF CAPITAL

UNIT 12 : CAPITAL STRUCTURE DECISION

UNIT 13 : DIVIDEND DECISION

UNIT 14 : WORKING CAPITAL MANAGEMENT

UNIT 15 : INVENTORY MANAGEMENT

UNIT 16 : CASH MANAGEMENT

UNIT 17 : RECEIVABLE MANAGEMENT

UNIT 19 : MERGER AND ACQUISITION

1.1 Unit Objectives

1.2 Meaning of Corporate Finance

Finance is the lifeblood of every business and its management requires

1.3 Scope and Importance of Corporate Finance

From the above definitions, it is clear that financial management or corporate

Scope of Corporate Finance

Fig.1.1 : Inter-linkage between Investment, Financing and Dividend Decisions

Source: Paramasivan, C. and Subramanian, T (2008) financial management (chapter 1, pp10)

1.4 Goals of Financial Management

1.4.2 Wealth Maximisation

1.6 The Agency Problem and Control of the Corporation

Resolving the Agency Problem

Figure 1.2: Organization of Finance Functions

1.8 Key Terms

1.10 Questions and Excercises

1.11 Further Readings and References

2.1 Unit Objectives

2.3 Long Term Finance

2.4 Sources of Long Term Financing

Long term Sources Check Your Progrece

Figure 2.1: Various Sources of Long Term Finance

Exhibit 2.1: IDBI Bank Term Loans Scheme

Feature of Term Loans

2.4.2 Internal Sources of finance

Check Your Progress 2.5 Key Terms

2.7 Questions and Excercises

2.8 Further Readings and References

NOTES Web resources:

3.1 Unit Objectives

3.2 Short Term Financing

3.3 Advantages of Short Term Financing

3.4 Sources of Short Term Financing

Exhibit 3.1: Inter Corporate Deposits Scheme at SBI DFHI Ltd.

4. Letter of Credit (L/C) : This is a document that a financial institution(Bank)

Source:: http://www.cbbh.bapdf.phpid = 680&lang = en

3.7 Question and Exercises

3.8 Further Readings and References

4.2 Concept of Time Value of Money

4.3 Techniques of Time Value of Money

4.3.1 Compounding Techniques/Future Value Techniques

Year Amount Number of Compounded Future