MBOF912D Financial Management

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Course Design
Advisory Council
Chairman
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Mr. Utpal Ghosh
Members
Dr. S J Chopra Dr. Deependra Kumar Jha

Chancellor Vice Chancellor
Dr D N Pandey Dr Kamal Bansal Dr Tabrez Ahmad

Dean-SoB Dean-SoE Dean-SoL
Mr Ashok Sahu
Head-CCE
SLM Development Team

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Dr Raju Ganesh Sunder Mr. Aindril De
Head-Academic Unit Head-Operations
Dr. Rajesh Gupta Dr. Meenakshi Sharma Dr. Rakhi Dawar
Mr. Rahul Sharma Mr. Shantanu Trivedi Ms. Aparna
Author
Mr. Shantanu Trivedi/Mr. Rahul Sharma
All rights reserved. No Part of this work may be reproduced in any form, by mimeograph or any other
means, without permission in writing from University of Petroleum & Energy Studies.
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Course Code: MBOF 912D
Course Name: Financial Management
Version: January 2018

© University of Petroleum & Energy Studies
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Contents
Block–I
Unit 1: Financial Management–Introduction...........................................................................3
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Unit 2: Time Value of Money...................................................................................................13
Unit 3(a): Compounding Techniques of TVM.17
Unit 3(b): Discounting Techniques of TVM.23
Unit 4: Applications of Time Value of Money.........................................................................29
Unit 5: Case Study: An Analysis of Retirement Plans by ABC Corp....................................35
Block–II
Unit 6: Types of Financial Statements....................................................................................39

Unit 7: Financial Statement Analysis.....................................................................................47
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Unit 8: Ratio Analysis..............................................................................................................55
Unit 9: Dupont Analysis...........................................................................................................77
Unit 10: Case Study: Bata India: Step into Style.....................................................................83
Block–III
Unit 11(a): Short-Term Sources of Finance...................................................................................87

Unit 11(b): Long-Term Sources of Finance....................................................................................95
Unit 12: Fundamentals of Capital Budgeting.........................................................................109
Unit 13: Capital Budgeting Evaluation Techniques...............................................................115
Unit 14: Cost of Capital............................................................................................................127
Unit 15: Case Study: Airnet limited: A Telecommunication Takeover.................................141
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Block–IV
Unit 16: Leverage Analysis......................................................................................................139

Unit 17: EBIT–EPS Analysis...................................................................................................145
Unit 18: Capital Structure.......................................................................................................153
Content
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Unit 19: Dividend Decisions and Policies................................................................................163
Unit 20: Case Study: Velvet Hands–Designing Its Own Capital...........................................169
Block–V
Unit 21(a): Working Capital Management..................................................................................171
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Unit 21(b): Estimation and Calculation of Working Capital......................................................183
Unit 22: Receivables Management..........................................................................................187
Unit 23: Inventory Management.............................................................................................199
Unit 24: Cash Management.....................................................................................................205
Unit 25: Case Study: Inventory Management by Tulips Ltd.................................................213
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Detailed Contents
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UNIT 1: FINANCIAL MANAGEMENT– ll Summary
INTRODUCTION
ll Review Question
ll Introduction
ll Objectives of Financial Management UNIT 3(B): DISCOUNTING TECHNIQUES

OF TVM
ll Financial Management and the scope of same
ll Introduction
Functions of Financial Management
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ll Present Value of Single Cash Flow
ll How a Finance Functions Organisation
Operates and the Structure of it ll PV of a Series of Equal Future Cash
Flow or Annuity
ll Financial Goal–Maximization of Profit
versus Maximization of Wealth ll Present Value of Perpetuity and Annuity
ll Summary ll Present Value of Growing Perpetuity
ll Review Questions ll Summary
ll Review Questions
UNIT 2: TIME VALUE OF MONEY
ll Introduction UNIT 5: APPLICATIONS OF TIME
VALUE OF MONEY
ll Importance of Time Value of Money
ll Introduction
ll Concept of Valuation
ll To Find the Implied Rate of Interest
ll Summary
To Find the Number of Years
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ll Review Questions
ll Sinking Fund
UNIT 3(A): COMPOUNDING TECHNIQUES ll Capital Recovery

OF TVM
ll Summary
ll Introduction
ll Review Questions
ll The Effective Rate of Interest
ll The FV of a Series of Equal Cash Flows or UNIT 5: CASE STUDY: AN ANALYSIS OF

Annuity of Cash Flows RETIREMENT PLANS BY ABC CORP
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3
Unit 1
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Notes
___________________
Financial Management– ___________________
Introduction ___________________
___________________
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Objectives: ___________________
While the students complete the unit, they can: ___________________
\\ Understand what a Finance Manager’s role is along with what Finan-
___________________
cial Management is
\\ Know what are the Financial Management’s core objectives ___________________
\\ understand Financial Management’s key functions and the overall ___________________

scope of work
___________________
\\ easily narrate the finance function of any organisation
\\ Clearly outline the overall goals of FInancial Managerment which are
wealth maximisation and profit maximisation
Introduction
The term ‘Financial management’ can be described as the manage-
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ment of flow of funds. This involves making financial decisions, rais-
ing funds in the most economical way and utilizing these funds to
achieve maximum benefits for the firm and its shareholders. Finan-
cial management, as a functional area, is of prime importance as all
business decisions have financial implications.
Role of a Financial Manager

Formerly, the role of a financial manager was limited; however,
gradually, the involvement of a financial manager has increased as
every act, procedure or decision has a financial impact. A financial
manager estimates all the likely events that can occur in the course
of business and observes their monetary implications. Work of a fi-
nancial manager focuses on the following:
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1. Procuring the right amount of funds whenever necessary
2. Investing funds to gain maximum profits
3. Distributing funds to the shareholders to ensure wealth maxi-

mization
Financial Management
4
The above three functions cover a majority of the financial tasks of
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Notes
a firm; thus, the functions of a finance manager can be summarized
___________________ as follows:
___________________ 1. Conducting overall financial planning and control
___________________
2. Raising funds from different sources
___________________
3. Selecting fixed assets
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___________________
4. Managing working capital
___________________
5. Managing a financial crisis
___________________
___________________
Apart from these, the financial manager also acts as an intermedi-
ary between the firm’s operations and the capital markets. There
___________________
is a two-way flow of cash between the firm and the investors. One
___________________ way is when the investors plough in funds in the organization from
the capital markets and the other way is when the firm distributes
dividends and interests amongst the shareholders.
Objectives of Financial Management

Following are the main objectives of financial management:
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1. Liquid Asset Maintenance: This includes maintaining an
appropriate amount of liquid assets, thus, maintaining a bal-
ance between liquidity and profitability.
2. Profit Maximization: This involves ensuring that the firm

should gain maximum profits in a given amount of time. More-
over, all the decisions regarding investment, financing and div-
idend as well as strategic-level decisions of the organization
should be concerned with earning maximum profits.
3. Wealth Maximization: Wealth maximization is the maximi-

zation of wealth of the shareholders. It is also known as value
maximization or net worth maximization. It involves the com-
parison of the value to cost associated with the business.
Some other objectives of financial management include the following:

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1. Confirming reasonable return to the shareholders
2. Ensuring growth and expansion in the firm’s business and value
3. Utilising funds efficiently and effectively to ensure maximum

operational productivity
4. Maintaining financial control in the firm

Unit 1: Financial Management–Introduction
5
Financial Management and the Scope of Same
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Notes
The scope of this particular subject is indeed extremely fast. ___________________
The scope of financial management is very vast. It is related to ___________________

maintaining financial control, raising funds and ensuring proper ___________________
utilization of these funds. It also involves total management. Total
___________________
management is a very wide scope of financial management. All the
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functions performed by the finance manager of a company are un- ___________________
der the scope of financial management. The functions of the finance ___________________
manager vary from company to company, depending on the nature
___________________
of business. Financial management plays four important roles: uti-
lizing funds and controlling productivity and identifying and select- ___________________
ing the source of funds. Liquidity, profitability and management are ___________________
three primary functions of financial management.
___________________
The firm’s liquidity is defined by raising funds and the management
of flow of funds in a company. Profitability can be ascertained by con-
trolling costs, fixing a pricing policy and forecasting future profits.
It is the duty of the financial manager to utilise the sources of the

assets in maintaining the business. The management of assets
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plays an important role in financial management. Moreover, the
manager must ensure that the sources that are required are avail-
able for the easy functioning of the business. It is often categorized
as management of long-term funds and management of short-term
funds. Long-term funds management is associated with the devel-
opment of extensive plans; whereas, short-term funds manage-
ment is associated with the total business cycle activities. Finan-
cial management also facilitates coordination of various activities
in a business.
Therefore, financial management is necessary to maintain the over-

all success and growth of any firm or company.
Functions of Financial Management

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The key to a successful business processes is financial management

as no business can utilize its potential for growth and expansion
without effective administration and efficient utilization of financial
resources.
While looking into the different requirements of a firm, the finance

manager needs to make certain decisions from time to time. These
decisions can be broadly classified into three main categories:
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1. Investment Decision: Management of resources and its allo-
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Notes cation
___________________
2. Financing or Capital Structure Decision: Managing in-
___________________ vestments and its finance
___________________
3. Dividend Decision: Managing dividends, outflow of cash and
___________________ reinvestment
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___________________
Maximizing the shareholder’s wealth is the main objective of these
___________________ decisions. (See Figure 1.1)
___________________
___________________ Investment Decision
___________________
___________________ Financial Function Decision Financing Decision
Dividend Decision
Figure 1.1: Types of Financial Function Decisions

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Investment Decision: It is one of the most essential finance func-
tion decisions. Investment decisions not only include the decisions
that may reap revenues and profits (e.g., launching a new product
in the market), but also those that may reduce costs and save money
for the firm (e.g., investing in new, modern machinery, thus reduc-
ing cost). Thus, investment decisions are mostly related to the asset
composition of the firm. These assets are a sum of investments that
lead to a return on the investment made by the firm which result
in overall increase in the shareholders’ net worth. Further, these
assets can be classified into two main groups – fixed assets and cur-
rent assets. Thus, the investment decision can be divided into two
different categories, that is, working capital management (related
to current assets) and capital budgeting decisions (related to fixed
assets). These are described below:
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1. Current Assets or Short-term Assets (for example, raw mate-

rials, working in process, finished goods, debtors, cash, etc.):
These assets are liquefiable in nature and can be converted into
cash within a financial year without diminution in value. Man-
agement of current assets is called as ‘Working Capital Man-
agement’. These assets ensure smooth working of fixed assets
and do not directly contribute to the earnings.
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2. Fixed Assets or Long-Term Assets (for example plant and ma-
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chinery, land and buildings, etc.): These assets involve huge in- Notes
vestments and yield a return over a period of time. Any decisions ___________________
in regards of the fixed assets are classified as ‘Capital-Budget- ___________________
ing-Decisions’ and there are multiple decisions which are under
___________________
this classification. Some of them are regarding:
___________________
(a) Purchasing from the available alternatives
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___________________
(b) Purchasing leasing assets
___________________
(c) Producing or procuring assets. ___________________
Financing Decision: The financing decision determines how to ___________________

raise funds, for example, should the funds be raised from sharehold- ___________________
ers or should they be borrowed as debt? Both these sources have
___________________
their own features and affect the company’s left side of the balance
sheet. The borrowed funds are repayable with a commitment to bear
interest along with the principal. The borrowed funds are always
cheaper to the firm. However, these funds come with a risk element,
also referred to as ‘financial risk’, which include the risk of insolven-
cy due to non-payment of interest or capital amount.
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Dividend Decisions: Dividends are after-tax profits which are
available for distribution to the shareholders. These dividends can
also be retained by the firm for reinvestment purposes within the
firm. Dividends are also return on capital. Every firm decides the
amount of dividends that is to be distributed among the sharehold-
ers and those that should to be retained. The dividend policy is de-
veloped by the financial manager of the firm in a way that it suits
the shareholder’s interests and the company as well.
The above-mentioned decisions cannot be taken in isolation as they

are inter-related. The decisions are not taken one after the other in
an order but are executed simultaneously as one decision can affect
the course of action for the other.
For example, assume there is a company which has taken a de-

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cision to make an investment of INR 10 Crores to be put as a

fraction of capital budgeting. And there is an investment of INR
5 crore which has been kept to be a fraction of working capital
management. In other words, on total assets, the company is in-
vesting Rs. 15 crores. Therefore, the total funds required to be
raised is Rs. 15 crores. If the financial manager raises Rs. 9 crores
from external sources and the remaining Rs. 6 crores through re-
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tained earnings, the distribution of dividend to the shareholders
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Notes will be affected. However, if the dividend payout ratio is 100%, the
___________________ finance manager will have to raise the entire Rs. 15 crores from
___________________ external sources.
___________________ Thus, the financial manager has to take an optimal joint decision
after evaluating the choices that will affect the wealth of the share-
___________________
holders. If there is any negative effect on the wealth, it should be
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___________________
rejected.
___________________
___________________
How a Finance Functions Organisation Operates and
the Structure of it
___________________
Whatever decisions because of any person or any activity that are
___________________
being made - no matter how small or monumental they are - will
___________________
have an impact on the overall value of the company or firm in con-
text of the possible financial implications.
For example, any member participating in a financial process, any

engineer planning to replace existing machinery, any promotion
manager deciding to advertise strategies to increase sales of the
company or finance manager deciding on the dividend payout ratio
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have financial implications on the firm. These persons are said to be
performing finance functions.
Although every member in an organization contributes to the fi-

nance functions, there is a need of a separate finance department.
This department performs two major functions:
1. Management of the company’s finances and its future planning

and control the firm.
2. Taking decisions according to the objectives of the firm and con-

solidation of impactful financial proposals from all the depart-
ments.
The Chief Financial Officer (CFO) takes all the major financial de-
cisions of a company. His main responsibilities are to plan, control
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and increase the wealth of the shareholders. Some of the functions

of the CFO include the following:
1. Financial planning and analysis
2. Management of the asset structure of the firm
3. Management and balancing of the financial structure of the

firm.
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Thus, the CFO is a part of the top management and helps in formu-
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lation of all strategic policies relating to acquisitions, mergers, cap- Notes
ital structure, portfolio management, risk appetite, diversification, ___________________

etc. The functions of a CFO are classified into two groups: ___________________
1. Controller: As a controller, the CFO mainly focuses on budget- ___________________

ing, evaluations, planning and control, internal audit, taxation,
___________________
etc.
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___________________
2. Treasurer: As a treasurer, the CFO focuses on cash manage-
___________________
ment, raising of funds for both short term and long term re-
quirements. ___________________
___________________
There are a number of individuals working directly or indirectly un-
der the CFO. Refer to Figure 1.2 to get a clear idea of the organiza- ___________________
tion of financial function. ___________________
Chief Finance Officer
Treasure Controller
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Cash Manager Credit Manager Financial Accounting Cash Accounting
Manager Manger
Capital Budget Fund Raising

Manager Manager Tax Data Processing
Manager Manager
Portfolio Manger Internet Auditor
Figure 1.2: Organization of Finance Function

Source: (Rustagi, 3rd Edition)
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Financial Goal–Maximization of Profit versus

Maximization of Wealth
A firm’s efficiency can be assessed by its financial goals (target). Sever-
al goals are considered as a benchmark to measure the financial health
of a company. For instance, if a firm’s primary objective is to make prof-
its, it would take steps and develop policies that would help in profit
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maximization. However, these steps will not involve wealth maximi-
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Notes zation of the stakeholders. It may help a firm to achieve its objective to
___________________ make profits in the short-run, but it will not contribute toward the cre-
___________________ ation of wealth. The creation of wealth needs more time; thus, financial
management primarily focuses on wealth maximization and not profit
___________________
maximization. For a growth-oriented business, profit making must not
___________________ be the only objective. Other aspects such as sales increases, acquiring
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___________________ more market share and return on capital must also be considered as
they help in earning long-term profitability.
___________________
___________________
However, the following two goals are considered as the main objec-
tives of financial management:
___________________
1. That the profit of the company or the firm should reach
___________________
maximum
___________________
2. That the shareholders’ wealth also reaches the maximum
Profit Maximization
As it is clear from the terminology, it focusses on increasing the
account profit that is there for the shareholders and take it to the
maximum.
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Since this has an implied effect on the firm’s objective, it has been
retained as one of the financial goals.
Advantages of Profit Maximization

1. Better decision making: It provides a yardstick to judge the
economic performance of an enterprise and is, thus, considered
as the best criterion of decision making.
2. Efficient allocation of resources: Allocation of resources

is diverted to ensure maximum profitability, hence, utilizing
scarce resources effectively.
3. Optimum utilization of resources: Profit maximization, be-

ing the primary objective of the firm, is possible only through
optimum utilization of resources. All business activities are ac-
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complished through the use of certain resources, which lead the

business toward profitable results. Profit maximization helps
in acquiring resources in the required quantity, at a reasonable
cost and in a timely manner. It is aimed to ensure the adequacy
of resources relative to business needs and their appropriate
use. The efficiency of resources is determined by the achieve-
ment of the business objectives.
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4. Maximum social welfare: If all businesses follow this objec-
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tive, it will ensure optimum and efficient utilization of all eco- Notes
nomic resources available in the society. This will also ensure ___________________
profitability and, in turn, lead to social welfare. ___________________
Disadvantages of Profit Maximization ___________________
1. Risk factor: Any investment that may be potentially profit- ___________________
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able may carry a high risk quotient. Concept of profit maximi- ___________________
zation ignores this risk and looks into high profit generating ___________________
investments.
___________________
2. Ignores time factor: It does not take into consideration the
___________________
time of cost and returns, therefore ignoring the time value of
money. ___________________
___________________
3. Ambiguous: There is no clear picture since the profit is not
being drawn against the time that is being passed during the
operations of the firm or otherwise.
Wealth Maximization
The concept of wealth maximization was introduced to remove all
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the drawbacks of the profit maximization method.
The method to define the value is by knowing that what is the value
of company’s share in terms of its actual market price within the
overall stock market.
The total economic value of the wealth belonging to the shareholder

- which is also called as the measure of wealth - can be calculated by
the share’s market price–which in turn is calculated as the current
value of future dividends and whatever benefits that can be then
expected from the company.
The wealth of shareholder at any point of time can be determined

with the help of the total value of shareholdings by the respective
shareholder. Clearly, any increase in the wealth is the outcome of
the shares’ market price increment that belong to the firm. Hence, it
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clearly indicates that the main objective of the firm is maximization

of shareholders’ wealth.
Summary
The main motive of financial management is to meet the objectives
of the firm by efficient management of inflow and outflow of funds.
It is a function that involves the role of the top management of a
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firm. Financial management involves raising capital and allocating
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Notes that capital. It also involves allocating short-term resources, such as
___________________ current liabilities. Moreover, it deals with the dividend policies of its
___________________ stakeholders. Profit maximization and wealth maximization are its
primary objectives. The estimation of funds required, determination
___________________
of capital structure, investment of funds and total management are
___________________ the major role of financial management.
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___________________
Review Questions
___________________
___________________ 1. What are the two financial goals? Explain in detail by differen-
tiating between the two.
___________________
2. What is the scope of finance functions?
___________________
___________________ 3. What are the key roles of the finance manager?
4. Explain the inter-relationship between investment, financing

and dividend functions.
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Unit 2
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Notes
___________________
Time Value of Money ___________________
___________________
Objectives:
___________________
While the students will finish this unit, they can:
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___________________
\\ have a clear understanding of the Time value of money concept
\\ have a clear understanding of the importance of same ___________________
\\ distinctly explain the valuation concept ___________________
___________________
Introduction
___________________
As explained in the previous unit, the main objective of the firm is max- ___________________
imization of shareholders’ wealth. In addition, shareholders’ wealth is
measured by the economic value added which is the market price of the
share, which is also the present value of future dividends and benefits
expected from the firm. For this, the finance manager takes various fi-
nance decisions, such as investment, financial and dividend decisions.
However, when he takes these decisions, he has to keep in mind the
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concept of economic value that is added and the time factor.
Importance of Time Value of Money

This concept is developed because there is a stark difference in the
current value of money as compared to the value of money that will
be in future.
For example, if given an option between receiving Rs. 500 today and
receiving Rs. 500 in the future, any individual would choose the for-
mer since this Rs. 500 would have a higher value today than what it
will have after a year. This difference in the worth or value of money
over time is called TVM.
While any financial decisions are being made, Time Value of Money
acts as a critical factor that is to be considered by any finance man-
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ager. As understood from the above example, the money that we

have today is ideally preferred to the same amount in the coming
future. The reasons of the following are:
1. Future uncertainties
2. Preference for present consumption
3. Reinvestment opportunities
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Let us understand the concept with a help of the following example.
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Notes
Example 2.1 A car manufacturing company is selling one of its cars
___________________
for a bargain price of Rs. 5,00,000. However, the buyer offers to pay
___________________ now or pay the same amount after a year. What is the preferable
___________________ choice for the company?
___________________ Solution: The company should definitely choose to receive the cash
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___________________ now. They can then invest the money at 10% rate of interest for
a year. By doing so, the company will receive 5,00,000 + 50,000 =
___________________
5,50,000 after a year as compared to Rs. 5,00,000, which they would
___________________ have received had they chosen the latter offer. This difference of Rs.
___________________ 50,000 is referred to as TVM. In an alternate way, Time value of
___________________
Money indicates to the rate of return that an investor can earn by
investing his present money.
___________________
At the same time, ascertaining that what will be the rate of return
is not sufficient. It is equally critical to find out the value of current
assets of company or firm.
Ascertaining the rate of return is not enough. It is also important to

determine the value of current assets in the firm. Valuation helps
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in ascertaining this value. It involves the process of determining the
present values of assets.
Concept of Valuation
Time value of money helps in ascertaining the future value of mon-
ey. This depends on the rate of return or interest rate that can be
achieved on the investment. TVM is applicable in various areas,
such as corporate finance including capital budgeting, bond valua-
tion and stock valuation. For example: A bond generally pays inter-
est on periodical basis until maturity, when the bond’s face value is
also repaid. Thus, the present value of the bond depends upon what
these future cash flows are worth in today’s amount.
Let us understand the concept of valuation of TVM with the help of

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an example.
Example 2.2 A firm, ABC Pvt. Ltd, manufactures garments. The

firm purchases machinery today, say at time T0 for Rs. 10,00,000,
and it is expected to give a return of Rs. 10,50,000 at the end of one
year, say at time T1. This implies that the company will be spending
Rs. 10,00,000 today and will receive Rs. 10,50,000 after one year.
However, we cannot say whether the investment is profitable for
Unit 2: Time Value of Money
15
the company as the cash inflow and outflow are occurring at two
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different time periods. Notes
___________________
Solution: There are two ways by which we can evaluate this sce-
___________________
nario:
___________________
By calculating the future value of investment, that is Rs. 10,00,000
___________________
at time T1
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___________________
By calculating the present value of return, that is Rs. 10,50,000 at
___________________
time T0.
___________________
Refer to Figure 2.1 for better understanding.
___________________
Rs 10,00,000---------(adjustment)---------- Rs 10,50,000 ___________________
T0-----------------------------------------------T1 ___________________
Rs 10,00,000-------(adjustment)-----------------Rs 10,50,000
Figure 2.1
In the above illustration, we easily adjust the cash flows for TVM by
using either of the following methods:
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1. By compounding Rs. 10,00,000 at the required rate of return for
one year and comparing it with Rs. 10,50,000, or
2. By discounting Rs. 10,50,000 at the required rate of return for

one year and comparing it with Rs. 10,00,000
In a firm, the finance manager deals with various cash flows pertain-
ing to different time periods; thus, TVM plays an important part in
decision making by comparing these cash flows. As discussed, TVM
converts the value of money for a particular time to anytime in the
future or present. So, these values can be called Present Values (PV)
and Future Values (FV).
The FV of an amount is the value of that amount sometime in the

future, while PV refers to the value of money during today’s time.
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A sum of Rs. 1,000 available today would yield a future value of Rs.
1,100 after one year at 10% interest per annum. Whereas, the pres-
ent value of Rs. 1,100 receivable after one year is Rs. 1000 at 10%
rate of interest.
The relationship between PV and FV arises because of the interest

rate and time gap. This relationship can be deduced as follows:
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FV = PV * (1 + r)n or
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Notes
PV = FV/(1 + r)n
___________________
___________________ Where r = rate of interest and n = time period
___________________ PV and FV hold a lot of importance in financial management. They

help in ascertaining the value of money today with respect to the
___________________
value of money in the future. It also helps in determining the value
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___________________
of an asset on a particular date in the future. Hence, PV and FV play
___________________ an important role in decision making in financial management.
___________________
Summary
___________________
Compounding involves the movement of cash flows forward in time;
___________________
whereas, discounting involves the movement of cash flows back in
___________________
time. TVM helps in the assessment of equivalency of difference in
cash flow over the time, including PV and FV. They play a very im-
portant role in the decision making in financial management.
Review Questions
1. What is the mathematical relationship between future vvlue
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and present value?
2. Explain how TVM can be used to compare cash flows from two
different periods.
3. What is TVM and explain its relevance in an organization?

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Unit 3(a)
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Notes
___________________
Compounding Techniques ___________________
of Tvm ___________________
___________________
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Objectives: ___________________
At the end of this unit, students will be able to:
___________________
\\ Determine the future value of single cash flow
___________________
\\ Determine the effective rate of interest
\\ Determine the future value of series of cash flow ___________________
___________________
Introduction ___________________
As discussed earlier, the present value (PV) and the future value
(FV) help in decision making in financial management. Following
are the ways in which you can compare the cash flows from time
periods:
1. Present amount to be compounded to a future date

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2. Future amoun t to be discounted to a present date
In this chapter, we will learn to compound the present amount to a

future date using two different methods.
The compounding technique is used to find the FV of a present

amount. Please note that the interest earned in the previous year
is reinvested at the existing rate of interest for the rest of the year.
Hence, the sum of principal and interest of the previous year become
the principal of the next year.
Here is how PV is compounded to determine the FV:
1. The FV of a single present cash flow
2. The FV of a series of cash flows

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3.1.1 FV of a single present cash flows:

The FV is defined as,
FV = PV (1 + r)n ... (3.1)
Where, FV = Future value (which is to be calculated)
PV = Present value (which is given)

18
r = Percentage rate of interest
S
Notes
n = time gap after which FV is to be calculated
___________________
The above equation implies that there are three variables that affect
___________________
the FV, which are PV, r% and n. When the values of these variables
___________________
change, the value of FV will also change. Since the FV is directly
___________________ proportional to these three variables, it means
PE
___________________ Higher the rate of interest, higher the FV
___________________ Higher the time period, higher the FV
___________________
Compound value factor (CVF) is (1 + r)n. We can also write FV as
___________________ follows:
___________________ FV = PV * CVF(r, n)
___________________
Non-Annual compounding: We have assumed that the FV is calcu-
lated on the basis of r and n. These two variables are compounded
annually but there are cases wherein the time period may be other
than one year. The equation given above can be adjusted to reflect
the different time periods. For example, if the compounding is made
every six months, the time period will be two times and the number
)U
of time periods will be divided by two.
Table 3.1: Effect of Compounding on the Time Period
Compounding Period Number of Periods

Annual 1
Half-Yearly 2
Quarterly 4
Monthly 12
Daily 365
From this we can deduce the following:
If the interest is compounded more frequently, the FV is bound to

increase more quickly.
If the interest is compounded more frequently, it starts earning

more interest. This improves the effective annual compound rate of
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interest as well.
We will be able to better understand the above through the follow-

ing example.
Example 3.1 An amount of Rs. 1,000 is invested at a rate of 10%

for a period of one year in two different projects. 1) It is compounded
annually, and 2) It is compounded semi-annually
Unit 3(a): Compounding Techniques of Tvm
19
Solution:
S
Notes
1. When compounded annually as per equation 3.1, FV = PV * (1
___________________
+ r)n
___________________
FV = 1000 (1 + 0.1) = Rs. 1,100
___________________
2. When compounded semi-annually as per equation 3.1 , FV = PV
___________________
* (1 + r)n
PE
___________________
FV = 1000 (1 + 0.05)2 = Rs. 1,102.5
___________________
The Effective Rate of Interest ___________________
The effective rate of interest is the rate of interest compounded an- ___________________
nually, which is equivalent to the interest rate compounded for more ___________________
than once per year.
___________________
(1 + re) = (1 + r/m)m, where re = effective rate of return
r = normal rate of return compounded annually
m = number of compounding periods in a year
When m = 1, then re = r, that is, the effective rate of return is equal

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to nominal rate of interest.
Effective rate of interest is an important tool that helps finance man-

agers to take decisions regarding investments with different rates of
interest that are compounded over different time intervals. Let us
understand this with the help of the example given below.
Example 3.2: A firm borrows Rs. 10,000 from a lending company.

The company provides two options to the firm 1) Receive a rate of
interest of 12% p.a., compounded monthly, or 2) Receive a rate of
return at 12.25% p.a., compounded half yearly. Which option will be
beneficial for the firm?
Solution: To understand which option will be beneficial for the firm,

effective rate of interest needs to be calculated.
Option 1: Interest at 12% p.a. compounded monthly –

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Effective rate of interest (1+re) = (1+r/m)m = (1+0.12/12)12 = 1.1268
Which means re = 12.68%
Option 2: Interest at 12.25% p.a. compounded half yearly –
In this case, effective rate of interest (1 + re) = (1 + r/m)m = (1 +

0.1225/2)2 = 1.1263
20
Which means re = 12.63%
S
Notes
Hence, it is evident that the rate of interest in the 2nd option is low-
___________________
er, despite of the fact that the nominal interest rate is higher. Thus,
___________________ the borrower should select Option 2.
___________________
The FV of a Series of Equal Cash Flows or Annuity of
___________________
Cash Flows
PE
___________________
Many decisions on investments are based on cash flows occurring
___________________
over a number of years on the same principal amount. An annuity
___________________ refers to a certain number of equal cash flows made at regular inter-
___________________ vals of time. Here is an example.
___________________ Example 3.3: A person deposits Rs. 1,000 in a bank for the next
___________________ three years. This is referred as an annuity of Rs. 1,000 for the next
three years.
Solution: In this case, each cash flow is compounded to give a FV.

The sum of all the FV’s is the FV of the annuity.
Table 3.2: Calculation of Future Value of Annuity from Example3.3
Year0 Year1 Year2 Year3

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1000 1000 1000
| | |
1210 1100 1000
Total 3310
Thus,
FV = Annuity Amount * CVAF(r, n)
Example 3.3 Mr. A got an annuity that paid him Rs. 1,000 every
three months for three years. Determine the PV of the annuity when
the money is compounded annually at the rate of 16%.
Solution: In this case,
Amount received as annuity is Rs. 1,000

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Rate of interest, r is 16%
Time period, t is 3.
So,
16%
i= = 4%
4
n = 4(3) = 12
Unit 3(a): Compounding Techniques of Tvm
21
The annuity can be calculated as follows:
S
Notes
é1 - (1 + 0.04 ) - 12 ù
A = 1000 ê ú
___________________
ë 0.04 û
___________________
= 9385.07 ___________________
Thus, the annuity is Rs. 9385.07. ___________________
PE
Example 3.4 Find the PV of an annuity with a FV of Rs. 11375 after ___________________
five years at a rate of 6% per annum. ___________________
Solution: In this situation, ___________________
FV is Rs. 11,375 ___________________
___________________
Rate of interest, r is 0.06
___________________
Number of years, n is 5.
The PV can be calculated as follows:
11375
PV =
(1 + 0.06)5
)U
Thus, the PV of an annuity is Rs. 8,500.
Summary
The compounding technique is used to find the FV of a present
amount. The above equations imply that there are three variables
that affect the FV, which are PV, r% and n. The effective rate of
interest is the rate of interest compounded annually, which is equiv-
alent to the interest rate compounded for more than once per year.
An annuity is a finite series of equal cash flows made at regular
intervals.
(More solved numericals on present value and specially annuity and

annuity compounding need to be provided. The student won’t be able
to solve the review questions since very less examples of such type
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has been discussed here.)
Review Question
1. A contract was offered to a company with the following terms:
An immediate cash outflow of Rs. 15,000 followed by a cash in-
flow of Rs. 17,900 after three years. What is the company’s rate
of return on this contract?
22
2. A five-year annuity of Rs. 2,000 per year is deposited in a bank
S
Notes account that pays 10% interest compound yearly. The annuity
___________________ payments begin 10 years from now. What is the FV of the an-
___________________ nuity?
___________________ 3. How is the FV affected when the interest rate is decreased or a

holding period is increased, and why?
___________________
PE
___________________ 4. Calculate the PV of cash flows of Rs. 850 per year till infinity (a)
at an interest rate of 8% and (b) at an interest rate of 10%.
___________________
___________________ 5. Find out the PVs of the following:
___________________ (a) Rs. 2,500 receivables in five years at a discount rate of

10%;
___________________
___________________ (b) An annuity of Rs. 950 starting after one year for five years
at an interest rate of 12%;
(c) An annuity of Rs. 7,700 starting in seven years’ time last-

ing for seven years at a discount rate of 8%.
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23
Unit 3(b)
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Notes
___________________
Discounting Techniques ___________________
of Tvm ___________________
___________________
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Objectives: ___________________
After finishing this unit, students will be able to understand and explain:
___________________
\\ The present value of a single cash flow
___________________
\\ The present value of series of equal future cash flow
\\ The present value of perpetuity and annuity ___________________
\\ Present value of growing perpetuity and annuity ___________________
___________________
Introduction
Discounting Technique is employed for calculation of the present
value (PV) from a given future value (FV). The PV is calculated
based on the following formula:
PV = FV/ (1 + r)n
)U
Present Value of Single Cash Flow
The PV of single cash flow can be described in relation to the follow-
ing:
1. A future amount’s PV
2. A future series PV
Present Value of a Future Amount

The PV of a future amount will be of lesser value in comparison to its
FV because this amount does not take into consideration the oppor-
tunity of earning interest through investing. This can be explained
by the following example:
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Example 3(b).1: If a person will get Rs. 1,100 at the end of a year
with the expected return of 10%, then PV is calculated using the
formula below.
PV = FV/ (1 + r) n (Equation 4.1)
PV = 1100/(1+0.1) = 1,000
24
This explains that Rs. 1,100 receivable after one year is worth Rs.
S
Notes
1,000 today. We can also say that, if invested, Rs. 1,000 will earn
___________________ an interest of Rs. 100 and will yield Rs. 1,100 at the end of one
___________________ year.
___________________ From Equation 3(b).1, it is deduced that the PV depends on three

___________________
variables:
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___________________ 1. FV of the amount
___________________ 2. Rate of interest
___________________
3. Time period
___________________
From what we have learned so far, it is clear that
___________________
1. For a given period of time, PV will be lower if the rate of inter-
___________________
est increases
2. For a given rate of interest, PV will be lower if the time period

increases
PV of a Series of Equal Future

Cash Flow or Annuity
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As discussed in the previous unit, an annuity is the finite series of
regular cash flows made at regular intervals. Series of future cash
flows can be generated from decisions taken at present. Let’s under-
stand this with the following example:
Example 3(b).2 ABC, an investment institution, offers two differ-

ent policies for three years at 10% per annum to a person, in which
the person 1) invests Rs. 2,500 only at the start of the first year or
2) pays Rs. 1,000 at the end of the 1st, 2nd and 3rd year from now.
Which of the two options should the person choose?
Solution: The best policy can be determined based on calculating

the PV:
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Option 1 – Here, the investment of Rs. 2,500 is paid today; there-

fore, it is already the PV.
Option 2 – Rs. 1,000 is paid at the end of the 1st, 2nd and 3rd
year; thus, by discounting the value of Rs. 1,000 and changing the
time periods from 1, 2 and 3 at 10% rate of interest, we get the
PV of investment required. We get the following values by using
Equation 3(b).1.
Unit 3(b): Discounting Techniques of Tvm
25
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Time period Value PV
Notes
Year0 0 0
Year1 1000 909 ___________________
Year2 1000 826 ___________________
Year 3 1000 751
___________________
Total 3000 2487
___________________
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Calculating PV of the Investment in Example 4.2 ___________________
From the above table, we see that option two is profitable for the ___________________
investor. ___________________
Thus, based on the understanding of the compounding and discount- ___________________

ing techniques, we can defer the following about the PV and FV: ___________________
The PV and FV are related to one another. We can make any of the ___________________
value as an independent variable and the other as the dependent
variable and calculate its value.
FV factor will be more than one and the PV factor less than one, for
single cash flow. The FV contains the interest portion; whereas, the
PV is devoid of interest.
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Present Value of Perpetuity and Annuity
Apart from single cash flow and series of cash flow in equal install-
ment, there are other types of cash flows as well –
1. Perpetuity: Perpetuity is the never-ending sequence of identi-

cal cash flows at identical intervals. This implies that the time
period n = infinity
PV = Cash flow/(1 + r)1 + Cash flow/(1 + r)2 + Cash flow/(1 + r)3

+…………+ Cash flow/(1 + r) ∞
This can be simplified to PVp = Annual Cash Flow/r
Thus, to derive the PV of annuity, amount of perpetuity is to be

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divided by rate of interest.
2. Annuity Due: It was assumed that the amount was paid at

maturity and then the calculation pf PV and FV were done.
However, it may happen that the amount is paid at the begin-
ning of the time period, which is called Annuity Due.
FV = Annuity Amount * CVAF(r, n) * (1 + r)

26
Where,
S
Notes
r = Rate of interest
___________________
n = Time period
___________________
___________________ and CVAF = Compounded Value of Annuity factor
___________________ PV = Annuity Amount * PVAF(r, n) * (1 + r)
PE
___________________ Where,
___________________ r = Rate of interest
___________________
n = Time period
___________________
and PVAF= Present Value of Annuity factor
___________________
___________________
Present Value of Growing Perpetuity
1. Growing Perpetuity: is defined as the never-ending cash flow
sequences, growing at a fixed rate per period. This can be de-
scribed mathematically as follows:
PV = Cash flow/(r − g)
)U
Where cash flow = amount at the completion of the period
g = Growth rate in the perpetuity amount
2. Growing Annuity: It is the finite series of cash flow growing

at a periodic rate. This can be mathematically defined as:
PV = CF1/(r – g)[1 − {(1 + g)/(1 + r)}2]
Where CF1 = cash flow at finish of the first period
g = Growth rate
n = Life of annuity
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Summary
Discounting technique is a method to determine PV from a given
FV. For any given period, PV will be lower if the rate of interest
falls. PV will be lower for any given rate of interest is there is an in-
crease in the time-period. The PV and FV are related to one another.
For single cash flow, the FV factor will be greater than one, and the
PV factor is less than one.
Unit 3(b): Discounting Techniques of Tvm
27
Review Questions
S
Notes
1. An investment is expected to offer returns of Rs. 3,500/- p.a. for ___________________
an indefinite period with a rate of interest at 10%. Calculate its
___________________
Present Value.
___________________
2. ABC, a finance company, offers to deposit a sum of Rs. 2,200
___________________
and then receives returns of Rs. 160 p.a. perpetually.
PE
___________________
If the rate of interest is 8%, should this offer be accepted? Should
___________________
the decision change in case the rate of interest is 5%?
___________________
3. Mr. Nagpal is offered a scheme to open a recurring deposit ac-
count for a period of 10 years earning 12% interest. Under this ___________________
scheme, Rs. 3,150 will be deposited in the first year, and for ___________________
subsequent years, the deposit amount will increase by 5% every
___________________
year. What is the PV of this scheme?
4. A company issued bonds worth Rs. 50 lacs with a repayment

tenure of seven years. If a sinking fund is earning 12%, how
much should the company invest so as to be able to repay the
bond?
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5. What is the PV of operating expenditures of Rs. 2,00,000 per
year, which is assumed to be incurred continuously throughout
a five-year period, if the effective annual rate is 12% ?
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29
Unit 4
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Notes
___________________
Applications of Time ___________________
Value of Money ___________________
___________________
PE
Objectives: ___________________
At the end of this unit, students will be able to under and calculate:
___________________
\\ The implied rate of interest
___________________
\\ The number of periods
\\ The concept of sinking funds ___________________
\\ The concept of capital recovery ___________________
___________________
Introduction
The concept of time value of money (TVM) is chiefly dependant on
interest rates. A borrower who borrows money today will have to
repay the money along with interest. The principle of TVM defines
that a particular amount of money lent to someone has more value
)U
when received back early. This is due to its capacity to earn inter-
est. Financial managers are involved in making various decisions
that have financial implications. The TVM tool can be used for such
decision making. The application of the concept of TVM is listed
below:
llCalculating the implied rate of interest
llCalculating the number of periods
llSinking funds
llCapital recovery
The prerequisites of using TVM are:

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1. Understanding the cash flows
2. Applying the adequate techniques (Compounding/Discounting)
3. Applying the selected technique correctly
We will further learn about the various applications of TVM.

30
To Find the Implied Rate of Interest
S
Notes
___________________ When Deep Discount Bonds (DDBs) are issued by several financial
institutions, investors must pay an amount at the time of issue of
___________________
the bond. The investor, in turn, receives an amount of cash (which
___________________ might be higher) at the completion of the stated period. Thus, using
___________________ TVM, we can compute the applied rate of interest for DDBs.
PE
___________________ For example – A DDB is issued today at Rs. 1,000 and will mature
___________________ after five years amounting to Rs. 15,000. On the basis of this, we can
calculate the implied rate of interest, r, using the following formula:
___________________
___________________ FV = PV + (1+r)5
___________________ Where:
___________________ FV – Future Value
PV – Present Value
r – the rate of interest
To Find the Number of Years

)U
Finding out the time period at which an amount will grow to a cer-
tain value at a given rate of interest is something a financial man-
ager be interested in. This can be shown by the following formula,
where number of years, n, can be calculated:
FV = PV + (1 + r)5
Sinking Fund
A financial manager will want to accrue an amount along with in-
terest earned over a period of time where the annual amount to be
paid remains same for all years. He would also be willing to accumu-
late a certain amount for replacing an asset or repaying a liability
in that specific period. Now, the amount collected annually becomes
the annuity for a given period wherein the amount collected annu-
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ally shall be invested for the balance duration in such a way so that
the target amount is equivalent to the amount collected at the end
of the period.
For example, Rs. 10,000 is required after five years from now in or-
der to repay a liability. How much amount should be accrued at the
end of every year with a 10% rate of interest? This can be calculated
as follows:
Unit 4: Applications of Time Value of Money
31
FV = Annuity amount *CVAF (r, n)
S
Notes
Annuity amount = FV/CVAF(r, n)
___________________
Here, CVAF stands for Compounded Value of Annuity factor. ___________________
r is the rate of interest. ___________________
n is the time period. ___________________
PE
___________________
= 10000/6.105 = 1638
___________________
Therefore, an amount of Rs. 1,638 should be accumulated and in-
vested at 10% rate of interest to attain Rs. 10,000 by the end of five ___________________
years. ___________________
___________________
Capital Recovery
___________________
A finance manager may want to calculate the amount to be paid
annually along with interest, at a fixed rate of the interest, for reim-
bursing a borrowed amount over a specified period.
For example, Rs. 10,000 is to be repaid in five equal installments,

with each installment being payable at the end of each of the next five
)U
years, so that the interest accrued at 10% per annum can also repay.
This can be calculated as follows:
PV = Annuity amount *PVAF (r, n)
Here, PVAF stands for Present Value of Annuity factor.
r is the rate of interest.
n is the time period.
Annuity amount = PV/PVAF(r, n)
= 10000/3.791 = 2637.8
Thus, if at the end of each year an amount of Rs. 2,673.8 is paid then
the initial debt of Rs. 10,000 together with interest accrued 10% will
(C
be repaid in five years.
The factor 1/PVAF(r, n) is also called Capital Recovery Factor.
Deferred Payment
If a loan along with interest has to be repaid such that every year
the payment being made remains identical and the initial install-
ment has to be deferred for a period of few years. In such a case,
32
the period for which the payment has been delayed, its interest are
S
Notes taken into consideration while calculating the amount to be repaid
___________________ annually for paying off the entire loan with interest.
___________________ Example 4.1 A debt of Rs. 100,000 is to be paid, starting from the
___________________ 3rd year onwards, at 10% interest in six equal installments as fol-
lows.
___________________
PE
Figure 4.1: Calculation of Annual Payments Delayed at r = 10%
___________________
Years
___________________
0 1 2 3 4 5 6 7 8
___________________
Interest
___________________ 1,00,000 for 1,21,000 27,784 27,784 27,784 27,784 27,784 27,784
delay in
___________________ payment
___________________
Solution: Here, the amount to be repaid is Rs. 1,00,000, but there
is a delay of two years for which interest has been calculated at @
10% p.a.
FV = PV+ (1 + r)5 = 1,00,000 (1 + 0.10)2
FV = Rs. 1,21,000
)U
Now, PV = Annuity amount * PVAF
Annuity amount = PV/PVAF = 27784
Summary
The principle of TVM defines that a particular amount of money
lent to someone has more value when received back early. It is a
foundation for numerous applications, which include calculating im-
plied rate of interest, number of periods, sinking funds and capital
recovery.
Review Questions
1. XYZ PVT Ltd, a firm, buys machinery worth Rs. 8,00,000 and
(C
as down payment pays Rs. 1,50,000 and repays the balance

money in installemnts of Rs. 1,50,000 for six years each. What
is the firm’s rate of interest?
2. Ten years from now Mr. Amit Bhatnagar will start receiving
a pension of Rs. 2,000 per year. The payment will continue for
15 years. What is the worth of the annuity now, if the rate of
interest is 10%?
Unit 4: Applications of Time Value of Money
33
3. Mayura Industries is creating a sinking fund to repay Rs.
S
60,00,000 bond issue which will mature in 15 years. How much Notes
amount do they have need put into the fund at 10% interest ___________________
rate at the end of each year to accumulate Rs. 60,00,000, with ___________________
interest being compounded annually?
___________________
4. Naveen Co. Pvt. Ltd. is creating a sinking fund to repay the
___________________
preference share capital of Rs. 10,00,000 which matures on 31-
PE
___________________
12-2017. The annual payments start on 1-1-2010 which is the
date of issue. The company wants to invest an equal amount ___________________
every year, which will earn 10% p.a. How much is the amount ___________________
of sinking fund annuity?
___________________
___________________
___________________
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PE
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35
Unit 5
S
Notes
___________________
Case Study: An Analysis of ___________________
Retirement Plans by ABC Corp. ___________________
India is an upcoming financial capital of Southeast Asia. Large ___________________
PE
business houses, investors, small business enterprises and high net ___________________
worth individuals use different methods and avenues of investment
to be able to meet their short-term and long-term requirements. ___________________
These investment opportunities differ based on their returns, ma- ___________________
turity period and the investor’s risk appetite.
___________________
ABC Corp. is a financial institution that provides financial services
___________________
with its headquarters in Mumbai, India. It provides different fi-
nancial plans or policies to its customers. This corporation helps ___________________
its customers in investment plans like savings plans, stock-market
investment plans, term policies, retirement plans, etc. These plans
depend on the following characteristics:
llHigh Risk High Return Policies
llDuration Short-term and Long-term Policies

)U
llAmount under Consideration
Time Value of Money is the basic concept under which these policies
are formulated. Large business conglomerates have huge capital
requirements for multiple projects. Hence, for such firms, seeking
a loan at the appropriate time or investing in the right plan at the
right time is very important to increase the firm’s earnings.
Mr. Sudeep, who is 35 years of age, would like to retire at the age
of 65. He wants to invest in a retirement plan such that he has an
annual income of Rs. 12 lacs per annum 30 years from today.
Mr. Sudeep visits ABC Corp. and understands the different pol-
icies offered by them. He informs Mr. Aman, an executive of the
company, about his requirements. Mr. Sudeep wants to open a re-
tirement account and is able to pay Rs. 1,50,000 lump sum with
annual payments of Rs. 50,000 for the next 10 years. Mr. Sudeep
(C
has other commitments for the first 10 years; however, after 10

years, he will have more disposable income and can increase the
annual payment.
The task for Mr. Aman is to help him meet his goals of retirement
by estimating how much he will need to save every year 10 years
from now. Assume an average annual rate of 8% return on the
retirement account.
Contd....
36
Mr. Sudeep is also interested in knowing how much amount is to
S
Notes be paid upfront to reduce the annual payments after 10 years (10
___________________ years–30 years) to half the value calculated initially.
___________________
___________________
___________________
PE
___________________
___________________
___________________
___________________
___________________
___________________
)U
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PEBLOCK–II
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Detailed Contents
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UNIT 6: TYPES OF FINANCIAL STATEMENTS ll Steps in Ratio Analysis
ll Financial Statements ll Types of Comparison in Ratio Analysis
ll Income Statement ll Classification of the Ratios
ll Balance Sheet ll Liquidity Ratios

ll Activity Ratios
ll Statement of Appropriation of Profit
PE
ll Leverage Ratios
ll Statement of Change in Financial Position
ll Profitability Ratios
ll Summary
ll Summary
ll Review Questions
ll Review Questions
UNIT 7: FINANCIAL STATEMENT ANALYSIS

UNIT 9: DUPONT ANALYSIS
ll Analysis of Financial Statements
ll Introduction
ll Types of Analysis of Financial Statements
ll DuPont Analysis or Profile of Profitability
ll Methodical Presentation of Analysis of Financial State- ll How is the Return on Equity Dependent on other Key
ments Ratios of a Company?
ll Techniques/Tools of the Analysis of Financial State- ll Relationship between Debt Financing and Growth
ments
ll Summary
ll Summary
ll Review Questions
ll Review Questions
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UNIT 10: CASE STUDY: BATA INDIA: STEP INTO
UNIT 8: RATIO ANALYSIS STYLE
ll Introduction
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39
Unit 6
S
Notes
___________________
Types of Financial Statements ___________________
___________________
Objectives: ___________________
PE
At the end of this unit, the students will be able to:
___________________
\\ Define an Income Statement
___________________
\\ Create a Balance Sheet
\\ Describe a Profit Appropriation Statement ___________________
\\ Formulate a Change in Financial Position Statement ___________________
___________________
Financial decision making and financial planning that is benefi-
___________________
cial for a company require the right amount of information to make
these decisions. This information encompasses previous and present
values of the firm and its operations and the changes in it over time.
Such information is known as financial information. This financial
information is derived from financial statements.
)U
Financial Statements
A precise and concise form of financial information is available
through Financial Statements. There are various reasons to prepare
financial statements:
1. To convey the real position of the firm to external parties
2. To analyse the operation and performance of the firm
Every company holds an annual general meeting in which they pres-

ent the annual report of the company to their shareholders as per
The Companies Act, 1956. This annual report contains various re-
ports, such as the chairman’s report, balance sheet, income state-
ments and auditors’ reports along with several scheduled annex-
ures, key operating statistics, etc. Following financial statements
(C
have to be prepared by every firm, irrespective of its size:
1. Income Statement (IS)
2. Balance Sheet (BS)
3. Statement of Appropriation of Profit
4. Cash Flow Statements

40
Income Statement
S
Notes
___________________ An income statement (IS) provides information regarding the rev-

enue and expenditure of the firms for a given accounting period. It
___________________
gives information regarding all incomes and expenses and the firm’s
___________________ operating results for a specified period. As it matches revenues with
___________________ the costs incurred while generating that revenue, it supports the
PE
financial managers in understanding a firm’s performance and then
___________________
help them finally calculate the net profit or net loss incurred during
___________________
that period. The format to prepare an IS for a company for a partic-
___________________ ular period is given in Table 6.1.
___________________ Table 6.1: Performa Income Statements for the Year Ending…
___________________ Particulars Amount (Rs.) Amount (Rs.)

Revenues:
___________________
Sales Revenue
Less sales returns and
allowances
Service revenue
Interest revenue
Other revenue
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Total revenues Rs.________ Rs. _______
Expenses:
Advertising
Bad debts
Commissions
Cost of goods sold
Depreciation
Furniture and equipment
Insurance
Interest expense
Maintenance and repairs
Office supplies
Payroll taxes
Rent
Research and
development
(C
Salaries and wages

Software
Travel
Utilities
Others
Total expenses
Net income before taxes
Contd.
Unit 6: Types of Financial Statements
41
S
Particulars Amount (Rs.) Amount (Rs.)
Notes
Income tax expenses
Income from continuing ___________________
expenses
___________________
Net income
___________________
___________________
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___________________
___________________
___________________
___________________
___________________
___________________
The contents of an IS are divided into three categories:
1) Revenue
2) Expenses
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3) Net Profit and Loss
Revenue
The amount of money that comes into a company during a particu-
lar time, including discounts and deductions for business activities
or sale and purchase of goods and services, is called revenue. The
revenues is generated from the sale of goods and services and oth-
er non-operating incomes. Revenue is also generated in the form of
interest and dividend received from investments made in another
firm. An increase in the value of assets or decrease in the value of
liabilities represents the increase in shareholder’s funds due to rev-
enue generation.
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Expenses
The costs incurred while generating revenues are called expenses.
Some of the major expenses that company has to incur are the cost of
goods sold, salaries, repair and maintenance, transportation expens-
es, etc. An expense is said to be incurred if there is an enhancement
in liabilities or reduction in assets. Depreciation is also an expense
to the firm as it decreases the value of the asset over a given time.
42
Net Profit/Loss
S
Notes
The net profit or loss is a result of the tallying of revenues and ex-
___________________
penses. When revenues are more than expenses, there is a net prof-
___________________ it. If expenses are more than revenues, there is a net loss. These
___________________ values of net profit and loss determine the profitability of the firm.
Thus, an IS is also called a profit and loss statement.
___________________
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___________________ Balance Sheet
___________________
A Balance Sheet (BS) is considered to be the most significant finan-
___________________ cial statement of any firm as it presents a clear picture of a compa-
___________________ ny’s financial position at a given point in time. A BS provides details
regarding different components such as assets, liabilities, and capi-
___________________
tal of the A BS balances the assets of the firm to its liabilities. That
___________________ is the total value of assets must be equal to total claims against the
firm. This can be represented as follows:
Total Assets = Total Claims (Debt+ Shareholder’s contribution)
= Liabilities + Shareholder’s Equity
The format for preparing the BS of a company for a particular period

)U
is given in Table 6.2.
Assets 2017 (Rs.) 2018 (Rs.)

Current Assets:
Cash
Accounts receivables
Inventory
Prepaid expenses
Short-term investments
Total current assets
Long-term assets:
Long-term investments
Property, plant, and equipment
Total fixed assets
Other assets:
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Deferred income tax

Other
Total other assets
Total Assets Rs.________ Rs.________
Liabilities and Owner’s Equity:
Current liabilities:
Accounts payable
Short-term loans
Contd.
43
S
Assets 2017 (Rs.) 2018 (Rs.)
Notes
Income taxes payable
Accrued salaries and wages ___________________
Unearned revenue
___________________
Current portion of long-term debt
Total current liabilities ___________________
Long-term liabilities: ___________________
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Long-term debt
___________________
Deferred income tax
Other ___________________
Total long-term liabilities
___________________
Owner’s equity
Owner’s investment ___________________
Retained earnings ___________________
Other
Total owner’s equity ___________________
Total liabilities and Owner’s Equity
Table 6.2: Performa Balance Sheet for the Year Ending…The differ-
ent components of a BS are:
1. Assets
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2. Liabilities
3. Shareholder’s Funds
Assets
An asset can generate future inflows and reduce cash outflows. The
assets of a firm represent the investments it makes to generate earn-
ings. Assets can be categorized as: Fixed Assets and Current Assets.
1. Fixed Assets: These are also called capital assets. They are
permanent in nature, and it is not possible to liquidate them in
a short span of time cannot. Examples of fixed assets are plant
and machinery, furniture and fixtures, land and building, etc.
These assets are shown in the BS at their written down value,
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that is, the purchase cost less depreciation to date.
Depreciation is the process of allocation of the cost of the assets

in a particular time period during which the assets were used for
the company’s activities. The amount of depreciation does not
involve any cash outflow and, thus, is taken as an expense item
and is included in the cost of goods sold or indirect expenses.
44
2. Current Assets: These are liquid assets that can be monetized
S
Notes quickly ideally within a period less than one year. Examples of
___________________ current assets are cash in bank balance, inventory, receivables,
___________________ loan in advances given to suppliers, etc. The total of all current
assets is also called gross working capital.
___________________
___________________ Debts or Liabilities
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___________________ Any claims that the outsiders have against the assets of the com-
___________________ pany are called Debts or Liabilities. It is the amount payable to the
claimholders by the company. A title is called a liability if i) it leads
___________________
to a cash outflow in the future, ii) the firm has to take this obligation
___________________ into account and cannot avoid it and iii) the transaction which was
___________________ responsible for the obligation should already have occurred. Liabili-
ties can be classified as:
___________________
1. Long-term liabilities – These are such debts that must be
repaid over many years. Examples of long-term liabilities are
bonds, debentures, mortgage loans, loans from financial insti-
tutions, etc.
2. Current liabilities or short-term liabilities – These are the

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debts incurred by a firm and must be repaid within one year.
These short-term liabilities are related to the operating cycle
of the firm. Examples of current liabilities are outstanding ex-
penses, bills payable, bank overdraft, etc.
Shareholders’ Equity
The Shareholder’s Equity is an obligation of a firm toward its own-
ers. It comprises of share capital and retained earnings. The share
capital is the contribution of the shareholders toward the firm;
whereas, the retained earnings reflect the accumulated effect of the
firm’s earnings less the dividends. The shareholder’s equity is also
called the net worth of the firm.
Statement of Appropriation of Profit

(C
This statement is also called the profit and loss appropriation ac-
count. This statement shows us how the profits are utilized by the
firm as it may be bifurcated into dividends and retained earnings.
Thus, the net profit which is obtained from the IS, is transferred to
the P&L appropriations account. The format to prepare the state-
ment of appropriation of accounts is given in Table 6.3.
45
Table 6.3: Performa of Profit and Loss Appropriation A/c
S
Notes
Particulars Amount Particulars Amount
___________________
To General ***** By Balance b/d *****
Reserve ___________________
To Interim ***** By Net Profit *****
___________________
Dividend
To Proposed ***** By Transfer from ***** ___________________
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Dividend General Reserve
___________________
To Corporate *****
Dividend Tax ___________________
To Balance c/d *****
___________________
(balancing figures)
Total ***** Total ***** ___________________
___________________
General Reserve
___________________
The amount that a company keeps separately out of the profits
earned or future purpose is called general reserves.
Interim Dividend
The distribution that has been declared and paid before the com-
pany has estimated its complete earnings for a particular financial
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year is called interim dividend.
Corporate Dividend Tax

The profits of a company are taxable at the average marginal tax
rates of shareholders’ when distributed as dividends.
Net profit/loss
The net profit or loss is a result of the tallying of revenues and ex-
penses. When revenues are more than expenses, there is a net profit.
If expenses are more than revenues, there is a net loss.
Statement of Change in Financial Position

The BS and IS determine the financial condition of the company
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during a period but does not give any information on the change in
financial position over that period. In order to identify the move-
ment of funds during a period a Statement of Change in Financial
Position (SCFP) must be prepared. The SCFP illustrates how funds
are generated during a time period and how these funds are utilized.
The SCFP can be prepared in two different ways: Working Capital
Basis and Cash Basis
46
The working capital basis is a method by which the SCFP is pre-
S
Notes pared of a company between two BSs. It represents the inflow and
___________________ outflow of funds or the sources and applications of funds for a spe-
___________________ cific period.
___________________ Cash basis is a method to record transactions for revenues and ex-
penses when it is received, or payments are made.
___________________
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___________________ When the SCFP is prepared on the basis of Working Capital, it is
termed as Funds Flow Statement, and when it Cash basis is used
___________________
to prepare the statement it is called Cash Flow Statement.
___________________
Thus, financial statements are an important tool to aid the finance
___________________
manager in better decision making. The information provided in
___________________ these statements can be further analysed to determine the financial
___________________ health of the firm.
Summary
The financial statements are used to present essential financial in-
formation is a concise and precise company. They are used to help
external parties understand the financial position of the firm and
)U
to analyse the level of operation and performance of the company.
Various types of financial statements include the IS, BS, statement
of appropriation of profit and cash flow statements.
Review Questions
1. What is the relation between Income Statement (IS) and Bal-
ance Sheet (BS)?
2. Explain the significance of two basic financial statements with

respect to various stakeholders?
3. What are the three main categories in which the contents of IS

can be grouped? Explain each of them.
4. Explain the difference between fixed assets and current assets.

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How are the assets illustrated in the BS?
5. Statement of Change in Financial Position is explained by two

statements. What are the two statements? On what basis are
these statements prepared? Explain their significance to the
firm.
47
Unit 7
S
Notes
___________________
Financial Statement Analysis ___________________
___________________
Objectives:
___________________
At the end of this unit, the students will be able to understand and explain:
PE
___________________
\\ Purpose of financial statements analysis
\\ Various types of financial statements analysis ___________________
\\ Financial statement presentation ___________________

\\ Financial statements analysis
___________________
___________________
Analysis of Financial Statements
___________________
As discussed earlier, critical financial information is made avail-
able through financial statements. In order to take key decisions
regarding the functioning of the company, Finance Manager and
other Management personnel have to analyze various financial
statements. As such, analysis of financial statements (AFS) can be
defined as the process of studying the relationship amongst different
)U
financial information provided available through the financial state-
ment. AFS assists a financial manager in identifying the financial
standing of the company.
Objectives of Analysis of Financial Statements

Following are the various objectives of AFS: -
1) Profitability and Efficiency analysis of the whole firm as well as

of individual departments.
2) To identify the relative significance of various components that

affect a firm’s financial standing.
3) Analysis of the reasons for changes in the financial standing of

the firm.
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4) Calculation of the firm’s short-term as well as long-term

liquidity.
Types of Analysis of Financial Statements

The type of AFS to be used depends on the end purpose for which it
is being done. AFS is mainly required by the shareholders, creditors
48
and investors and management. Following are the various ways to
S
Notes categorize it:
___________________
Internal and External Analysis of Financial Statements
___________________
Internal Analysis of financial statements is done by an individual or
___________________
company has easy access to the company’s book of accounts as well
___________________ as all other relevant information to measure the company’s manage-
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___________________ rial and operational efficiency.
___________________ External Analysis of financial statements is done by an external

___________________ person without having access to the company’s basic accounting re-
cords and is only based on the company’s published financial data in
___________________
annual reports and other sources.
___________________
Dynamic and Static Analysis of Financial Statements
___________________
Dynamic analysis is used for long-term analysis and planning based
on horizontal analysis of the financial statements covering a peri-
od of several years. Whereas, Static Analysis or Vertical analysis
covers a period of up to one year and provides information as on a
particular date without any periodic changes being incorporated.
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Methodical Presentation of Analysis of Financial
Statements
The data available can be modified and suitably rearranged to make
it more logical and easier to analyze. In order to facilitate an in-
ter-firm comparison, financial information can be presented me-
thodically. The following is an example of an income statement (IS)
of a company for a particular year.
Particulars Amount ($) Amount ($)

Revenues:
Sales Revenue
Fewer sales returns and
allowances
Service revenue
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Interest revenue
Other revenue
Total revenues $________ $ _______
Expenses:
Advertising
Bad debts
Commissions
Cost of goods sold
Contd.
Unit 7: Financial Statement Analysis
49
S
Particulars Amount ($) Amount ($)
Notes
Depreciation
Furniture and equipment ___________________
Insurance
___________________
Interest expense
Maintenance and repairs ___________________
Office supplies ___________________
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Payroll taxes
___________________
Rent
Research and ___________________
development
Salaries and wages ___________________
Software ___________________
Travel
___________________
Utilities
Others ___________________
Total expenses
Net income before taxes
Income tax expenses
Income from continuing
expenses
Net income
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Income Statement (Methodical Presentation)
The following is an example of the balance sheet (BS) of a company

for a particular year.
Table 7.2: Balance Sheet (Methodical Presentation)
Assets 2017 ($) 2018 ($)

Current Assets:
Cash
Accounts receivables
Inventory
Prepaid expenses
Short-term investments
Total current assets
Long-term assets:
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Long-term investments
Property, plant, and equipment
Total fixed assets
Other assets:
Deferred income tax
Other
Total other assets
Contd.
50
S
Total Assets $________ $________
Notes
Liabilities and Owner’s Equity:
___________________ Current liabilities:
___________________ Accounts payable
Short-term loans
___________________
Income taxes payable
___________________ Accrued salaries and wages
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___________________ Unearned revenue
Current portion of long-term debt
___________________
Total current liabilities
___________________ Long-term liabilities:
___________________ Long-term debt
Deferred income tax
___________________
Other
___________________ Total long-term liabilities
Owner’s equity
Owner’s investment
Retained earnings
Other
Total owner’s equity
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Total liabilities and Owner’s Equity
Techniques/Tools of the Analysis of Financial

Statements
Earlier in this chapter, we have discussed the purpose of AFS. We
will now discuss the techniques of performing AFS. The following
are few techniques:
1. Comparative Financial Statements (CFS)
2. Common-Size Financial Statements (CSS)
3. Trend Percentage Analysis (TPA)
4. Ratio Analysis
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Comparative Financial Statements

In Comparative Financial Statements (CFS), a BS or an IS is con-
densed for two or more years. This means that the person conducting
CFS can compare the BS or IS across different years. It is observed
that information of financial statements across different time pe-
riods will be more beneficial as compared to the information for a
single financial period. The CFS is prepared to depict the following:
51
1. Monetary Value of different items
S
Notes
2. Monetary Changes over a period
___________________
3. Calculate proportionate changes on the basis of periodic changes ___________________
in %.
___________________
Let’s have a look at an illustration of cash flow statement.
___________________
PE
Particulars Year, 20XX ___________________
___________________
Cash flows from operating activities:
Revenues from School Districts ___________________
Grant revenues ___________________

Contributions and fund-raising activities
___________________
Miscellaneous sources
Payments to vendors for goods and services rendered ( ) ___________________
Payments to charter school personnel for services rendered ( )

Interest payments ( )
Net cash provided by operating activities
Cash flows from investing activities:

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Purchase of equipment ( )
Net cash used in investing activities ( )
Cash flows from financing activities:

Principal payments on long-term debt ( )
Net cash provided by investing activities ( )
The net increase in cash

Cash at the beginning of the year
Cash at ending of the year
Reconciliation of change in net assets to net cash provided by

operating activities:
Change in net assets
Adjustments to reconcile change in net assets to net cash
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provided by operating activities:

Depreciation
(Increase) Decrease in assets:
Accounts receivable
Increase (Decrease) in liabilities:
Accounts payable
Accrued liabilities ( )
Net cash provided by operating activities
52
CFS is compared for both BS and IS.
S
Notes
llComparative Balance Sheet: In order to analyze the financial
___________________
standing of the company, a comparative BS is of great assis-
___________________ tance as it depicts the different value of assets and liabilities
___________________ across different dates.
___________________ llComparative Income Statement: A comparative IS shows
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___________________ the values of different items of the IS and its change from
one period to another. This change can be calculated in per-
___________________
centages and provides useful data to analyze and draw con-
___________________ clusions. This can also help a financial analyst to predict in-
___________________ creasing or decreasing trends in entities like the cost of sales,
___________________
manufacture of goods, etc.
___________________
Common-Size Financial Statements
1) A Common-Size Financial Statements (CSS) represents the re-
lationship between the components of financial statements like
BS or IS by calculating the values in the form of percentages.
For example, the BS for two years can be compared by convert-
ing each component of a BS into a percentage. This percentage
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is calculated by taking the absolute value of the component di-
vided by the total of the BS and multiplying by 100. In the same
way, the components of the IS are converted into percentages
by taking the value of the component, dividing it by the net
sales and multiplying the factor by 100. Here is an illustration
of a CSS.
Particulars 2017 (Rs.) 2018 (Rs.)

Sales
Cost of goods sold
Gross Profit
Taxes
Total profit
(C
Trend Percentage Analysis

This is the technique in which different financial statements are
examined over a series of years and is used for both BS and IS. The
trend percentage is calculated for every constituent and compared
with that of the base year with the value of the base being 100. TPA
can be used to study historical data and forecast the future trend.
53
Ratio Analysis
S
Notes
Ratio Analysis is one of the most used technique for AFS and gives
___________________
a precise data for analyzing the firm’s overall financial standing. It
will be discussed elaborately in the next chapter. ___________________
___________________
Summary
___________________
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AFS is a study of the relationship between various financial infor- ___________________
mation (facts and figures) provided by the financial statement. AFS
___________________
can be employed by the Finance Manager to identify and analyze
company’s financial strengths and weaknesses. It helps analysis of ___________________
operating efficiency and profitability of the whole company as well ___________________

as different individual departments. This helps establish relative
___________________
significance of various constituents of the company’s financial posi-
tion. ___________________
Review Questions
1. How is a dynamic analysis of financial statements done?
2. Explain how the methodical presentation of financial state-

)U
ments helps while calculating various ratios?
3. How is each item expressed in common-size financial state-

ments (CSS)? Explain by using an example.
4. Explain how trend percentage analysis helps in the dynamic

analysis?
5. What is the difference between the CSS and CFS for both in-
come statement and balance sheet?
(C
(C
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S
55
Unit 8
S
Notes
___________________
Ratio Analysis ___________________
___________________
Objectives:
___________________
At the completion of this unit, the students will be able to understand and
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explain: ___________________
\\ Liquidity Ratios ___________________
\\ Activity Ratios
___________________
\\ Leverage Ratios
___________________
\\ Profitability Ratios
___________________
Introduction ___________________
A financial ratio helps establish a relation between multiple ac-

counting figures which help summarize a vast amount of financial
data into key ratios which are then used by financial analysts or
company management to analyze the financial health and perfor-
mance of the firm.
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Example 8.1 – If a firm is making a profit of Rs. 10,00,000 and net
sales of the firm are Rs. 25,00,000, then find the ratio of net profit.
Solution: In this case,
Net profit is Rs. 10,00,000
Net sales are Rs. 25,00,000
The formula to determine the ratio of net profit is:
Net profit after tax

Net profit ratio = × 100
Net sales
10, 00, 000

Net profit ratio = × 100
25, 00, 000
(C
= 40%
Thus, the ratio of net profit to net sales is 40%.
Steps in Ratio Analysis

Basically, there are two steps of ratio analysis. These two steps in-
volve:
56
1. Calculation of the ratios
S
Notes
2. Comparison of the calculated ratio with a benchmark ratio. The
___________________
benchmark ratio could be the industry’s standard or the base
___________________ year’s ratio.
___________________
Types of Comparison in Ratio Analysis
___________________
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___________________ There are three ways in which ratios can be analyzed:
___________________ 1. Time Series Analysis: When the performance or the ratios

___________________ of the firm are evaluated over a period of time, it is called time
series analysis. The information provided through time series
___________________
analysis illustrates a trend in the values, which can then be
___________________ used to examine the following:
___________________
(a) Prediction of values for the future
(b) Deviation from the present and long-term goals of the

firm
(c) Shift in trend and assess any significant deviation
(d) The progress of the firm

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2. Cross Section Analysis: In this particular analysis, the ratios
are calculated within a given time period and then compared
with same ratios of different firms in the same industry. This
helps analyze the progress of the company in comparison to the
competitors in the market.
3. Combined Analysis: Data from both the previous analysis is

combined to extract meaningful information about the firm’s
performance.
Classification of the Ratios

Different ratios are categorized as per its nature. These ratios pro-
vide information regarding the different aspects of the firm’s per-
(C
formance. Mainly, the financial ratios give information on the oper-

ational and financial performance of the firm. Thus, the ratios are
classified as follows:
1. Liquidity Ratios
2. Activity Ratios
3. Leverage Ratios
4. Profitability Ratios
Unit 8: Ratio Analysis
57
Liquidity Ratios
S
Notes
These ratios provide information on the firm’s short-term solvency ___________________
and its ability to pay off debts. Thus, it mainly refers to the mainte-
___________________
nance of cash, cash balances and current assets. The liquidity ratios
keep a track on the extent of the firm’s exposure to risks that will af- ___________________
fect its short-term goals. In case a firm has low liquidity, it won’t be ___________________
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able to meet its current liabilities which will result in loss of credit-
___________________
worthiness. All the information required to calculate liquidity ratios
___________________
appear on the balance sheet, that is why these are called balance
sheet ratios as well. ___________________
Some of the important liquidity ratios are as follows: ___________________
___________________
Current Ratio
___________________
It is a measure of a company’s total current against its current lia-
bilities
Total Current Assets
Current Ratio =
Total Current Liabilities
The total current assets include cash, cash convertible (which can
)U
be converted into cash in one year), prepaid expenses and short-
term investments. Whereas, the current liabilities include all the
liabilities that need to be paid off in a period of one year, such as
outstanding expenses, bills payable, bank overdraft, provision for
tax, provision for dividends, etc. It highlights the fact if the firm’s
current assets are enough to meet its current liabilities.
Interpretation of the Ratio: The satisfactory level is 2:1; however,

this may not be applicable to all cases and may be different for dif-
ferent industries. This explains that the firm has twice the margin
with which the value of current assets may go down without affect-
ing the operations of the firm.
The only flip side of using current ratio is that it considers only the
current assets of the company, not the current liabilities. Thus, the
(C
real ability of the firm is measured using the quick ratio.
Quick Ratio
The quick ratio is also called the acid-test ratio or the liquid ratio. It
establishes the relationship between quick/liquid assets of the com-
pany to its current liabilities. A current asset is said to be a liquid
asset if it can be converted to cash with a period of one year without
58
any loss of value. Quality of current assets is taken into consider-
S
Notes ation, and in comparison, doubtful assets such as obsolete stock,
___________________ defaulting debtors, and prepaid expenses are not considered.
___________________ Quick / Liquid Assets
Quick Ratio =
___________________ Total Current Liabilities
___________________ Interpretation of the Ratio: The quick ratio of 1:1 is considered sat-
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___________________ isfactory; however, this may not be applicable to all cases and may
be different for different industries. This explains that the firm has
___________________
enough liquid assets to repay the current liabilities.
___________________
There is a serious drawback for the quick ratio, as the assets or
___________________
their components which may not be converted into cash within a
___________________ year are also added sometimes. Inventories that were removed from
___________________ the quick assets may not always be illiquid, or the receivables or
marketable securities that are considered may not be liquid enough.
Thus, the absolute liquid ratio provides a more rigorous and better
measure.
Absolute Liquidity Ratio

It takes into consideration the absolute liquidity available within
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the firm. Thus, it includes cash, bank balances and marketable se-
curities and divides them by the current liabilities. As such it is also
known as a super quick ratio or cash ratio.
Cash in hand and bank + Marketable Securities

Cash Ratio =
Total Current Liabilities
Interpretation of the Ratio: The cash ratio of 0.5:1 or 1:2 is consid-

ered satisfactory; however, this may not be applicable to all cases
and may be different for different industries. This also explains that
too much of highly liquid assets will be unprofitable for the compa-
ny. Every firm has a borrowing capacity. Thus, the total cash reser-
voir ratio or the reserve borrowing capacity is also relevant.
Defensive Interval Ratio

(C
This ratio emphasizes that not just current liabilities but also cur-
rent assets should be large enough to meet the daily requirements
of liquidity to pay expenses. For this reason, defensive interval ratio
is calculated.
Total Defensive Assets

Defensive interval Ratio =
Projected Daily Cash Requirements
59
Total Liquid Assets
S
= Notes
Projected Daily Cash Requirements
___________________
Cash + Bank + Debtors + Marketable Securities
= ___________________
Projected Daily Cassh Requirements
___________________
Current Assets − Inventory − Prepaid Expenses
=
Projected Daily Cash Requirements ___________________
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___________________
This also explains that the projected daily cash requirement is equal
___________________
to the Cost of Goods Sold + General Expenses− Depreciation /365.
___________________
Activity Ratios ___________________
Activity ratios are also known as turnover ratios and performance ___________________
ratios and can be calculated as a reference to the cost of goods sold ___________________
or sale of goods as it relates to the fact how efficiently the firm has
used its assets and resources.
Following are the major activity ratios:
Inventory/Turnover Ratio
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It is also known as the stock turnover ratio as it measures the rela-
tion between cost of goods sold and average inventory held during
the year. It can be represented as:
Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory
Where,
Opening Stock + Closing Stock

Average Inventory =
2
Cost of Goods Sold = Opening Stock + Purchase – Closing Stock
= Net Sales – Gross Profit
Interpretation of the Ratio: The higher the Inventory/Turnover Ratio

(C
(I/T ratio), more efficient is the inventory management. Different

standards of calculating the I/T ratios are used across different in-
dustries. Moreover, a higher ratio may be acceptable to a certain
point. In case the I/T ratio is on the higher side, it means problems in
the area of short stocking of inventory. If the I/T ratio is too high, it
may indicate problems, such as under-stocking of inventory or poor
management of purchases and sales.
60
Receivables (or Debtors) Turnover Ratio
S
Notes
This ratio focuses on the receivables concept. If a company sells
___________________
goods on credit and the revenue is received at a later stage, the
___________________ receivables are created. The earlier the receivables are received or
___________________ recovered better would be the company’s liquidity. The company’s
credit and collection policy are reflected through the Debtor Turn-
___________________
over Ratio. This ratio determines the speed of the receivables col-
PE
___________________ lection by dividing the annual net sales by the average accounts
___________________ receivables. It is represented as follows:
___________________ Annual Net Credit Sales
Receivables Turnover Ratio =
___________________ Average Receivables
___________________
Interpretation of the Ratio: The higher the R/T ratio (or a low aver-
___________________ age collection period) denotes that the receivables are highly liquid
and indicates a very restricted credit policy. This also implies that
the firm might lose prospective customers by maintaining such a
credit policy. For this reason, the company’s credit policy should be
in line with the industry standards.
Payables (or Creditors) Turnover Ratio

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This ratio underlines the payables concept. If a company buys goods
or raw materials on credit and the cost is incurred at a later stage,
payables are created. Thus, the Payables (or Creditors) Turnover
Ratio (P/T ratio) determines the speed of the debt payment made
by the firm by dividing the annual credit purchases by the average
payables. It is represented as –
Annual Net Credit Purchases

Payables Turnover Ratio =
Average Payables
Interpretation of the Ratio: A high P/T ratio (or a low average reten-
tion period) denotes that the payables are paid out in time and rep-
resents the company’s goodwill toward its suppliers. The suppliers
of the company will be interested in this ratio as this will explain the
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payment pattern of the firm.
Working Capital Turnover Ratio

It signifies the company’s ability to effectively use its working cap-
ital . It signifies the speed with which the firm used the working
capital during the year. The working capital here refers to the net
working capital.
61
Net Working Capital = Total Current Assets – Total Current
S
Liabilities Notes
___________________
The WCT ratio can be described as follows:
___________________
Annual Net Sales
WTC Ratio =
Average Working Capital ___________________
___________________
Interpretation of the Ratio: A high WCT ratio denotes that the in-
PE
___________________
vestment in working capital is less and the profitability is high (as
net sales are high). However, a very high WCT may also signal risk ___________________
and problems with the firm. Moreover, it may denote overutilization ___________________
of working capital or over trading by the firm with respect to its net
___________________
working capital.
___________________
Leverage Ratios ___________________
Leverage ratios are used to analyze the company’s long-term finan-

cial position. In other words, the long-term sources of funds comprise
shareholders’ funds and borrowings. Thus, the long-term sources of
funds comprise the following:
(a) Preference Share Capital

)U
(b) Equity Share Capital
(c) Retained Earnings or Accumulated Profits
(d) Debenture/Loans or Long-term Debt
Debt can be interpreted here as a company’s long-term commitment

to pay interest along with principal on the amount due. That is why
this particular statistic holds great significance for every person as-
sociated with the company as a stakeholder as it signifies the compa-
ny’s ability to pay off its debts as well as its degree of indebtedness.
The more the debt the firm uses, the higher is the risk, which means
the higher is the probability of default. Following are the key ratios
that help analyze the degree of a company’s debt and its ability to
pay them off as follow: -
(C
Debt-Equity Ratio
The Debt—Equity Ratio (DE Ratio) ratio examines the indebtedness
of the firm. It measures the financial leverage of a firm by dividing
the total liabilities with the stockholders’ equity. It compares the
total long-term debt to the shareholders’ funds. This ratio is repre-
sented as follows:
62
S
Dept
Notes Debt-Equity Ratio =
Net Worth
___________________ Total Long-term
=
___________________ Shareholder's Funds
___________________ Interpretation of the Ratio: The DE ratio cannot be generalized as

___________________ the best measure, it has to be compared with the industry standard
PE
in which the business is operating. Every industry has its own ac-
___________________
ceptable characteristics, such as a DE ratio in heavy industry will be
___________________
higher as compared to small manufacturing firms.
___________________
Total Debt Ratio
___________________
This ratio also examines the indebtedness of the firm. It measures
___________________
the financial leverage of a firm by dividing the total liabilities with
___________________ the stockholders’ equity. It compares the total debts to the total as-
sets in a firm. This ratio is represented as follows:
Total Dept
Total Debt Ratio =
Total Assets
Long-term Debts + Current Liabilities
=
Total Debts + Net worth
)U
Interpretation of the Ratio: The Total Debt Ratio (TD ratio) com-
pares parts of the assets that are financed by the proportion of total
liabilities; whereas, the remaining parts of the assets are financed
by shareholders’ funds. A high TD ratio implies a higher debt for the
company, which also implies higher financial risk.
Interest Coverage Ratio

The Interest Coverage Ratio is also known as times interest earned
ratio as it measures a firm’s ability to pay off its fixed interest pay-
ment liabilities. Moreover, it examines how the operating profit cov-
ers the interest liability. This ratio is represented as follows:
EBIT
IC Ratio =
Interest
(C
Where, EBIT = Earnings Before Interest and Taxes
Interest = Fixed Interest Liability of the Firm
Interpretation of the Ratio: A high IC ratio is beneficial for the com-

pany and its lenders; whereas, if the interest coverage ratio is to-
wards the lower end it shows that the firm’s profitability is low in
regards to the liability of interest payment .
63
Preference Dividend Ratio
S
Notes
It is also known as PC ratio and is complementary to the IC ratio as
___________________
it analyses a firm’s ability to pay a dividend to the preference share-
holders. As the preference dividends are paid out from the profits ___________________
after calculation of taxes, this ratio is represented as follows: ___________________
Point After Tax(PAT) ___________________

PC Ratio =
PE
Preference Dividend ___________________
Interpretation of the Ratio: The PC ratio is of importance to the pref- ___________________
erence shareholders as a high PC ratio indicates a high likelihood of ___________________

payment of preference dividends.
___________________
Fixed Payment Coverage Ratio ___________________
The Fixed Payment Coverage Ratio (FC ratio) ratio examines the ___________________
firm’s ability to service debt. It examines the coverage of principal
repayment, which is ignored in both IC and PC ratios. It analyses
the relationship between the net operating profits and fixed inter-
est liabilities, preference share dividends and principal repayments.
This ratio is represented as follows:
)U
EBIT
FC Ratio =
I + ( PR + PD) (1 − t )
Where, I = Interest Liability

PR = Principal Repayment
PD = Fixed Preference Divided
t = Tax Rate
Interpretation of the Ratio: A high FC ratio is beneficial for the com-

pany and its lenders. It helps in measuring the ability of a firm to
satisfy the fixed charges. It is useful for lenders who are interested
in analysing the cash flow amount that a firm has for repayment of
debt. A low ratio would indicate that the lenders may try to avoid
the firm. If a firm can cover its fixed charges at a faster rate than its
competitors, it is not only more effective but also profitable.
(C
Cash Flow Coverage Ratio

This ratio examines the firm’s ability to service debt. It analyses the
coverage of debt based on cash profit only as the other ratios take
into consideration the non-cash accruals as well. Thus, the FC ratio
is modified to cash coverage of fixed liabilities. This most commonly
used formula to determine the cash-flow coverage ratio is given below.
64
Operating cashflows
S
Notes Cash flow coverage Ratio =
Total Debt
___________________
Interpretation of the Ratio: The CC ratio ascertains the firm’s degree
___________________
of risk of default in payment. Therefore, the lower the coverage ra-
___________________ tio, the riskier it is for the lenders of the firm.
___________________
Profitability Ratios
PE
___________________
___________________ The profitability ratios ascertain the profitability and operating ef-
ficiency of the firm which are of great interest to the higher man-
___________________
agement, financial analysts, shareholders, and investors. Therefore,
___________________ the performance of the firm can be classified by relating the profits
___________________ to the sales of the firm, assets of the firm and owner’s contribution
toward the firm. We have categorized the ratios accordingly into the
___________________
following categories:
(I) Profitability Ratios based on Sales of the firm
(II) Profitability Ratios based on Assets/Investments
(III) Profitability Ratios based on Owner’s Contribution

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Gross Profit Ratio
The Gross Profit (GP) ratio compares the gross profit of the firm
with net sales. It helps in ascertaining the profit margin of the firm.
It is also called the average markup ratio. This ratio is represented
as follows:
Gross Profit
GP Ratio = × 100
Net Sales
Net Sales − Cost of Goods Sold
= × 100
Net Sales
Interpretation of the Ratio: The GP ratio is measured in a time series

and ascertains the efficiency with which the firm produces/purchas-
es the goods. The GP ratio cannot be studied for a single year as if
won’t produce any significant results. However, when studied in a
(C
time series, the change in trend indicates a change in operational

efficiency.
Operating Profit Ratio

The Operating Profit (OP) ratio is based on the sales of the firm and
examines the profit margin of the firm. It compares the operating
profit of the firm to the net sales. This ratio is represented as follows:
65
EBIT
S
OP Ratio = × 100 Notes
Net Sales
___________________
Interpretation of the Ratio: The OP ratio examines the efficiency of ___________________
the percentage of pure profit earned on every Re. 1 of the sale. This
___________________
ratio ascertains the efficiency with which a firm is able to manufac-
ture and sell goods. ___________________
PE
___________________
Net Profit Ratio
___________________
The Net Profit (NP) ratio is based on the sales of the firm and ex-
___________________
amines the net profit margin of the firm. This ratio compares the
net profit of the firm with the net sales. This ratio is represented as ___________________
follows: ___________________
___________________
Net PAT
NP Ratio = × 100
Net Sales
Interpretation of the Ratio: The NP ratio analyses the net contri-

bution made one very Re. 1 of the sale to the owner’s funds. It rep-
resents the proportion of sales that can be offered to the sharehold-
)U
ers of the organization.
Return on Assets Ratio

The Return on Asset (ROA) ratio is based on the Assets/Investments
of the firm. It compares the net profit of the firm to the assets em-
ployed by the firm. This ratio is represented as follows:
Net PAT
ROA Ratio = × 100
Average Total Assets
Net PAT
= × 100
Average Tangible Assets
Net PAT
= × 100
Average Fixed Assets
(C
Interpretation of the Ratio: The ROA ratio helps in ascertaining the

overall efficiency of a firm in generating assets through certain as-
sets. If the ROA decreases, it implies that the firm has increased
the size of assets but has not been able to increase its profits propor-
tionately. The ROA of the firm needs is compared with the industry
average as it cannot be generalized.
66
Return on Capital Employed Ratio
S
Notes
The Return on Capital Employed (RCE) ratio compares the profit of
___________________
the firm with the total funds employed/capital employed by the firm.
___________________ The capital employed (CE) by the firm can be represented as follows:
___________________
CE = Shareholders fund + Long-term Debt = Fixed Assets + Net
___________________ Working Capital
PE
___________________ This ratio is represented as follows:
___________________
Net PAT + {Interest*(1 − t )}
___________________ RCE Ratio = × 100
Average Capital Employed
___________________ EBIT
= × 100
___________________
Average Capital Employed
___________________ Interpretation of the Ratio: RCE ratio, when compared with the in-
dustry average, depicts the profitability for the shareholders. High-
er the ratios, more profit the shareholders earn. Moreover, it is also
considered a long-term profitability ratio as it indicates the efficien-
cy of assets while considering long-term financing. It is useful to
shareholders as it helps evaluate the longevity and financial condi-
)U
tion of a company.
Return on Equity Ratio

Based on the owner’s contribution towards the firm, the Return on
Equity Ratio compares profits of the firm with the contribution of
the equity shareholders of the firm. This ratio is represented as fol-
lows:
PAT − Preference Dividend

RCE Ratio = × 100
Equity Shareholders Funds
Net PAT
= × 100
Total Shareholder's Funds
Interpretation of the Ratio: The RCE ratio should be compared with

the industry average. It explains how well the shareholders’ funds
(C
are utilized. Therefore, the higher the ratio, the more profitable it is
for the shareholders.
Earnings Per Share

The Earnings per Share (EPS) ratio is based on the number of eq-
uity shares available. It compares the profits of the firm to the total
number of equity shares. This ratio is represented as follows:
67
PAT − Preference Dividend
S
EPS = Notes
Number of Equity Share
___________________
Interpretation of the Ratio: EPS ratio, when examined in a time se- ___________________
ries, shows an increasing or a decreasing trend of a company. EPS ___________________
needs to be adjusted when bonus shares are issued or for retained
___________________
earnings.
PE
___________________
Dividend per Share ___________________
The Dividend per Share (DPS) is the sum of declared dividends is- ___________________
sued by a firm every ordinary share outstanding. It is total dividends
___________________
paid out by a business divided by the outstanding shares issued. It
___________________
compares the profits of the firm to the total dividends or the distrib-
uted profits. This ratio is represented as follows: ___________________
Total Profit Distributed Dividends

DPS =
Shares outstanding for the period
Interpretation of the Ratio: Similar to the EPS ratio, the DPS ratio is
best examined in a time series. DPS should be adjusted when bonus
)U
shares are issued. The company declares a dividend as a percentage
of the paid-up capital. This also gives rise to the DPS Ratio = DPS/
EPS.
Price Earnings Ratio

The Price Earnings (PE) ratio is based on the market price of the
shares. It compares the EPS to its market price. This ratio is repre-
sented as follows:
Market Price Per Share

PE Ratio =
Earnings Per Share
Interpretation of the Ratio: The PE ratio determines the investor’s

expectations. A high PE ratio implies that the shares will have low
(C
risk and the investor expects high dividend growth.
Refer to the below example of ABC Corp to help understand the cal-
culations of all ratios using the financial statements.
Example 8.2 – Below is the income statement and balance sheet for
ABC Corp. for the accounting year 2016.
68
Table 8.1: Income Statement of ABC Corp
S
Notes
INCOME STATEMENT
___________________ for the year ending Dec. 31st, 2016
Particulars Amount (Rs)
___________________
Credit Sales 61,48,000
___________________ Less : Cost of Goods Sold 41,76,000
___________________ Gross Profit 19,72,000
PE
___________________
Less : Administrative Expenses 4,58,000
___________________ Less: Selling Expenses 2,00,000
Less: Depreciation 4,78,000
___________________
Operating Profit(EBIT) 8,36,000
___________________ Less: Interest Charges 1,76,000
___________________ PBT 6,60,000

Less: Provision for Tax 1,98,000
___________________
PAT 4,62,000
Less : Preference Share Dividends 20,000
Earnings for Equity Shareholders 4,42,000
Less: Dividend Paid 1,96,000
Retained Earnings 2,46,000
Table 8.2: Balance Sheet of ABC Corp

)U
BALANCE SHEET
as on Dec. 31st, 2016
Capital and Amount (Rs) Assets Amount (Rs)
Liabilities
5% Preference Share 4,00,000 Fixed Assets 93,38,000
Capital
(of Rs 100 each)
Equity Share Capital 3,82,000 Less Depreciation 45,90,000
(38,200 shares of Rs
10 each)
Total Share Capital 7,82,000 Net Block(1) 47,48,000
Add: Securities 8,56,000 Cash and Bank 7,26,000
Premium A/c
Add: Profit and Loss 22,70,000 Receivables 10,06,000
A/c
Shareholders’ Funds 39,08,000 Marketable 1,36,000
Securities
(C
Add: Long-Term 20,46,000 Liquid Assets 18,68,000

Loans
Capital Employed 59,54,000 Add: Inventories 5,78,000
Total Current Assets 24,46,000
(2)
Less: Trade 7,64,000
Creditors
Bills Payables 1,58,000
Contd.
69
S
Capital and Amount (Rs) Assets Amount (Rs)
Liabilities Notes
Expenses 1,20,000 ___________________
Outstanding
Provision for Tax 1,98,000 ___________________
Total Current 12,40,000
Liabilities (3) ___________________
Net Working Capital 12,06,000
___________________
(4) = (2) – (3)
PE
Total Assets (1) + (4) 59,54,000 ___________________
Additional Information: ___________________
1. A loan of Rs. 1,42,000 is to be paid every year. ___________________
2. The market price of a share as on Dec. 31, 2016, is Rs. 80. ___________________
3. The firm provides a credit of 50 days to its customers but re- ___________________
ceives a credit of 90 days from its suppliers. ___________________
Calculate various financial ratios to analyze the different aspects of

operations and financial position of the firm.
Solution: The operational profitability and financial position of

ABC Corp. can be analyzed by calculating the following ratios.
)U
Using the formulas in the chapter, we can calculate the following
ratios:
1. Liquidity Ratios
2446000
(a) Current Ratio = =1.97
1240000
2446000 − 578000
(b) Quick Ratio = = 1.51
1240000
726000 + 136000
(c) Absolute Liquidity Ratio = = 0.69
1240000
2. Activity ratios
4176000 − 578000
(a) Inventory Turnover Ratio = = 7.22
578000
(C
6148000
(b) Debtors Turnover Ratio = = 6.11
1006000
4176000
(c) Credits Turnover Ratio = =4.53
764000 + 158000
6148000
(d) Working Capital Turnover Ratio =
2446000 − 1240000
= 5.10
70
3. Leverage Ratios
S
Notes 2046000
(a) Debt Equity Ratio = = 0.52 or 52%
___________________ 3908000
___________________ 2046000 + 1240000
(b) Total Debt Ratio = =0.46 or 46%
7194000
___________________
836000
___________________ (c) Interest Coverage Ratios = =4.75
176000
PE
___________________
462000
(d) Preference Dividend Coverage Ratio = = 23.1
___________________ 20000
___________________ 836000
(e) Fixed charge Coverage Ratio = = 1.27
___________________ 660000
___________________
4. Profitability Ratios
___________________ 1972000
Gross Profit Ratio = = 0.321 or 32%
6148000
836000
Operating Profit Ratio = = 0.136 or 13.6%
6148000
462000
Net Profit Ratio = = 0.075 or 7.5%
6148000
)U
462000
Return on Asset Ratio = = 0.0642 or 6.42%
7194000
462000 + 176000(1 − 0.3)
Return on Capital Employed = =
3908000 + 2046000
0.0982 or 9.82%
442000
ROE = = 0.126 or 12.6%
3908000 − 400000
442000
EPS = = 0.1157 or 11.57%
38200
186000
DPS = = 0.0514 or 5.14%
38200
2446000
PE Ratio = = 1.97
1240000
(C
Example 8.3 – Payal Steel Co. has the following figures related to
its accounts:
Particulars 2015 (in Rs.) 2016 (in Rs.)

Sales(Rs. in Lacs) 12,00,000 15,00,000
Net Block 5,00,000 8,00,000
Contd.
71
S
Particulars 2015 (in Rs.) 2016 (in Rs.)
Notes
Receivables 2,00,000 2,95,000
Payables 1,00,000 2,00,000 ___________________
Cash at Bank 50,000 20,000
___________________
Closing Stock 2,00,000 4,00,000
Bank Over Draft 1,00,000 2,50,000 ___________________
Purchases 9,00,000 12,00,000 ___________________
PE
Expenses 1,00,000 1,50,000
___________________
Depreciation 75,000 1,20,000
Interest on Over Draft 15,000 40,000 ___________________
Loan – 2,00,000
___________________
Interest on Loan – 35,000
Share Capital 4,00,000 4,00,000 ___________________
Reserves and Surplus 1,90,000 2,07,500 ___________________
Provision for Income Tax 1,20,000 1,97,500
Proposed Dividends 40,000 60,000 ___________________
Stock on 0.1-0.1-2015 1,80,000
Comment on the present state and trend with respect to profitability,

liquidity, and leverage of the company.
Solution – To understand the present state and trend of the firm

)U
with respect to profitability, liquidity, and leverage, we calculate the
following ratios using formulas given in the chapter.
Profitability Ratios 2015 2016

1) Gross Profit Ratio 3, 20, 000 5, 00, 000
× 100 × 100
12, 00, 000 15, 00, 000
= 26.7% = 33.3%
2) Return on Capital
1, 30, 000 1, 90, 000
Employed × 100 × 100
5, 90, 000 8, 07, 500
= 2.03% = 23.53%
Liquidity Ratios 2015 2016

1) Current Ratio 4, 50, 000 7,15, 000
3, 60, 000 7, 07, 500
(C
= 1.25 = 1.01
2) Absolute Liquidity 2, 50, 000 3,15, 000
Ratio
2, 60, 000 4, 57, 500
=0.96 =0.69
Contd.
72
S
Leverage Ratio 2015 2016
Notes
1) Debt Equity Ratio 0 2, 00, 000
___________________
5, 90, 000 6, 07, 500
___________________
=0 = 0.33
___________________
Profitability of the firm – The gross profit of the firm increased
___________________
from 26.7% to 33.3% and the return on capital employed has also
PE
___________________ increased from 22.03% to 23.53%. This establishes better manage-
___________________ rial and operational efficiency and shows a marginal increase in ef-
ficiency.
___________________
___________________ Liquidity of the firm – The current and absolute liquidity ratios
have decreased from the previous year. This means that the liquid-
___________________
ity has decreased which may be due to the increase in operational
___________________ activity or increase in current liability.
Leverage of the firm – The firm had no leverage employed in the

year 2015 but raises its debt component to 0.33 in the year 2016.
This demonstrates growth as the company wants to raise more cap-
ital at a lesser cost. The company still has scope to increase the
leverage.
)U
Example 8.4 – ABC Corp. and XYZ Corp. are two companies in the
same industry and maintain the inventory at the same level at the
beginning of the year. From the below financial details of the two
firms, comment on the financial and operational efficiency.
ABC Corp.(Rs. in Lacs) XYZ Corp.(Rs. in Lacs)

Sales 250 200
Bank Overdraft 25 10
Stock 35 40
Expenses 30 25
Creditors 65 28
Expense Creditors 3 2
Liquid Assets 4 8
(C
Debtors Velocity 3 Months 2 Months

Capital Velocity(to sales) 8 Times 2 Times
Gross Profit Ratio 20% 30%
Information on industry norms for comparison: Current Ratio 1:8,

Liquid Ratio 1:1, Gross Profit Ratio 25%, Return on Capital 40%,
Debtors Velocity 80 days, Creditors Velocity 75 days and Stock Ve-
locity 4 days.
73
Solution: The following ratios are calculated and compared with
S
the industry norms. The ratios are calculated using formulas in the Notes
chapters. ___________________
Particulars ABC Corp. XYZ Corp. Industry Norm ___________________
1) Current Ratio 101.50 81.33 1.8 ___________________
93 40 ___________________
PE
= 1.09 = 2.03 ___________________
2) Liquid Ratio 66.5 41.33 1.1
___________________
68 30
___________________
= 0.98 = 1.38
___________________
3) Gross Profit Ratio 50 60 25%
___________________
250 200
___________________
= 20% = 30%
4) Return on Capital 20 35 40%
31.25 100
= 64% = 35%
5) Inventory Turn 200 140 4
)U
Over
35 40
= 5.71 = 3.5
The current ratio of ABC Corp. is lower than the industry average.
On the other hand, the current ratio of XYZ Corp. is higher than
the industry average, which indicates strong liquidity position. The
same is established by the liquid ratio. The gross profit ratio of XYZ
is higher than the industry average, and that of ABC is lower than
the industry average. Furthermore, the inventory turnover for ABC
is higher than XYZ and the industry average as well. Thus, we can
say that XYZ Corp. appears to be better managed in terms of mana-
gerial and operational efficiency.
Summary
(C
The relationship between two or more accounting figures is called

financial ratio. This helps in simplifying large amounts of financial
data into ratios which are then used to identify and assess a firm’s
financial position and performance. The different types of ratios
are liquidity ratios, activity ratios, leverage ratios and profitability
ratios.
74
Review Questions
S
Notes
___________________ 1. Examine the difference between the acid test-ratio and current
ratio. Why is the stock and bank overdraft excluded from the
___________________
former?
___________________
2. Explain the effect of an increase in the capital turnover ratio on
___________________
net profit and operating leverage.
PE
___________________
3. Which ratios can explain the inability of the firm to pay its
___________________ dues?
___________________ 4. Which ratios would you examine while evaluating the perfor-
___________________ mance and future profitability of a company as an investor and
as a prospective lender?
___________________
5. The financial statements of ABC Corporation Pvt. Ltd. contain
___________________
the following information. Analyse the statements and exam-
ine the financial position of the firm by calculating the follow-
ing ratios:
(a) Liquidity Ratio
(b) Profitability Ratio

)U
(c) Activity Ratio
Particulars Year1(in Rs.) Year2(in Rs.)

Cash 2,00,000 1,60,000
Sundry Debtors 3,20,000 4,00,000
Temporary Investments 2,00,000 3,20,000
Stock 18,40,000 21,60,000
Prepaid Expenses 28,000 12,000
Total Current Assets 25,88,000 30,52,000
Total Assets 56,00,000 64,00,000
Current Liabilities 6,40,000 8,00,000
Loans 16,00,000 16,00,000
Capital 20,00,000 20,00,000
Retained Earnings 4,68,000 8,12,000
Statements of Profit for the current year

(C
Sales Rs. 40,00,000

Less Cost of Goods Sold 28,00,000
Less Interest 1,60,000
Net Profit 10,40,000
Less: Taxes @50% 5,20,000
PAT 5,20,000
Profit Distributed 2,20,000
75
Naveen Corp. Ltd. had a paid-up capital of Rs. 1,00,00,000 as on
S
31st March, 2017. The ratios as on the date were as follows. Prepare Notes
the balance sheet for Naveen Corp. Ltd. ___________________
Current Debt to Total Debt 0.4 ___________________

Total Debt to Equity 0.6 ___________________
Fixed Assets to Equity 0.6
___________________
Total Assets Turnover(based on sales) 2 times
PE
Inventory Turnover(based on sales) 8 times ___________________
___________________
___________________
___________________
___________________
___________________
)U
(C
(C
)U
PE
S
77
Unit 9
S
Notes
___________________
Dupont Analysis ___________________
___________________
Objectives: ___________________
PE
After completion of this unit, the students will be aware of the following
topics: ___________________
\\ DuPont Analysis or Profile of Profitability ___________________
\\ How is the Return on Equity Dependent on other Key Ratios of a Com- ___________________
pany?
\\ The relationship between Debt Financing and Growth ___________________
___________________
___________________
Introduction
Dupont Analysis or Profile of Profitability
The overall profitability of the firm consists of two key elements:
)U
1) The profit margin on sales – This explains the earnings made
on the sale of every rupee
2) The turnover of the firm – This indicates the total activities

undertaken by the firm
Earning power of the firm is determined by combining the above two

factors. This can be described as follows:
Profitability or earnings power = Profit Margin x Assets Turnover

PAT sales
× =
sales Total Assets
PAT
=
Total Assets Investment
(C
Here, PAT is profit after taxes.
This ratio is also called return on investment (ROI). Refer to the

Figure 9.1, which represents the elements contributing to the return
on investments.
78
S
Return on Investment
Notes (ROI)
___________________
___________________ Net Profit Margin Total Assets –

(NP Ratio) Turnover
___________________
___________________
Profit After Tax
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Sales Sales
___________________ (PAT) Total Assets
___________________
___________________
Fixed Assets Current Assets
___________________
___________________ Sales – Cost of Goods Sold – Oper-

ating Expenses – Interest – Tax
___________________
Figure 9.1: DuPont Analysis or Profile of Profitability – Return

on Investment
The left-hand side of Figure 9.1 explains the profit margin where the
cost of goods sold, interest and taxes are deducted from sales reve-
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nue to generate the PAT. The PAT is then divided by the total sales
to generate the Net Profit (NP) ratio. The right side of the above fig-
ure focuses on the total assets or investments turnover. The current
assets together with fixed assets equal to the total investments of
the firm. The sales are divided by the total investments to obtain the
asset turnover ratio.
The value of probability of a firm can be obtained by multiplying

both the LHS and RHS, that is, both the NP Ratio and Asset Turn-
over Ratio. This is the analysis of profitability of the firm and is
named after the famous US manufacturer DuPont Corporation, who
developed this analysis.
The above interpretation can be further used to deduce the return

on shareholders’ funds. As we understand from the previous chap-
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ter, the shareholders’ funds depend upon the use of debt in financ-
ing the total assets. Thus,
% Return on Investment
Return on Shareholders' Funds = × 100
% Assets Financed by the Shareholders
The above-mentioned formula can be illustrated as below:

Unit 9: Dupont Analysis
79
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Return to Shareholders Notes
___________________
___________________
___________________
% of Assets Financed by
Return on Investments(ROI)
Shareholders ___________________
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Figure 9.2: DuPont Analysis – Return to Shareholders
___________________
___________________
How is the Return on Equity Dependent on other Key
Ratios of a Company? ___________________
___________________
In the previous chapter, we have learned that the difference between
Return on Assets (ROA) and Return on Equity (ROE) reflects the ___________________
use of debt financing. This can be deduced as follows: ___________________
PAT
Return on Shareholders' funds =
shreholders Funds
PAT Total Assets
= ×
shreholders Funds Total Assets
PAT Total Assets

= ×
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Total Assets Shareholders Funds
= ROA x Equity Multiplier
= ROA x [1 + Debt Equity Ratio]
On the same lines, ROE can also be explained as below:

PAT Sales Total Assets
ROE = × ×
Sales Total Assets Shareholders Funds
= Profit margin x Total Asset Turnover x Equity multiplier
Relationship between Debt Financing and Growth

The relationship between debt financing and growth rate is such
that when the growth rate increases the need for external financing
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also increases.
llInternal Growth Rate – It is the maximum growth rate that is

achieved with no external financing and is maintained using
internal financing only. This can be described as follows:
ROA * b
Internal growth rate =
1 − ROA * b
80
Where,
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Notes
b = Retention Rate, that is, (1 – Dividend per Share or DPS Ratio)
___________________
llSustainable Growth Rate – It is the growth rate that the
___________________
company can maintain without increasing its financial lever-
___________________ age. In this case, the company maintains the debt-equity ratio
___________________ without any external equity financing. This can be described
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as follows:
___________________
ROE * b
Sustainable growth rate =
___________________ 1 − ROE * b
___________________ Where,
___________________ b = Retention Rate, that is (1 – DPS Ratio)
___________________
Summary
___________________
Overall profitability of a firm is indicated by two key elements,

namely Turnover and Margin of Profit. The combination of these
elements helps in ascertaining the earning power of the firm. The
difference between ROA and ROE reflects the use of debt financing.
The relationship between debt financing and growth rate is such
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that when the growth rate increases the need for external financing
also increases.
Review Questions
1. What is DuPont analysis of profitability of the firm? Explain
and enumerate the elements of this analysis.
2. “A comprehensive parameter that provides information regard-

ing everything happening in a company is Return on Invest-
ment.” Please explain.
3. Naveen Corporation has equity of Rs. 2,50,000 and a debt of Rs.

2,50,000. The net profit is Rs. 66,000.
(a) Calculate ROE.

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(b) Calculate sustainable growth rate, assuming retention

ratio is 66.67%.
4. Total assets of ABC Ltd. are Rs. 5,00,000 and its net profit of
Rs. 66,000.
Unit 9: Dupont Analysis
81
(a) Calculate ROA
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Notes
(b) Assume that the payout ratio of a company is 33.33%.
___________________
Now calculate its internal growth rate.
___________________
___________________
___________________
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___________________
___________________
___________________
___________________
___________________
___________________
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83
Unit 10
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Notes
___________________
Case Study: Bata India: Step ___________________
into Style ___________________
___________________
Bata India Limited was established in 1931 in India. It is a prime
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retailer and producer of footwear in the country. It has a strong ___________________
retail presence with 1,293 stores across 500 cities in India. Other
___________________
than company owned stores, Bata brand is also available through
a large network of dealers as well. The brand is known for its qual- ___________________
ity, footwear design, comfort, and affordability. This makes Bata
___________________
a trustworthy footwear manufacturing company and the number
1 brand in India. Considering global, regional and local fashion ___________________
trends, it strives to offer fresh new collection, every season and ev-
___________________
ery year for the customers.
The vision of the company is ‘To make great shoes accessible to

everyone.’
The statistics of the company looks impressive, few of which are

mentioned below:
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ll4 strategically located manufacturing units
ll1293 retail stores across India
ll8034 employees across functions and locations
ll2.62 million square feet of retail space available
ll21 million pairs of footwear production capacity
llRs. 24972 million turnovers for the year 2016–2017

Table 2: Financial Highlights of Bata India Limited for the year 2016–2017
Financial Highlights 2016–17 (in Million Rs.)

2016 2017
Profit and Appropriations
Sales and Other Income 24753.15 25438.87
Profit before Depreciation and Taxes 3754.5 2985.81
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Depreciation 788.01 650.05

Profit before Tax 2966.49 2335.75
Taxation 790.54 748.28
Profit after tax 2175.95 1587.48
Net Profit 2175.95 1587.48
Dividend and Dividend Distribution Tax 502.75 541.42
Retained Earnings 1673.2 1046.06
Contd....
84
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Notes
Assets Employed
___________________
Fixed Assets – Gross 3987.87 4338.22
___________________ Fixed Assets – Net 3211.5 2957.86
Investments 49.51 49.51
___________________
Net Current Assets 7424.54 8562.3
___________________ Other Non–current Assets 2564.01 2722.84
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___________________
Financed By
___________________
Equity Shares 642.64 642.64
___________________ Reserves 11578.21 12610.17
Shareholders’ Funds 12220.85 13252.81
___________________
Debt 1028.71 1039.71
___________________
(Source: Bata India Annual Report)
___________________
Questions
1. Prepare an income statement for the two years for Bata India
Ltd.
2. Prepare a balance sheet for the two years for Bata India Ltd.
3. Calculate the ratio of the stakeholders for both years 2016

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and 2017 to measure the following:
4. Measure of Investments
5. Measure of Performance
6. Measure of Financial Status
4. Calculate the percentage change in the ratios and comment

on the company’s overall performance.
Source: Annual Report of Bata India Limited
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Detailed Contents
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UNIT 11(A): SHORT-TERM SOURCES OF FINANCE UNIT 13: CAPITAL BUDGETING EVALUATION
TECHNIQUES
ll Introduction
ll Introduction
ll Source of Short-Term Finance
ll Techniques of Evaluation
ll Summary
ll Traditional or Non-Discounted Cash Flow
ll Review Questions
Modern or Discounted Cash Flow Technique
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ll
UNIT 11(B): LONG-TERM SOURCES OF FINANCE ll Summary

ll Introduction
ll Review Questions
ll Types of Long-term Sources of Finance
UNIT 14: COST OF CAPITAL
ll Internal Sources of Finance
ll Introduction
ll Retained Earnings
ll Concept of Cost of Capital
ll External Sources of Finance
ll Significance of Cost of Capital
ll Share Capital
ll Factors Affecting the Cost of Capital
ll Preference Shares
ll Computation of Cost of Capital
ll Debenture
ll Summary
ll Venture Capital
ll Review Questions
ll Summary
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ll Review Questions UNIT 15 CASE STUDY: AIRNET LIMITED: A
TELECOMMUNICATION TAKEOVER
UNIT 12: FUNDAMENTALS OF CAPITAL
BUDGETING
ll Introduction
ll Meaning and Definition
ll Features of Capital Budgeting Decisions
ll Significance of Capital Budgeting
ll Problems and Difficulties in Capital Budgeting
ll Capital Budgeting Decisions and their types
ll Summary
ll Review Questions
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87
Unit 11(a)
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Notes
___________________
Short-Term Sources of Finance ___________________
___________________
Objectives:
___________________
At the end of this unit, the students will be able to:
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___________________
\\ Identify the short-term sources of finance
\\ Identify the advantages and disadvantages of these sources ___________________
___________________
Introduction ___________________
An organization may source money to meet various objectives. Tradi- ___________________

tional areas of requirements may vary from capital asset acquisition ___________________
to new inventory or new product development. After establishing
a business, funds are required for daily operational requirements.
Thus, there is a constant need for liquid money to be present for
meeting these requirements. To support such requirements, short-
term funds are required. The availability of short-term funds is vital
as a lack of these may lead to shutting of business operations.
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In this unit, we will understand the sources of short-term finance.
Source of Short-Term Finance

Some of the short-term sources of finance are as follows:
ll Trade credit
ll Bank credit
ll Accruals
ll Deferred Income
ll Commercial Papers
ll Public Deposits
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ll Inter-corporate Deposits
Trade Credit
Trade credit refers to the credit that is approved or given to trad-
ing and manufacturing firms by the suppliers of raw material and
semi-finished and finished products. Generally, business organiza-
tions procure funds on a 30–90 days credit cycle.
88
Features of Trade Credit
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Notes
There are two key features of trade credit:
___________________
___________________
1. A company should not opt for cash discounts in lieu of quick
payment as the cost of trade credit is very significant beyond
___________________
the cash discount period.
___________________
2. In case the company is unable to avail cash discounts then it
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___________________ can choose to pay by the end of the credit period. Any delay of
___________________ 1-2 days is insignificant and has no impact on credit rating.
___________________ Advantages of trade credit

___________________
ll Available Easily
___________________
ll Highly Flexible
___________________
ll No unnecessary documentation required
Disadvantages of trade credit
ll Goodwill can be lost on a permanent basis
ll Raw materials are priced highly

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ll Opportunity Cost of discount availed
ll Administration cost
Bank Credit
Commercial banks’ short-term financing to business organizations
is referred to as bank credit. When bank credit is given, the borrow-
er gets a right to draw the amount of credit at one time or in install-
ments as and when needed. Bank credit can be provided in the form
of loans, cash credit, overdraft and discounted bills.
Features of bank credit
ll Most widely used credit facility offered by banks
ll Based on revolving credit system

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ll Interest to be paid on the borrowed amount
Advantages of bank credit
ll Flexible repayment terms
ll Less expensive than cash advance loans
ll Better rates
Unit 11(a): Short-Term Sources of Finance
89
Disadvantages of bank credit
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Notes
ll Make expensive purchase
___________________
ll Long-term costs ___________________
ll Stricter Eligibility Requirements ___________________
___________________
Accruals
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___________________
Accruals are those expenses that the company owes to other orga-
nizations or people but have yet not been paid. It is aquick and in- ___________________
terest-free source of financing. For example, salaries, wages, inter- ___________________

ests,and taxes are few of the key constituents of accruals. If by the
___________________
end of the financial year these expenses are not paid, they reflect as
accrued salaries/wages. ___________________
___________________
Due to the fact that no interest is payable on accruals, they are
considered as a virtually “cost-free” means of finance. But in many
countries, it might not hold true due to strict provisions for payment
of labor salaries with any delay in payment leading to significant
penalties or prosecutions. Therefore it is advisable for a company to
not use accruals as a source of finance because they may be required
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to be repaid anytime.
Advantages of accruals
ll Increased transparency on the cost of all public services
ll Improved accountability
ll Improved allocation of expenditure
Disadvantages of accruals
ll Increased accounting estimates in the budget
ll Increased complexity in the budget
ll Minimized parliamentary interference over budget

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Deferred Income
Deferred income payments are incomes received by the firm in ad-
vance for the supply of goods and services for a future period. These
incomes are not reflected in the revenue category until the supply of
goods and services are not completed. In fact, until then, these are
reflected as ‘advance received income.’ Advance payment can only be
demanded by the firms having the following:
90
ll Monopoly power
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Notes
ll Great demand for its products and services
___________________
___________________ ll Special orders which are manufactured as customized prod-

ucts
___________________
___________________ Advantages of deferred income
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___________________ ll Unlimited savings and tax benefits
___________________ ll Capital gains
___________________ ll Investment options
___________________
Disadvantages of deferred income
___________________
ll No early withdrawal provision
___________________
ll Strict distribution schedule
ll No ERISA (Employee Retirement Income Security Act) pro-

tection
Commercial Papers
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Commercial papers (CPs) signify an unsecured short-term promis-
sory note allotted by companies that are more secured and have a
higher credit rating. In India, the introduction of CPs was based on
the guidelines of the Vaghul Working Group.
Features of CPs
ll In general, the maturity period of CPs ranges from 15 days to

365 days. However, in India, it is 91 to180 days.
ll It is possible to sell them at a discounted price and redeem

that at face value.
ll The difference between the redeemable value and par value

constitute the returns on a CP.
ll A CP can be sold indirectly through dealers or directly

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through investors.
Advantages of Commercial Papers
ll A cost-effective method of financing working capital
ll Cheaper than bank loans
ll It requires a rating. Good rating reduces the cost of capital

91
Disadvantages of Commercial Papers
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Notes
ll This mode of finance is available only to a select few firms.
___________________
ll It may reduce the availability of credit from banks ___________________
ll Reserve Bank of India (RBI) strictly monitors its issuance ___________________
___________________
Issuing Criteria for Commercial Papers
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___________________
ll As CP is a promissory note under regulations by RBI, there
___________________
are certain requisites for companies to fulfill in order to be
eligible for fundraising through them ___________________
___________________
ll The tangible net worth of the company should be more than
Rs. 4 crores according to the latest audited balance sheet ___________________
___________________
ll The company should be sanctioned as a fund based limit for
bank(s) finance.
ll Maximum of 75% of the bank credit allowed to the firm can be

used to issue CP’s
ll CP’s can be issued in multiples of 5 Lakhs only

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ll Size of a single issue should be more than Rs. 1 crore
Public Deposits
Public deposits are also called term deposits. These are unsecured
deposits; however, the main purpose is to finance the company’s
working capital requirements. It is considered as an important
source of financing medium- and long-term requisites of a firm. It
refers to any cash received by a company through loans acquired
from the public or through deposits.
Advantages of public deposits
ll It makes the process of acquiring finance easier
ll The interest that is paid on public deposits is deducted from

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taxes
ll It does not dissolve the rights of the shareholders
Disadvantages of public deposits
ll It is a risky and an uncertain way to finance the company’s

working capital requirements
92
ll It is available for a very short period
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Notes
ll The deposits maybe misused by the management as they are
___________________
not secured
___________________
___________________ Inter-Corporate Deposits

___________________ Deposits made by a firm with another firm, usually for up to a pe-
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riod of six months, are known as Inter-Corporate Deposits (ICDs).
___________________
Following are the various types of ICDs in practice:
___________________
ll Call deposits: In this category, deposits are repaid at the
___________________
time when they are called back. Typically, repayment can be
___________________
demanded, giving notice of just one day.
___________________
ll Deposits for three months: These deposits are primarily
___________________
used among companies for investing surplus funds. The bor-
rower opts for this option to cater to short-term cash require-
ment.
Deposits for six months
The deposits are generally given for a short duration of up to six

)U
months maximum at a pre-specified rate of interest.
Features of Inter-Corporate Deposits
ll Not regulated by any authority
ll They involve secrecy while trading.
ll ICDs are issued based on borrower’s financial health.
Advantages of Inter-Corporate Deposits:
ll The lender can utilize the funds in surplus with efficacy.
ll They are secure in nature.
ll It avails easy procurement of inter-company deposits

(C
Disadvantages of Inter-Corporate Deposits:
ll Its market is not structured.
ll It involves a lot of risk due to uncertainty.
ll It comes with restrictions on the amount that can be lent or

borrowed.
93
These were the short-term funding sources, along with their advan-
S
Notes
tages and disadvantages. In the next unit, long-term funding sourc-
es shall be discussed. ___________________
___________________
Summary
___________________
Short-term funds are essential to support various requirements of a
___________________
firm. The availability of short-term funds is vital as a lack of these
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___________________
may lead to shutting of business operations. Some of the common-
ly available short-term funding sources include trade credit, bank ___________________
credit, accruals, deferred income, commercial papers, public depos- ___________________
its and inter-corporate deposits.
___________________
Review Questions ___________________
___________________
1. Can trade credit be categorized as a source of working capital
finance? Explain.
2. With the help of an example of any Indian corporate analyze

the significance of issuing Commercial Papers to the firm and
to their investors.
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3. Can accruals be considered an interest free source of finance?
4. Elucidate the short-term sources of finance, which are cost-free

finances available to the firm.
5. What is a commercial paper? What are the guidelines for issu-

ing commercial papers in India?
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95
Unit 11(b)
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Notes
___________________
Long-Term Sources of Finance ___________________
___________________
Objectives: ___________________
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At the end of this unit, the students will be able to understand and explain
the concepts of: ___________________
\\ Types of Long-Term Sources of Financing ___________________
\\ Retained Earnings ___________________

\\ Share Capital – Features, Advantages,and Disadvantages of Equity
Shares ___________________
\\ Share Capital – Features, Advantages,and Disadvantages of Preferen- ___________________

tial Shares
___________________
\\ Debentures and Bonds
\\ Venture Capital
Introduction
In the previous unit, we learned about the short-term sources of fi-
)U
nance. Let us now understand long-term sources of finance, which
are usually required for a period exceeding a year. The requirement
may arise due to many reasons, few of which are mentioned below:
ll To expand the existing office space
ll To buy a new office premise
ll To launch a new product in the market
ll To buy a new company
Types of Long-term Sources of Finance

Long-term sources of finance are classified on the basis of from where
the funds are generated, i.e., Internal and External. New firms have
the option of raising long-term funds from external sources whereas
(C
established companies have the luxury of generating funds from in-

ternal as well as external sources of finance.
Types of long-term financial sources are as follows:
ll Internal Financial Sources
ll External Financial Sources

96
Internal Sources of Finance
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Notes
___________________ Retained Earnings

___________________ Retained earnings are a crucial source of long-term funding for
___________________ well-established companies as they are that portion of income which
was not spent and was invested back into the company. It is the
___________________
process of accumulating profits and reinvesting them in the busi-
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___________________ ness for funding development and expansion plans. It is that portion
___________________ of equity which has been foregone by the shareholders. In normal
___________________
practice, companies save around 20-70% of profits as retained earn-
ings and capitalize them.
___________________
The retained earnings could be used for various business growth
___________________
plans, such as the following:
___________________
ll Development programs of the company
ll Replacement of obsolete assets
ll Renovation of equipment and plant
ll Redemption of preferential shares or debentures, loans, etc.

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Factors Influencing Retained Earnings
ll Earnings Capacity of a Company: The need for plowing

back of profits arises only when the company has sufficient
earnings. Larger earnings imply a larger reinvestment ratio.
ll Type of Dividend Policy: Retained earnings depends on

the dividend policy, specifically the distribution of earnings,
which is decided by the top management (Board of Directors).
Companies that intend to retain extra earnings need to fol-
low a conservative dividend policy. A conservative dividend
policy comes with instability and lots of changes in the div-
idend payment. It means irregular payment of dividends at
changing rates. The dividend policy also gets affected by the
category of the shareholders. If the shareholders are in the
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high-income tax bracket, they expect to retain more profits

and receive lesser dividends,whereas, if the shareholders
seek regular income, they desire profits to be utilized for
paying more dividends and fewer amounts to be saved as re-
tained earnings.
ll Taxation Policy of the Government: Earnings available

to stakeholders are the Profit after Taxes (PAT) minus the
Unit 11(b): Long-Term Sources of Finance
97
preference shareholders dividend. When the tax rates are
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high, fewer profits are available and less retained earnings Notes
will be available. ___________________
ll Profitable Investment Opportunities: A company having ___________________
more lucrative investment prospects may decide to retain the ___________________

profits for the project.
___________________
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ll Additional Factors: The following may also affect the re- ___________________
tained earnings:
___________________
o Attitude and philosophy of top management ___________________
o Industry customs ___________________
___________________
o Prevailing economic and social environment of the coun-
try ___________________
o The life cycle of industry, etc.
Advantages of Retained Earnings to the Company
ll Funds are raised easily without any obligation from share-

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holders.
ll As compared to other sources of finance, Retained earnings do

not involve any floatation cost thus making them a preferable
source of finance.
ll Retained earnings grow the capital of the company, thus, en-

hancing the credit standing of the company.
ll It maintains a stable dividend policy,and during years of less

or no profits, the company may pay uniform dividends out of
retained earnings.
ll It acts as a cushion to abnormal market fluctuations like de-

pression, recession and sudden drop in the market.
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Advantages of Retained Earnings to the Shareholders/Owners
ll In the long run, the net worth of the portfolio increases by an

increase in the share’s value.
ll As the share price increases, its creditworthiness increas-

es and, hence, the security is more acceptable as collateral
security.
98
ll If shareholders reinvest retained earnings in profitable ven-
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Notes tures, it results in an increase in future dividends for the
___________________ shareholders.
___________________ ll It reduces the burden of income tax, which is paid when divi-
___________________ dends are declared.
___________________
Advantages of Retained Earnings to the Society and Nation
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___________________
ll It promotes the economic development of the country by rais-
___________________
ing the capital formation rate.
___________________
ll It encourages industrialization by internal financing.
___________________
___________________ ll It encourages and creates more jobs by creating more indus-

___________________
tries (profitable investment opportunities)
ll It increases the productivity as the retained earnings are

used for process improvements and growth of the company,
such as replacing old machinery and formulation of new com-
panies.
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Disadvantages of Retained Earnings
ll Retained earnings cause a reduction in the availability of liq-

uid funds.
ll Continuous profit retention may result in over capitalization.
ll It creates a monopoly – In bigger organizations, large re-

tained earnings helps the business to grow bigger, which may
lead to monopoly.
ll The loss to shareholders – If the firm pays alesser dividend

and increases the retained earnings, shareholders will re-
ceive lesser cash in hand, which may lead them to sell their
shares for meeting their expenditures.
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ll Excess concentration of wealth in the hands of management

may result in the misuse of retained earnings and, hence,
results in reduced shareholders’ wealth.
ll Excess retained earnings lead to super profit tax evasion,

which results in loss of revenue for the government.
99
External Sources of Finance
S
Notes
Share Capital ___________________
A share constitutes a small unit of the firm’s total capital. Value of a ___________________
share is obtained by dividing the total share capital of the company ___________________
by the numbers of shares. Any person who has purchased one or
___________________
more shares of a company is called a shareholder.
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___________________
Types of Shares ___________________
As per the provisions of the Companies Act, 1956, there are only ___________________
two types of shares in India, namely Preference shares and equity ___________________
shares
___________________
Equity Shares: They are also known as ordinary shares, and they
___________________
entitle the holder to a part in company’s capital. Mentioned below
are the key features of equity shares:
ll All shareholders have equal rights
ll All shareholders share rewards and risks equally

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ll All equity shareholders are the joint owners of the company
and receive dividends as per the company’s dividend policy
formulated by the board of directors.
Major Components of Equity Shares:
ll Permanent Capital: Equity is the primary and permanent

source of long-term finance. It can be redeemed only at the
end of the liquidation process after all liabilities have been
settled. This also implies that the shareholders cannot sell
their share back to the company unless the company offers a
corporate action for it such a buyback. However, the share-
holders are free to sell their equity shares in the stock market
freely.
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ll Income’s Residual Claim: The income that is available after

paying all the claims is called the Residual Claims. Thus, the
income from which dividend is announced is known as Resid-
ual Income, which is PAT minus preference dividends.
ll Residual Claim to Assets: As is the case with residual income,

shareholders are entitled to residual claims on assets of the
company,but they have the last priority over the assets.
100
ll Voting Rights or Rights to Control: equity shareholders are
S
Notes
the real owners of the company and have the right to vote, ap-
___________________ point directors and auditors at the annual general meetings.
___________________ ll Limited Liability: the extent of liability of equity sharehold-
___________________ ers is limited to their investment in the company.
___________________
Advantages of Equity Shares from the Company’s Viewpoint
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___________________
ll It is a stable and perpetual long-term source of finance.
___________________
___________________ ll It involves no liability for repayment.
___________________ ll No charge is created over the assets of the company.

___________________
ll With an increase in the number of equity shares issued, the
___________________
Creditworthiness of the company also increases.
Advantages of Equity Shares from the Investor’s Viewpoint
ll Equity shares act as a source of income (Residual).
ll Equity shareholders have the right to ownership, participa-

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tion, and control of the company.
ll The possibility of investment being multiplied in future along

with steady income over the years in the form of a dividend.
Disadvantages of Equity Shares from the Company’s Viewpoint
ll The cost of the source of fund is high.
ll The floatation cost is high.
ll Management control dilutes when the equity shares issued

increase.
ll The tax advantage is not available.
Disadvantages of Equity Shares from the Investor’s Viewpoint

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ll Equity shares provide no regularity or guarantee on the dis-

tribution of dividends.
ll They involve a high risk with less or no guarantee of returns.
ll Due to fluctuations in the share market, it is possible that the

investment might be wiped off.
101
Preference Shares
S
Notes
Preference shareholders have some privileges as compared to equity ___________________
shareholders.
___________________
ll Preference shareholders get preference in payment of divi- ___________________

dend where they are paid a fixed rate of dividend.
___________________
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ll Preferential shareholders receive priority over equity share- ___________________
holders in case of liquidation of the company.
___________________
But a few features of the preferential shares bear a close resem- ___________________
blance to equity shares in the following ways:
___________________
o Dividends are paid after deduction of taxes from profit ___________________
o Dividend policy of the company determines the dividend ___________________

to be paid to the preference shareholders.
o Tax cannot be deducted from dividend payment.
o There is no maturity date on irredeemable preference

shares.
)U
Features of Preference Shares
ll Claim on Assets: Preferential shareholders enjoy priority

over equity shareholders in this regards and enjoy preferen-
tial rights over the assets after all other liabilities have been
settled.
ll Claim on Income: Preferential shareholders enjoy priority

over equity shareholders in this regard also and enjoy prefer-
ential rights over income after all other liabilities have been
settled.
ll Dividend Accumulation: All the unpaid dividends are carried

forwarded to the next financial year and paid as a cumulative
amount.
(C
ll Redeemable in nature: Preference share capital when issued

as redeemable will have a limited maturity date.
ll Dividend Rate: Rate of dividends is fixed.
ll Voting Rights: Preference shareholders don’t have any say in

the working of the company as they do not have any voting
rights.
102
Advantages of Preference Shares from the Company’s Viewpoint
S
Notes
ll The control of the company is not diluted as preference shares
___________________
do not carry any voting rights.
___________________
ll With an increase in the preference share capital, there is a
___________________
corresponding increase in the net worth of the company as
___________________ well as its creditworthiness.
PE
___________________
Advantages of Preference Shares from Investor’s Viewpoint
___________________
ll Fixed rate of dividends is paid to preference shareholders.
___________________
___________________ ll Enjoy preference over equity shares in case the company goes
into liquidation.
___________________
___________________ ll Low-risk factor as compared to equity shareholders.
Disadvantages of Preference Shares from the Company’s Viewpoint
ll An expensive option for the firm as dividend payment is not

tax deductible.
ll In case there is default in the payment of dividends, credit-

)U
worthiness of the firm is adversely affected.
Disadvantages of Preference Shares from Investor’s Viewpoint
ll Returns are limited as decided by the management.
ll In general, the rate of preference dividend for preference

shareholders is less than that for equity shareholders.
ll More fluctuations in market price when compared to deben-

tures.
Debenture
A debenture is an acknowledgment of a debt owed by a company to
the debenture holder. Debentures have a maturity date and carry a
(C
fixed rate of interest but are without any collateral. Debentures are
an essential source of long-term funding for Public Limited Compa-
nies. Debentures are secured against the assets of the company.
Features of Debentures
ll Fixed Rate of Interest: Usually debentures carry a fixed rate

of interest but can also have floating or zero interest rate.
103
Fixed rate debentures are more in use in India with interest
S
being paid annually or half-yearly and are calculated on the Notes
face value. The interest paid is tax deductible. ___________________
___________________
ll The maturity of Debentures: Debentures have a fixed matu-
rity date, that is, they are issued for a fixed duration such ___________________
as 5 years or 10 years. The maturity period may vary from ___________________

1 year to 20 years. In India, non-convertible debentures are
PE
___________________
redeemed after 7–10 years.
___________________
ll Redemption of Debentures: The repayment of debentures is ___________________
made either in installments or lump sum. It is mandatory
___________________
for a company to make a debenture redemption reserve re-
demption reserve for one-time payment of debentures with a ___________________
maturity period of eighteen months or beyond. ___________________
ll Call and Put Option: Debentures may have ‘call’ option which
gives the issuing company a right to ‘buy’ at a certain price
before the maturity period. The call option is exercised at
a premium rate; this means that the buyback price may be
more than the debenture’s face value. Debentures may also
)U
have a ‘put’ option that gives the debenture holder the right
to ‘sell’ and seek for redemption at pre-decided prices.
ll Security Interest of Debentures: Although debentures can ei-

ther be secured or unsecured but in India secured debentures
are more in prevalence. Secured debentures are secured as a
charge against the assets of the company whereas unsecured
or naked debentures do not have any charge against the as-
sets of the company.
ll Convertibility: Debenture holders can exercise their deben-

tures into shares if they want.
ll Credit Ratings: Before public issue, debentures are rated by

credit rating agencies.
(C
ll Claims on Income and Assets: Interest on debentures is paid

from EBIT and is tax deductible. Debenture interest holds
priority over preference and equity shares. As such debenture
holders have priority over assets of the company and failure
to pay debenture interest on time can push the company to-
wards bankruptcy.
104
Types of Debentures
S
Notes
ll On the basis of redemption, debentures can be classified into
___________________
two categories:
___________________
(a) Redeemable Debentures are those debentures which
___________________
must be repaid by the company at the end of the maturi-
___________________ ty period. Due notice shall be served to denture holders
PE
___________________ regarding redeeming debentures in lump sum or install-
ments.
___________________
(b) Irredeemable Debenture: is also known as perpetual de-
___________________
bentures and are repayable only if the company defaults
___________________ on interest payments or during liquidation proceedings.
___________________
ll On the basis of conversion, debentures can be classified into
___________________ two categories:
(a) Convertible Debenture: are those debentures that can

be converted into equity shares at a fixed price and after
completion of a specified period, at the option of the hold-
ers. Debenture capital can be Fully Convertible or Par-
tially Convertible. Convertible debentures are more pref-
)U
erable as compared to non-convertible debentures even
though the rate of interest is lower.
(b) Non-convertible Debenture: These debentures cannot be

converted into equity shares
ll On the basis of security, debentures can be classified into two

categories:
(a) Secured or Mortgaged Debenture: Secured or Mortgaged
debentures are those debentures that are issued with a
charge on immovable assets of the company. In case of
failure in payment of interest or principal amount, deben-
ture holders can sell the assets to satisfy their claims.
(b) Naked, Simple or Unsecured Debenture: Naked deben-
tures do not carry any charge on the company’s assets
(C
with respect to the payment of interest and repayment of

principal amount.
ll On the basis of transfer or registration, debentures can be

classified into two categories:
(a) Registered Debenture: Registered debentures are those

debentures that are registered with the issuing company.
105
Names, addresses and other particulars of the holders are
S
recorded in a debenture register, which is kept by the is- Notes
suing company. Transfer of this type of debentures needs ___________________

a regular transfer deed. The interest is paid only to the ___________________
person on whose name the debenture is registered.
___________________
(b) Bearer Debenture: Bearer debentures are those debentures
___________________
that can be freely transferred and are payable to the bearer
PE
___________________
only. Bearer debentures are negotiable instruments, and
the company keeps no records of them. The interest also ___________________
must only be paid to the bearer of the debenture. ___________________
ll Other Types of Debentures ___________________
(a) Zero Interest (Coupon) Debentures (ZID): are generally ___________________
issued at a discount against their maturity value and do ___________________

not earn any interest. The return on this type of deben-
ture is the difference between purchase (issue) price and
maturity value.
(b) Deep Discount Debenture/Bond (DDB): Deep discount

bond is the same as zero coupon bonds but is issued at a
)U
price lower than its face value with the face value repaid
at the time of maturity. Only Public financial institutions
issue such bonds. DDBs are exposed to high risk but still
attract investors as there is minimal risk that these bonds
will be called before the maturity.
(c) Floating Rate Bonds (FRBs): Floating rate bonds are

those bonds for which the rate of interest is not fixed. The
interest rate is floating,and it’s linked interest rate on
Treasury Bills (TBs) and Bank Rate (BR) is considered as
a benchmark.
(d) Secured Premium Notes (SPNs): SPN is secured deben-

tures redeemable at a premium over the face value. It is
like zero interest debenture as there will be no interest
payment in the lock-in-period. SPN holders have the op-
(C
tion to sell back the debenture/note to the issuing firm at

face value after the given lock-in-period. SPNs are trad-
able instruments.
(e) Guaranteed Debentures: For these debentures, the repay-

ment of principal amount and interest are guaranteed by
a third party during the issue. The third parties are finan-
cial institutions, government, etc.
106
(f) Callable Bonds: Callable bonds are those bonds that al-
S
Notes
low the issuer to call the bond before it reaches its ma-
___________________ turity. Companies generally call back bonds only when
___________________ the interest rates fall in the market less than the bond’s
interest rate.
___________________
Advantages of Debentures from Company’s Viewpoint
___________________
PE
___________________ ll Debenture capital is one of the cheapest sources of long-term
finance as the floatation cost is low and interest payment on
___________________
debentures is tax deductible.
___________________
ll Control of the company is maintained as the debenture hold-
___________________ ers do not have voting rights.
___________________ ll Shareholder’s wealth is maximized as debentures permit the
___________________ company to take advantage of trading on equity.
ll It ensures flexibility of the capital structure.
ll There is no need to pay any dividends on debentures only the
interest and principal amount are to be repaid.
ll It protects against inflation as the rate of interest is fixed and
is to be paid at face value only.
)U
Advantages of Debentures from Investor’s Viewpoint
ll Debentures are a fixed, regular and stable source of income.
ll Its maturity period is definite.
ll Debenture holder’s returns are protected by indenture.
Disadvantages of Debentures from Company’s Viewpoint
ll Raising debenture capital involves high risk as it includes

payment of fixed interest charges and repayment of principal
amount, which are legal obligations of the issuing company.
Failure to honor such obligations may lead to bankruptcy.
ll According to Capital Asset Pricing Model (CAPM), raising de-
benture capital increases financial leverage, which raises the
(C
cost of equity.
ll There are lots of restrictions on the process of raising deben-
ture capital.
ll Disadvantages of Debentures from Investor’s Viewpoint
ll Without any voting rights, debenture holders cannot exert
any degree of control over the working of the company.
107
ll Due to no provision of dividend, the possible return for deben-
S
Notes
ture holders is limited.
___________________
ll Receipt of debentures is fully taxable under the head income
from other sources. ___________________
ll Debenture holders’ lose interest charges if the inflation in- ___________________

creases. ___________________
PE
Thus, so far, the units describe the different sources of short-term ___________________
and long-term sources of finance and its advantages and disadvan- ___________________
tages. Further, the chapter will explain other sources of finance like
___________________
venture capital.
___________________
Venture Capital ___________________
Venture capital (VC) is the financial capital invested in the early ___________________
phases of anew or expanding a business that has high potential and
risk. It is the finance that is provided by the investors or venture
capitalists to start-ups or small business that is believed to have
long-term potential growth.
The objective of Venture Capital

)U
The main objective of venture capital is to provide finance to start-
ups that do not have access to capital markets. Thus, venture capital
becomes an essential source of finance for small businesses.
The risk is significantly high for venture capitalists or investors but

they have a say in the company’s decision-making process and as
such have a significant degree of control over the company affairs.
Features of Venture Capital Investments
ll Carry high degree of risk
ll Liquidity is lacking
ll Need a Long-term outlook

(C
ll Investments are made usually with innovative projects only
ll Suppliers get to participate in the company’s management.
Different Venture Capital Funds
Following are the four types of Venture Capital Funds available to

the companies:
108
ll Venture capital funds that are promoted by the Central Gov-
S
Notes ernment, such as Technology Development and Investment
___________________ Corporation of India (TDICI) by ICICI, Risk Capital and
___________________ Technology Finance Corporation Limited (RCTFC) by IFCI
and Risk Capital Fund by IDBI.
___________________
ll Venture capital funds that are promoted by the State Gov-
___________________
ernment controlled development finance institutions, such as
PE
___________________
Gujarat Venture Finance Company Limited (GVCFL) by Gu-
___________________ jarat Industrial Investment Corporation (GIIC).
___________________ ll Venture capital funds that are promoted by Public Sector
___________________ Banks, such as Canfina by Canara Bank and SBI cap by the
State Bank of India.
___________________
___________________ ll Venture capital funds that are promoted by foreign banks or

private sector companies and financial institutions, such as
Credit Capital Venture Fund, Indus Venture Fund, etc.
Summary
The long-term sources of finance are those funds which are required
)U
for a period exceeding a year. They may be required to expand the
existing office space, buy a new office premise, launch a new product
in the market and buy a new company. The major types of long-term
sources of finance are internal financial sources and external financ-
ing sources.
Review Questions
1. List out the pros and cons of equity financing.
2. How and in what sense do the preference shareholders have

‘preference’? Explain the preferences available to the prefer-
ence shareholders.
3. How do the equity shares represent the residual claim in the

company? Explain.
(C
4. Explain the advantages and disadvantages of debentures from

the company as well as the investor’s viewpoint. Comment on
its suitability as a long-term source of finance.
5. Which option out of debt and equity is a suitable source for

long-term finance? Compare their key features in a tabular
form.
109
Unit 12
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Notes
___________________
Fundamentals Of Capital ___________________
Budgeting ___________________
___________________
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Objectives: ___________________
At the end of this unit, students can expect to discuss and explain: ___________________
\\ Capital budgeting’s meaning and definition. ___________________
\\ Capital budgeting decisions features.
___________________
\\ Capital budgeting decisions importance.
___________________
\\ Capital budgeting decisions and difficulties in making them.
\\ Capital budgeting decisions and their types. ___________________
Introduction
Capital budgeting decisions are those decisions which are concerned
with the allocation of huge amounts of money to various long-term
assets. It is the process by which a firm assigns funds to varied in-
)U
vestment heads, designed to conform to the organization’s profit and
growth objectives in the long run. The capital budgeting process calls
for the estimation of cost and future benefits from the investment in
the long term. Thus, it is financial decision-making process.
In today’s competitive economy, the financial capability and pros-

perity of a business depend upon the effectiveness and efficiency of
capital expense evaluation and fixed assets management.
Meaning and Definition

Capital budgeting refers to the financial planning required to in-
crease an organization’s profits in the long run.
It is the organization’s decision regarding the investment of current

(C
funds on a new project or business in order to attain proficiency and

continuous flow of future benefits in the long-run term activities.
Thus, a capital financial plan can be devised to achieve long-run cash

flow over a period of time. It includes a cash resource’s current cost
or a series of cost in lieu for an likely inflow of expected paybacks.
Capital budgeting is the method or process to plan and prioritize the
investment process of long-term assets, whose revenues (cash flows)
110
are projected to exist more than a year. An organization’s asset de-
S
Notes cisions would usually embrace growth, acquirement, innovation,and
___________________ replacement of fixed assets or long-run assets.
___________________ Capital budgeting is a traditional planning process employed by or-
___________________ ganizations to decide if it is worth investing its present funds for
acquiring new or up gradation of fixed assets.
___________________
PE
___________________
Features of Capital Budgeting Decisions
___________________
Following are the various features of Capital budgeting decisions:
___________________
___________________ ll They require the exchange of existing resources for future

paybacks.
___________________
___________________ ll They have the weight of accelerating the capability, proficien-

cy, and extent of life regarding future hedges.
ll Funds are invested in long-run activities.
Some of the most commonly discussed capital budgeting decisions

are:
)U
ll Introduction of a new product.
ll Expansion of business by investment in plant and machinery
ll Replacing and modernizing a method
ll Mechanization of processes
ll Choosing between various machines
Significance of Capital Budgeting

Following reasons shed some light on the significance of Capital
budgeting decisions:
(C
Long-term Effects
One of the most significant features of capital budgeting decisions
is that they have long-term implications regarding the future of the
company. One wrong decision can greatly influence the survival of
a firm because the dearth of investment in assets might have seri-
ous implications regarding the future position of the company in
regards to the competitors.
Unit 12: Fundamentals Of Capital Budgeting
111
Substantial Commitments
S
Notes
A significant portion of capital is blocked due to capital budgeting
___________________
decisions as they entail the commitment of huge amounts of money.
___________________
Irreversible Decisions
___________________
Due caution and diligence must be exercised by the company before
___________________
taking capital budgeting decisions as there is less possibility of being
PE
___________________
able to revert the decisions which may lead to severe consequences.
___________________
Capacity and Strength to Compete
___________________
If crucial decisions related to capital budgeting are delayed, it may
___________________
result in the company losing its competitive edge and lose the ground
to competitors. ___________________
___________________
Problems and Difficulties in Capital Budgeting
Capital budgeting decisions facing a finance manager are affected
by various other issues also which might not be analytical in nature.
Let us consider some example given below:

)U
Measurement Problem
Analysis of a project involves identifying and calculating its prices
and benefits, which is difficult since it involves long and tedious cal-
culations. Majority of replacement or expansion programs have an
impact on some alternative activities of the business(introduction
of the latest product could lead to the decrease in sales of the other
prevailing product) or have some immaterial significances.
Uncertainty
Selection or rejection of a capital expenditure project depends on the
expected prices and benefits in the future. The future is uncertain;
hence,the prediction of future gains may be inaccurate. Due to the
inherent risk, it is impossible to predict long-term money inflows.
(C
Temporal Spread
The expected costs and benefits are related to an expense project
opened up over an extended amount of time, which are 10–20 years
for industrial assignments and 20–50 years for infrastructure proj-
ects. The temporal spread generates some issues in approximating
discount rates for conversions of future financial inflows to present
values (PVs) and establishing equivalences.
112
Capital Budgeting Decisions and their Types
S
Notes
___________________ Every capital budgeting decision is a specific decision in a given sit-

uation and in case a firm deliberates regarding a decision at two
___________________
different junctures of time, it can result in two entirely diverse out-
___________________ comes.
___________________
In general, the capital budgeting decisions can be categorized from
PE
___________________ two different viewpoints as mentioned below:
___________________
1. From the viewpoint of the Firm’s survival
___________________ It does not matter if the firm already exists or is a new entity,
___________________ it is important to take Capital Budgeting Decisions.
___________________
(a) For a new firm – a company which has only been recently
___________________ in corporated needs to take key decisions regarding plant
and machinery to be installed, standby arrangements, ca-
pacity utilization, etc.
(b) For an existing firm – a company which is well estab-

lished needs to take various critical decisions regularly
to maintain a competitive edge over others. Some such
)U
decisions can be: -
(i)
Replacement and Modernization Decisions – This
is the most common capital budgeting decision. All
types of plant and machinery have a fixed life, and
after it has completed its economic life, there is an ur-
gent need to replace it. This decision is called replace-
ment decision. However, if the existing plant needs to
be technologically updated (though the economic life
may not be over), the decision is known as modern-
ization decision. In general, these decisions are also
known as Cost Reduction Decisions.
(ii) Expansion – Sometimes, the firms are interested in

increasing the production and market share. In such
(C
instances, it is required on the part of the finance

manager to evaluate the marginal costs and marginal
benefits in order to take a decision regarding the ex-
pansion.
(iii) Diversification – Sometimes, the firm is interested in

diversifying into new product lines and new markets.
Unit 12: Fundamentals Of Capital Budgeting
113
When the company is facing a situation like this, it
S
Notes
is necessary for the finance manager to evaluate the
marginal benefits and cost along with the impact of ___________________
broadening product portfolio on profitability levels ___________________
and current market share. In general, these decisions
___________________
are also known as Revenue Increasing Decisions.
___________________
2. From the viewpoint of the decision situation
PE
___________________
The capital budgeting decisions under this category are classi-
___________________
fied as follows:
___________________
(a) Mutually Exclusive Decisions: in a case where a selec- ___________________
tion of one alternative results in automatic rejection of
___________________
remaining alternatives, it is called a mutually exclusive
decision. ___________________
(b) Accept—Reject Decisions: in a case where each alterna-

tive is evaluated independently without having any impli-
cations on other alternatives, it is called an accept-reject
decision which must be made when: -
)U
(i) A particular proposal’s cost and benefits does not im-
pact or get impacted by other proposals cost and ben-
efits.
(ii) Desirability of other proposals is not impacted by se-

lection or rejection of other proposals.
(iii) The various proposals that are being considered are

not competitive.
(c) Contingent Decisions: Sometimes, a capital budgeting

decision may be contingent on other decisions. For exam-
ple, installing a project at a remote location may require
expenditure for transportation development or develop-
ment of infrastructure. Any capital budgeting decision
(C
should be analysed in their entirety. Thus, consideration

and evaluation of contingent decisions must be done con-
currently.
So, we have learned the importance of capital budgeting, its types,and

features. In the next chapter, we will learn about the techniques of
capital budgeting.
114
Summary
S
Notes
___________________ The first and perhaps the foremost decision of a firm is to define
the business or new projects that it wants to be involved in. After
___________________
the business has been chosen the company needs to make decisions
___________________ regarding investment in machinery, plant, building, equipment, in-
___________________ frastructure, and various other fixed assets under the Capital Bud-
PE
geting process. As the funds available to a company will vary from
___________________
time to time, it is essential to take investment decisions which will
___________________
yield maximum returns. Determination of Debt-Equity ratio, price
___________________ of market securities, timing of raising funds are some of the essen-
___________________
tial capital budgeting decisions.
___________________
Review Questions
___________________
1. Explain the concept of capital budgeting and its various types?
2. What are mutually exclusive projects and how do they differ

from accept-reject projects?
3. What are the different categories of investment decisions?

What are the factors affecting capital budgeting decisions?
)U
4. Explain the concept that ‘Capital budgeting decisions are long-
term decisions.’
5. What are challenges that a firm may face while taking a deci-
sion regarding capital budgeting?
6. How does capital budgeting differ for a new firm and an exist-
ing firm?
7. How are capital budgeting decisions classified based on deci-

sions?
(C
115
Unit 13
S
Notes
___________________
Capital Budgeting Evaluation ___________________
Techniques ___________________
___________________
PE
Objectives: ___________________
After completion of this unit, students can be expected to understand and
discuss: ___________________
\\ Techniques of evaluation ___________________
\\ Payback period. ___________________

\\ The accounting rate of return.
___________________
\\ The net present value technique.
___________________
\\ The profitability index method.
\\ The internal rate of return.
Introduction
Capital budgeting decisions start with Cost and Benefit analysis
)U
of various alternatives. There are different techniques available to
evaluate the different alternative proposals. Each technique has its
own methodology and acceptance criterion. However, these tech-
niques follow two assumptions:
ll Certainty about cash flows
ll There are no constraints regarding the funds available to the

firm.
Techniques of Evaluation
The following elements affect the acceptance or attractiveness of
any investment proposal:
(C
ll The Net Investment (amount to be invested)
ll The Operating Cash Inflows (potential benefits)
ll The economic life of the project (Duration)
The techniques that can be used are grouped into two categories, as
shown in the figure 13.1 below:
116
S
Project Evaluation Technique
Notes
___________________
___________________ Traditional or Non-discounted Cash Flow Modern or Discounted Cash Flow
___________________
___________________ Pay Back Period Net Present Value Method
PE
___________________
___________________ Accounting Rate of Return Internal Rate of Return
___________________
Profitability Index
___________________
Figure 13.1: Techniques of Capital Budgeting
___________________
___________________
Traditional or Non-Discounted Cash Flow
This technique does not discount cash flows to find their present
worth. Under this technique two strategies are available: - Payback
period method and accounting rate of return method.
)U
Payback Period
Payback period (PBP) is defined as the duration during which the
initial investment in a project may be recovered and is one of the
most widely used techniques for estimating investment plans. It is
calculated based on cash flow after taxes.
There are two techniques to calculate PBP -
1. Equal Annual Cash Flows: Here, the cash inflows are in the
form of an annuity. PBP can be calculated using the following
formula: -
Initial investment cash outlay

PBP =
Annual cash inflow
(C
2. When annual cash inflows are unequal: Here the cash

flows are different for each year as such the following cumula-
tive cash flow method is used for calculation of PBP: -
Thus,
“PBP = Period after which the cumulative cash inflows are equal to
the net cash outflow at the commencement of the project.”
Unit 13: Capital Budgeting Evaluation Techniques
117
Rules of Acceptance and Rejection of the Payback Period
S
Notes
Standard or maximum PBP is compared with calculated PBP for the
___________________
basis for acceptance or rejection of a project.
___________________
Accept: Calculated PBP < Standard PBP
___________________
Reject: Calculated PBP > Standard PBP
___________________
Considered: Calculated PBP = Standard PBP
PE
___________________
Advantages of Payback Period ___________________
ll Easy to understand. ___________________
ll The cost involved in calculating the PBP is less as compared ___________________

to other methods. ___________________
Disadvantages of Payback Period ___________________
ll Cash Flows after PBP is ignored.
ll Due to the fact that it does not consider all cash inflows re-
sulting from an investment, it is not considered a suitable
technique to calculate profitability.
)U
ll Money’s time value is not considered.
ll There is no balanced foundation for setting a minimum PBP.
ll As share value is not dependent on PBPs of investments, it

does not necessarily result in maximization of shareholders
wealth.
Example 13.1 – A proposal requires a cash outflow of Rs. 30,000 and

it is desired to generate a cash inflow of Rs. 10,000, Rs. 8,000, Rs.
8,000,Rs. 6,000 and Rs. 4,000 each year over the next five years. PBP
is calculated using cumulative cash flow value. Determine the PBP.
Solution
Table13.1: Cash Flows for Time Periods

(C
Annual Cash Cumulative

Year
Flow Cash Flow
0 −30,000
1 10,000 10,000
2 8,000 18,000
3 8,000 26,000
4 6,000 32,000
5 4,000 36,000
118
From the above table, in the 4th year, the cash inflows surpass the
S
Notes
initial investment. Hence, the PBP is four years. Hence, the project
___________________ may be accepted.
___________________
Accounting Rate of Return
___________________
Accounting Rate of Return (ARR) is defined as the annualized net
___________________
income received on the average funds devoted to a project and is
PE
___________________ based on the concept of Return on investment.
___________________ Average annual accounting profit
AAR =
___________________ Initial investment in
n the project
___________________
Thus, ARR is like the financial ration rate of return on the capital
___________________ and, thus,indicates the profitability of the firm.
___________________
Rules of Acceptance and Rejection of the Accounting Rate
of Return
Standard ARR is the expected profits that a company expects on an
investment. Selection or rejection of a project is based on a compar-
ison of standard ARR with calculated ARR.
Accept: Calculated ARR > Standard ARR

)U
Reject: Calculated ARR < Standard ARR
Considered: Calculated PBP = Standard PBP
Advantages of ARR
ll Simple and easy to understand.
ll The relevant data and information required to calculate the

ARR can be conveniently obtained from the accounting re-
cords.
ll ARR illustrates an investment’s economic desirability in

terms of percentage return.
Disadvantages of ARR
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ll Post PBP cash flows are ignored.
ll Time value of money is not considered.
ll Expected Life of the proposal is ignored.
ll Size of the investment required for the project is not recog-

nized by the ARR.
119
Example 13.12 – Pooja Brass Co. is contemplating two different proj-
S
Notes
ects, each with a requirement of an initial cash out flow of Rs. 10,000
and with a life of five years. Company’s required rate of return is ___________________
15%,and the tax rate is 50%. Straight-line basis depreciation will be ___________________
used. The cash flows follow:
___________________
Years 1 2 3 4 5 ___________________
Project 1 4,000 4,000 4,000 4,000 4,000
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Project 2 6,000 3,000 2,000 5,000 5,000 ___________________
___________________
ll Calculate the average rate of return for the projects.
___________________
ll Solution: The Accounting Rate of Return or ARR is calculated
___________________
as follows:
___________________
Average Annual PAT
AAR = × 100 ___________________
Average Investment in the Project
ll Total Earnings from Project 1 = Rs. 20,000
ll Total Earnings from Project 2 = Rs. 21,000
ll Refer to the below table for calculations.

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Project Project
Years
1 2
1 4,000 6,000
2 4,000 3,000
3 4,000 2,000
4 4,000 5,000
5 4,000 5,000
Total Earnings 20,000 21,000
Earnings After Tax 10,000 10,500
Average Earnings After 2,000 2,100
Tax
Initial Investment 10,000 10,000
Accounting Rate of 20 21
Return
(C
ll Thus, the ARR for Project 2 is higher than that of Project 1.

Hence, Project 2 should be considered by Pooja Brass Co.
So far, we have discussed the traditional or non-discounted tech-

niques of capital budgeting. Now, let us discuss the modern or dis-
counted cash flow technique.
120
Modern or Discounted Cash Flow Technique
S
Notes
___________________ The discounted cash flow technique is also known as the time adjust-
ed cash flow technique. This technique explains that cash flows that
___________________
occur at different times will have different economic worth because
___________________ it considers the time value of money. All procedures used under this
___________________ technique work around the premise under which future cash flows
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are discounted for calculation of present values.
___________________
___________________ Net Present Value Method

___________________ Net Present Value (NPV) of an investment proposal is calculated
through summing up PV’s of all cash outflows related to a proposal
___________________
and reducing them from the sum of PV’s of all cash inflows, the re-
___________________
sult is the Net Present Value (NPV) of an investment proposal.
___________________
For the purpose of calculation of NPV, both cash inflows and outflows
are applied to both cash inflows and outflows. Being the overall cost
of capital, this discount rate, presents the minimum requirements
regarding the returns required for financial stability of shareholders.
Calculation of Net Present Value

)U
NPV = PV of inflows – PV of outflows
CF1 CF2 CFn

NPV = 1
+ 2
+ − CF0
(1 + k) (1 + k) (1 + k)n
CFi
∑ (1 + k) i
Where, I = 1,2,……,n
CFi= Cash flow at the i-th time
k = Discount rate
n = life of the project in years
Decision Rule:
(C
If the NPV > 0, proposal must be accepted and if the NPV < 0 pro-
posal must be rejected
Advantages of the Net Present Value Method
ll Time value of money is identified.
ll All cash inflows and outflows are considered.

121
S
ll It is based on real cash flows and not on accounting profits.
Notes
ll The discounting rate k, which is the minimum rate of return, ___________________
integrates both the return and premium to set off the risk.
___________________
ll Net contribution of a proposal towards the wealth of the firm ___________________
can be computed with its help.
___________________
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Drawbacks of the NPV Method ___________________
ll Many complex calculations are involved. ___________________
___________________
ll As the cash flows are occurring after a huge time gap there
___________________
might be some uncertainties.
___________________
ll Determine the rate of return beforehand is hard.
___________________
ll Projects are evaluated against an expected rate of return only
not against the actual rate of return.
ll The difference in the initial outflows, size of the proposals,

etc. are ignored, as the decisions under NPV are based on
value only.
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Example 13.3 – A firm is considering an investment proposal hav-
ing an initial investment of Rs. 1,50,000. The project is expected to
generate an annual cash inflow of Rs. 20,000, Rs. 50,000, Rs. 60,000,
Rs. 40,000 and Rs. 30,000, respectively, during the next five years.
Determine the NPV.
Solution-
Table13.2: Calculation of PV of Cash Flows
Present Value
Annual Cash Present Value of the
Year factor @ 10%
Flow cash flow
rate
0 −1,50,000 −1,50,000
1 20,000 1.100 18,182
2 50,000 1.210 41,322
(C
3 60,000 1.331 45,079

4 40,000 1.464 27,321
5 30,000 1.611 18,628
Total NPV 531
As the NPV is positive in the above-mentioned example, the

project will be accepted by the firm.
122
Internal Rate of Return Method
S
Notes
Internal Rate of Return (IRR) is the rate of discount at which the
___________________
NPV of a proposal is zero. In simple words, IRR is that discounting
___________________ rate which PV of cash outflow is same as PV of cash outflow.
___________________
In the IRR technique, the time schedule of occurrence of future cash
___________________ flows is known; however, the discounting rate is unidentified and
PE
___________________ has to be calculated through a trial and error method.
___________________ Calculation of Internal Rate of Return

___________________
CF0 CF1 CFn SV + WC
___________________ CO0 = 0
+ 1
+.+ +
___________________
(1 + k) (1 + k) (1 + k)n
(1 + k)n
___________________ Where,
CO0 = Cash outflow at time 0
CFi = Cash flow at the i-th time
k = Discount rate (yet to be calculated)

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n = life of the project in years
SV = Salvage Value
WC = Working Capital
Decision Rule
To take a decision on the basis of IRR method, it is required by the

firm to have its own cut-off rate/rate of return.
The proposal can be accepted only if IRR >cut-off rate and will be
rejected otherwise.
Advantages of Internal Rate of Return Method
ll Money’s time value is considered.

(C
ll All cash inflows and outflows are considered.
ll It is not based on accounting profits but based on actual cash

flows.
ll It is profit oriented and selects proposals that are expected to

earn more than the cut-off rate.
123
Disadvantages of Internal Rate of Return Method
S
Notes
ll It involves difficult calculations.
___________________
ll Pre-determination of cut-off rate/hurdle rate is required, ___________________

which is a difficult task
___________________
ll Being a scaled measure it tends to be prejudiced toward small ___________________
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projects that may yield higher returns. ___________________
ll It is assumed that future cash flows of a project are invested ___________________

again at the rate of IRR. ___________________
“Modified IRR is an enhanced version of IRR, and it recog- ___________________

nizes that original outlays are funded at financing cost of ___________________
the company, and positive cash flows are plowed back at
___________________
the company’s cost of capital.”
Profitability Index Method

Profitability Index (PI) or cost-benefit ratio or PV index is the profit
per rupee that has been invested in the proposal based on the dis-
counting of future cash flows. It can be calculated as the ratio of PV
)U
of future cash inflows to the PV of future cash outflows.
Computation of Profitability Index
Total present value of cash in flows

PI =
Total present valu
ue of cash out flows
n CFi
∑ (1 + k)
i =1 i
/ C0
Decision Rule
Accept a proposal if PI > 1; reject the proposal otherwise. However,

if PI = 1, the firm may be indifferent to the proposal.
(C
Example 13.4 – A firm is evaluating a proposal with a cash outflow

requirement of Rs. 40,000 at present and Rs. 20,000 at the end of
the 3rd year. It is anticipated to produce the cash inflows of Rs.
20,000, Rs. 40,000 and Rs. 20,000 at the end of the 1st, 2nd and 4th
year, respectively. The rate of discount is given as 10%, calculate
the PI of the project and arrive at a decision of whether to accept
the proposal.
124
Solution
S
Notes
Present Value Factor
___________________ Year Cash Flows (in Rs.) Present values
(@10%)
___________________ 0 −40,000 1 −40,000.00
1 20,000 0.909 18,181.82
___________________
2 40,000 0.826 33,057.85
___________________ 3 −20,000 0.751 −15,026.30
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4 20,000 0.683 13,660.27
___________________
___________________ PV of cash outflows: Rs. 40,000 + Rs. 15,026.3 = Rs. 55,026.3

___________________
PVs of cash inflows: Rs. 18,181082 + Rs. 33,057.85 + Rs. 13,660.27
___________________ = Rs. 64,900
___________________ 64, 900
PI = = 1.18
___________________ 55, 026.3
As PI > 1, the project can be accepted as per the profitability method

calculations.
Example 13.5 – ABC Ltd. is considering an expansion of the in-

stalled capacity of one of the plants at the cost of Rs. 35,00,000. The
)U
firm has a minimum required rate of return of12%. Below are the
expected cash inflows over the next six years, after which the plant
will be scrapped away for nil value. Using the IRR technique, find
out whether the proposal should be considered.
Year Cash Inflows

1 Rs. 10,00,000
2 Rs. 10,00,000
3 Rs. 10,00,000
4 Rs. 10,00,000
5 Rs. 5,00,000
6 Rs. 5,00,000
In order to find out the IRR, the approximate IRR needs to be ascer-
tained first. Calculating the PV @ rates 11%, 12% and 13%.
(C
Year Cash Inflows PVF PVF PVF PV (11%) PV (12%) PV (13%)

(@11%) (@12%) (@13%)
1 10,00,000 0.901 0.893 0.885 9,00,900.90 8,92,857.14 8,84,955.75
2 10,00,000 0.812 0.797 0.783 8,11,622.43 7,97,193.88 7,83,146.68
3 10,00,000 0.731 0.712 0.693 7,31,191.38 7,11,780.25 6,93,050.16
4 10,00,000 0.659 0.636 0.613 6,58,730.97 6,35,518.08 6,13,318.73
5 5,00,000 0.593 0.567 0.543 2,96,725.66 2,83,713.43 2,71,379.97
6 5,00,000 0.535 0.507 0.480 2,67,320.42 2,53,315.56 2,40,159.26
36,66,491.77 5,74,378.34 34,86,010.56
125
As we can see that the NPV is going negative between the rates 12%
S
and 13%, the IRR should be between 12% and 13%. Notes
___________________
NPV @ 12%: Rs. 74,378.34
___________________
NPV @ 13%: Rs. -13,989.44
___________________
Interpolating between 12% and 13%,
___________________
IRR = 12% + 74,378/(74,378+13,989.44)
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___________________
= 12.84%
___________________
As we can see that IRR > 12%, the project is acceptable based on the ___________________
IRR technique.
___________________
Summary ___________________
Capital Budget involves the decision regarding allocation of current- ___________________
ly available funds into new projects and as such becomes one of the
key decisions for a company. Several Capital Budgeting techniques
have been referred to which are employed by a company for analysis
of the potential of new projects. It encompasses two non-discounted
cash flow techniques, PBP and ARR and three discounted cash flow
)U
techniques, NPV, IRR,and PI.
The proposal for new project or business is accepted only under the
following conditions:
1. If calculated PBP is less than standard PBP.
2. If calculated ARR is more than standard ARR.
3. If IRR is more than the cut off rate.
4. If NPV is higher than 0.
5. If PI is more than 1.
Review Questions
1. Capital budgeting makes use of the concept of time value of
Money (TVM). How are they used? Which are the different cap-
(C
ital budgeting techniques that use TVM?
2. Do a comparison of NPV and IRR methods? Which of the two is

a more rational method?
3. What is the significance of profitability index (PI) method? How

is it used to compare projects having different sizes? In what
circumstances is PI better than NPV?
126
4. An investment proposal to install a new production plant is be-
S
Notes ing considered by ABC Ltd. at a cost Rs. 50,000 and life expec-
___________________ tancy of five years without any salvage value. The cash inflows
___________________ for the next five years are mentioned in the table below: -
Table13.3: Cash Flows for Time Periods
___________________
Year Annual Cash Flow
___________________
0 -50,000
PE
___________________ 1 10,000
2 12,000
___________________
3 13,000
___________________ 4 15,000
5 20,000
___________________
___________________ Compute the following:

___________________ (a) PBP
(b) ARR
(c) IRR
(d) NPV @ 10% discount rate
(e) PI value @ 10% discount rate

)U
5. Naveen Co. is considering purchasing one of the following two
machines, whose relevant data is provided below.
Table13.4: Values of Machine X and machine Y
Details Machine X Machine Y
Estimated Life 3 years 3 years
Capital Cost Rs. 90,000 Rs. 90,000
Year 1 Rs. 40,000 Rs. 20,000
Earnings Year 2 Rs. 50,000 Rs. 70,000
Year 3 Rs. 40,000 Rs. 50,000
Deduce the most profitable option for the company based on the
calculation of the following:
(C
(a) PBP
(b) ARR
(c) NPV using 10% discount rate

127
Unit 14
S
Notes
___________________
Cost of Capital ___________________
___________________
Objectives:
___________________
At the end of this unit, students will be able to explain and discuss:
PE
___________________
\\ Cost of capital
\\ Its Concepts ___________________
\\ Its Significance ___________________

\\ Factors affecting it
___________________
\\ Compute the cost of capital:
___________________
\\ Long-term debt and bonds cost
___________________
\\ Preference share capital cost
\\ Equity share capital cost
\\ Retained earnings cost
\\ Explain the weighted average cost of capital.
Introduction
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While formulating a company’s capital structure, one of the most im-
portant concepts is the cost of capital. It has two major applications:
1. Capital budgeting where it is employed as the rate of discount,

and
2. Determination of the firm’s best capital structure .
Two major approaches have emerged with a basic difference in the

relevance of cost of capital:
1. According to Modigliani Miller, cost of capital for a company is

fixed and is an independent financing level.
2. According to Traditionalists, capital cost is varying and is

linked to the capital structure.
(C
Under both the approaches, the most optimum policy is the one
which maximizes the value of a company. Thus, the cost of capital is
the lowest possible rate of return of the firm’s stakeholders or pro-
viders of funds.
128
Concept of Cost of Capital
S
Notes
___________________ The notion of cost of capital assumes varying meanings in diverse

context. Following are the three different viewpoints regarding the
___________________
cost of capital:
___________________
1. From Investors’ Viewpoint: An investor can describe it as
___________________
‘the measurement of the sacrifice made by him in capital forma-
PE
___________________ tion.’
___________________
2. From Firm’s View Point: It is the lowest aspired rate of re-
___________________ turn required to validate the capital’s usage.
___________________ 3. From Capital Expenditure’s View Point: The cost of capi-
___________________ tal is the least desirable rate of return which is used to value
cash flows.
___________________
In lieu of capital contribution from the side of investors, company
must pay cost of capital as the rate of return. It can also be said
that weighted average cost of all finance sources utilized by the firm
including equity, preference, long-term debt and short-term debt is
the cost of capital.
)U
Significance of Cost of Capital
The cost of capital is a key concept in the monetary decision-making
process and serves as a standard to assess decisions related to in-
vestment, debt policy, and financial performance.
Following are the decisions in which it is useful: -
1. Designing Optimal Corporate Capital Structure: It as-

sists with framing a robust and cost-effective capital structure
for a firm keeping in mind the cost constraints. In order to de-
velop a well-balanced capital structure, particular costs of var-
ious funding sources and weighted average cost of capital are
measured.
(C
2. Investment Evaluation/Capital Budgeting: The cost of

capital is used as a cut-off rate for capital budgeting. Capital
expenditure means investing in long-term projects such as in-
vestment in new machinery. It is also known as capital budget-
ing expenditure.
3. Financial Performance Appraisal: performance can be ef-

fectively appraised through analysis of the cost of the capital
Unit 14: Cost of Capital
129
framework as it compares the actual profitability of the invest-
S
Notes
ment project with the overall cost of raising funds. If the actual
profitability is lower than the cost of raising funds, then the ___________________
financial performance is not satisfactory and vice versa. ___________________
___________________
Factors Affecting the Cost of Capital
___________________
It is the minimum expected rate of return for the firm’s investor
PE
___________________
against their investment and is directly associated with firm’s risk
characteristic. Following are the factors relevant for deciding the ___________________
cost of capital: ___________________
1. Risk-Free Interest Rate(If): It is the interest rate that is re- ___________________

ceived on risk-free securities, for instance securities issued by
___________________
Indian Government. It is determined by the market sources of
___________________
demand and supply and consists of two mechanisms:
(a) Real Interest Rate: It is the rate of interest that is paid

to the investor.
(b) Purchasing Power Risk Premium: Purchasing pow-

er is maintained by investors and, for the period during
)U
which their money is lent to the firm, they want to be
compensated. Therefore, in order to calculate the risk-
free interest rate, the premium for purchasing power risk
is added to the real interest rate. Higher is the inflation,
bigger is the purchasing power risk premium, and higher
is the risk-free interest rate.
2. Business Risk: It is the intrinsic risk related to the firm’s com-

pulsion to pay dividend and interest to investors. Every proj-
ect has an effect on the business risk. If a proposal with high
risk is accepted by the firm, then in order to compensate for
the increase in the risk, the investors may increase the cost of
funds. This increase in cost to compensate for the business risk
is known as a business risk premium.
(C
3. Financial Risk: It is defined as the likelihood of the business

not being able to honor its financial obligations. Higher the
amount of fixed cost securities in the capital structure, the fi-
nancial risk would be bigger because a combination of sources
of finance may have an impact on investors income.
While measuring the cost of capital, company’s assets and capital

structure are assumed to be unchanged; there is another factor in
130
the form of demand and supply force, that affects the cost of finance
S
Notes
in the long run.
___________________
For calculation of cost of capital following method is used:
___________________
k = If + b + f
___________________
___________________
Where,
PE
___________________ k = Cost of capital from multiple sources
___________________ If = Risk-free interest rate

___________________ b =Business risk premium
___________________
f = Financial risk premium
___________________
Only changes in the demand and supply of a source of the fundwill
___________________
affect the cost of capital over time if the company’s business and
financial risks are assumed to be fixed. It has to be noted that cost
of capital raised by a firm can vary from another firm because the
extent of business and financial risk related with each business is
different because the risk- cost of a source of the fund remains fixed.
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Computation of Cost of Capital
1. Composite Cost and Component Cost: A company can use
multiple sources of finance including shares and debentures to
raise the requisite amount of money. The individual cost with
respect to the different sources of finances used is called the
component cost. It can also be termed as the composite cost of
capital which comprises of the sum of the average cost of each
source of fund utilized by the company.
Component costs are summed up to determine the overall cost

of capital.
2. Marginal Cost and Average Cost: Marginal Cost calculates

the additional cost incurred for raising new funds whereas Av-
erage cost is the mean of marginal costs of components.
(C
3. Explicit Cost and Implicit Cost: The cost of capital can be

either implicit or explicit. According to Porter field, “Explicit
cost of any source of capital is the discount rate that compares
the present value of cash inflows that are incremental to the
taking of the financing opportunity by the present value of its
incremental cash outflow.”
131
An interest-bearing debt’s explicit cost of will be the rate of dis-
S
Notes
count that equates net cash received today to the future inter-
est and principal payment. ___________________
___________________
The implicit cost is the opportunity cost for a firm that the firm
gave up to use the factor of production owned by it. The implicit ___________________
cost incurs from the utilization of owned rather than rented ___________________
assets.
PE
___________________
4. Historical Cost/Book Cost: The book cost has its origin in the ___________________
accounting system in which book values, as maintained by the
___________________
books of accounts, are readily available. They are related to the
___________________
past. It is commonly used for the computation of cost of capital.
___________________
5. Future Cost: It is the cost of capital that is highly probable for
___________________
raising funds for financing an investment proposal.
6. Specific Cost: It is the cost associated with a particular compo-

nent/source of capital. It is also known as the component cost of
capital. These costs include the costs of equity (Ke),preference
share (Kp)debt (Kd), etc.
)U
7. Spot Cost: It is the costs that are prevailing in the market at
a certain time. For example, a few years back, the cost of bank
loans (house loans) was around 12%; now, it is 6%, which is the
spot cost.
8. Opportunity Cost: The opportunity cost is the benefit that the

shareholder fore goes by not investing the funds elsewhere as
they have been retained by the management.
Computation of Specific Cost of Capital
It is the responsibility of a financial manager to calculate the specific

cost of each type of funding that may be required for the company’s
capitalization as a company can raise funding from multiple sources.
Investors required a rate of returns is equal to the component cost
(C
of a particular source of capital. Investors’ required rate of returns

includes interest, discount on debt, dividend, capital appreciation,
earnings per share on equity shareholders’ funds and dividend and
share of profit on preference shareholders’ funds.
Compensation of specific sources of finance, such as equity, prefer-

ence shares, debentures and retained earnings is discussed below:
132
Cost of Bonds and Debentures
S
Notes
The cost of debentures and bonds measure the price of borrowing
___________________
funds to finance the projects. Following variables help in deciding
___________________
the cost:
___________________
1. The present levels of interest rate – In case there is an increase
___________________ in the interest rate, debt cost for the company also increases.
PE
___________________
2. The risk of default from the firm – The Cost of debt increases
___________________ with an increase in the risk of default by a company.
___________________
3. The tax advantage –The tax benefit makes the after-tax cost
___________________ of debt lower than the pre-tax cost as it is a function of the tax
___________________ rate.
___________________ The cost of debt can be described as the returns desired by the likely
lenders of the company.
ll Cost of Capital of Perpetual Debt – Perpetual debt is

availed by the firm on a regular basis. It is computed as fol-
lows:
I
)U
Ki =
B0
Where, Ki = Cost of Capital of Debt (before tax)
I = Annual Interest Payable B0 = Net Proceeds
ll Cost of Capital of Redeemable Debt – The cost of capital

of redeemable debt is calculated as follows:
l (1 − t ) + (RV − B0) / N
kd =
RV + B0
2
Where, Kd = After-tax Cost of Debt
t = Tax Rate
(C
N = Life of Debenture
RV = Redemption Value of Debentures
B0 = Net Proceeds
Example 14.3 – XYZ Ltd. issues 20% debentures of face value Rs.
1,000 each, redeemable at the end of eight years. The debentures
133
are issued at a discount of 5% and the floatation cost is estimated to
S
be 1%. Find the cost of capital of debentures, assuming tax rate to Notes
be 50%. ___________________
Solution: The cost of debentures can be calculated by the simple use ___________________
of the formula: ___________________
l (1 − t ) + (RV − B0) / N ___________________

kd =
PE
RV + B0 ___________________
2
___________________
Where, Kd = After Tax Cost of Debt ___________________
___________________
t = Tax Rate = 50%
___________________
N = Life of Debenture = 8
___________________
RV = Redemption Value of Debentures = 1000
B0 = Net Proceeds = (1000 − 50 − 10 = 940)
200 (1 − 0.05) + (1000 − 940) / 7

kd =
1000 + 940
)U
2
Kd = 11.20%
Cost of Preference Shares

Preference share capital is also used by companies to raise capital
but is diverse from Equity Share capital in the following ways:
1. Preference share receive the dividends at a pre-determined rate

and have priority over equity shares
2. If the company goes into liquidation, preference shares have

priority over equity shares during repayment
Preference share-holders should be paid pre-determined dividends

regularly because it may otherwise affect the credibility of the com-
(C
pany significantly and may pose hindrances while raising funds in

future. If the dividend is not paid to preference shareholders, they
are entitled to voting rights under Sec. 87 of Companies Act 1956.
Cost of Capital of Redeemable Preference Share – If the preference

shares are redeemable by the firm at the end of the specified period,
it is computed as follows:
134
PDi Pn
S
n
Notes P0 = ∑ (1 + kp) + (1 + kp)
i =1 i n
___________________
___________________
Where P0 = Net Proceeds on Issue of Preference Shares
___________________
PD = A nnual Preference Dividend at a Fixed Rate of
___________________ Dividend
PE
___________________
Pn = Amount Payable at the Time of Redemption
___________________
kp = Cost of Preference Share Capital
___________________
n = Redemption Period of Preference Shares
___________________
___________________
An approximation of the above formula can also be written as
___________________ Pn − P0
PD +
kp = N
Pn + P0
2
ll Cost of Capital of Irredeemable Preference Share – In

case of irredeemable preference shares, dividends are paid
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perpetually at a fixed rate. It is computed as follows:
PD
Kp =
P0
Where P0 = Net Proceeds on Issue of Preference Shares
PD = Annual Preference Dividend at fixed Rate of Dividend
kp = Cost of Preference Share Capital
Example 14.4 – XYZ Ltd. issues 15% preference shares of face val-
ue Rs. 100 each, with a floatation cost of 4%. Find the cost of capital
of preference shares if,
(a) preference shares are irredeemable

(C
(b) preference shares are redeemable after 10 years with net

proceeds of Rs. 96 each.
Solution: When the preference shares are irredeemable, the cost of

preference shares can be calculated as follows:
PD
Kp =
P0
135
15
S
Kp = = 15.63% Notes
96
___________________
When the preference shares are redeemable, the cost of preference
___________________
shares can be calculated as follows:
___________________
Pn − P0
PD + ___________________
kp = N
PE
Pn + P0 ___________________
2
___________________
100 − 96
15+ ___________________
Kp = 10 = 15.71%
100 + 96 ___________________
2
___________________
Cost of Equity Share Capital
___________________
Equity share capital also incurs a cost that is calculated as the rate
of discount at which projected dividends are discounted to reach the
current value of shares. The investors invest their money in equity
shares only because they expect a stable return on their investment.
ll Cost of capital of equity shares when dividends are

)U
distributed perpetually – It is computed as follows:
D0 (1 + g )
P0 =
ke − g
D1
=
ke − g
Where, D1 = D0(1+g)
g = Constant Dividend Growth Rate
Ke = Cost of Equity Share Capital
P0 = Current Market Price of Equity Shares
ll Cost of capital of equity shares when zero dividends

are distributed – It is computed as follows:
(C
Pn
P0 =
(1 + ke )n
Where,P0 = Current Market Price of Equity Shares
Pn = Expected Market Price at the End of the Year n
Ke = Cost of Equity Share Capital

136
Example 14.5 – Determine the cost of equity capital from the fol-
S
Notes
lowing information of ABC Company. The current market price of
___________________ an equity share is Rs. 80. The current dividend per share is Rs. 6.40.
___________________ The company is expecting that dividends would grow at 8%.
___________________ Solution:
___________________ D1
Ke = +g
PE
___________________ P0
Rs.6.40
___________________ = + 0.08
Rs.80
___________________
= 0.08 + 0.08
___________________
___________________ = 0.16 or 16%
___________________ Cost of Retained Earnings

Earnings generated by the firm is distributed among the sharehold-
ers. However, some of it may be retained by the firm for reinvest-
ment purposes, which is known as retained earnings. Thus, in terms
of cost, the retained earnings are the opportunity cost of the fore-
gone dividends. Therefore, there is an opportunity cost involved in
)U
the firm’s retained earnings, and an estimation of this cost can be
considered as a measure of the cost of retained earnings, Kr.
Retained earnings are assumed as fresh subscription of the share

capital and therefore its cost, Kr, is assumed equivalent to the equity
share capital’s cost, Ke,
Moreover, there is no need to adjust the retained earnings for tax-

ation or flotation cost as the earnings have already been taxed. The
formula given below can be used for this:
Kr = Ke(1 – t)(1 – C)
Here,
Kr is the cost of retained earnings

(C
Ke is the cost of equity share capital
T is the marginal tax rate applicable to shareholders
C is the commission and brokerage costs in terms of percentage
14.5 Weighted Average Cost of Capital

The rate of return that should be earned by a company to meet in-
137
vestor requirements is described as the Overall cost of capital which
S
comprises varying costs in proportion to the capital structure. There- Notes
fore, WACC is defined as the weighted average of the cost of capital ___________________
from multiple sources and can be described as follows: ___________________
WACC = w1ke + w2kd + w3kp// ___________________
Where, WACC = Weighted Average Cost of Capital ___________________
PE
___________________
ke = Cost of Equity Capital
___________________
kd = After Tax Cost of Debt
___________________
kp = Cost of Preference Share Capital ___________________
w1 = Proportion of Equity Capital in Capital Structure ___________________
___________________
w2 = Proportion of Debt in Capital Structure
w3 = Proportion of Preference Capital in Capital Structure
Example 14.6 – Consider the following capital structure of Sudeep

Corp.
)U
Sources Amount Specific Cost of Capital
Equity Share Capital Rs. 20,00,000 11%
Preference Share Capital Rs. 5,00,000 8%
Retained Earnings Rs. 10,00,000 11%
Debentures Rs. 15,00,000 4.5%
Solution –
Now, WACC will be calculated as follows:
Source BV(Rs.) Weights Cost of Weighted

Capital Cost of
Capital
Preference 5,00,000 0.1 0.080 0.0080
Share Capital
Equity Share +20,00,000 0.4 0.110 0.0440
(C
Capital
Retained 10,00,000 0.2 0.110 0.0220
Earnings
Debentures 15,00,000 0.3 0.045 0.0135
50,00,000 1.0 0.0875
Therefore, the WACC for the company’s capital structure is 8.75%.

138
Example 14.7 – The following information is taken from the finan-
S
Notes cial statement of ABC Ltd.
___________________ Capital Rs. 8,00,000
___________________ Share Premium Rs. 2,00,000
Reserves Rs. 6,00,000
___________________
Shareholders’ Funds Rs. 16,00,000
___________________ 12% Irredeemable Rs. 4,00,000
Debentures
PE
___________________
An ordinary dividend of Rs. 2 has been paid. The dividends are ex-
___________________
pected to grow at a constant rate of 10%. The share price of ordinary
___________________
shares is quoted at Rs. 27.5 and debentures at 80%. Total number of
___________________ shares is 80,000. Calculate WACC.
___________________ Solution –
___________________
D1
Cost of Equity Ke = +g
P0
Rs 2 x 1.1
= + 0.1 = 18%
Rs 27.5
Market value of Equity = 80,000 * 27.5 = Rs. 22,00,000

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I
Cost of Debt =
B0
= Rs. 12/Rs. 80 = 15%
Market Value of Debt = 4,00,000 * 0.80 = Rs. 3,20,000
WACC = (22,00,000/25,20,000) * 0.18 + (3,20,000/25,20,000) * 0.15

= 0.176
WACC = Or 17.6%
Thus, in this chapter, we see how a business plans its capital bud-
geting by estimating its cost of capital from different sources. They
may raise funds from either equity or debt or both. Now, in the next
chapter, we will learn how to determine the optimal capital struc-
ture by using debt financing and its effect on earnings of the share-
(C
holders.
Summary
The least expected rate of return that a company desires is defined
as the cost of capital, so that it can attract requisite funds for its cap-
ital needs. To put in other words, it is the weighted average cost of
different sources of finance employed by the firm such as preference
139
shares, short term debt, long-term debt and equity shares.
S
Notes
Capital budgeting is an essential component of the financial deci-
___________________
sion-making process and helps with: -
___________________
- Investment decision evaluation
___________________
- Debt policy designing for a firm
___________________
- Financial performance appraisal.
PE
___________________
The cost of capital helps in understanding the corporate capital ___________________
structure, capital budgeting,and financial performance appraisal.
___________________
Cost of capital is aggregate of financial risk premium, risk-free in-
terest rate, and business rate premium. ___________________
___________________
Review Questions
___________________
1. Explain the significance of the cost of capital in capital budget-
ing.
2. Why are the expenses of raising preference share capital is low-
er than the cost of raising equity capital? Explain.
3. Explain why “a new issue of capital is costlier than the retained
)U
earnings.”
4. Discuss if WACC can be used as a cut-off rate for capital bud-
geting.
5. Calculate the cost of capital for a seven-year bond of Rs. 100 of
a firm that can be sold for Rs. 07.75 and is redeemable at a pre-
mium of 5%. The interest rate is 15%,and the tax rate is 55%.
6. Calculate the cost of capital when the company issues 10% irre-
deemable preference shares at Rs. 105 each when book value is
Rs. 100.
7. Calculate the cost of capital when the expected dividend at the
end of the year is Rs. 4.5, share price is Rs. 90 with a growth
rate of 10%.
8. Calculate the WACC based on the following financial informa-
(C
tion of the company.

Sources of Finance Amount (Rs) Cost of Capital
11% Preference Share 1,00,000 11%
capital
Equity Share Capital 4,50,000 18%
Retained Earnings 1,50,000 18%
16% Debt 3,00,000 8%
(C
)U
PE
S
141
Unit 15
S
Notes
___________________
Case Study: Airnet limited: A ___________________
Telecommunication Takeover ___________________
___________________
The telecommunications industry is a subset of the information
PE
and communication technology sector. This industry comprises of ___________________
telephone companies, internet service providers, and DTH service
___________________
providers. The telephone calls are still the industry’s biggest rev-
enue generator. Telecom, today, has revolutionized our lives; it’s ___________________
not just about voice calls anymore but about the text (messaging,
___________________
email), images (video streaming) and high-speed internet access for
computer-based data applications, such as broadband information ___________________
services.
___________________
India is one of the major telecommunications markets in the world
and has millions of internet subscribers. It is world’s second largest
smartphone market and is expected to have a billion unique mobile
subscribers by 2020.
Higher penetration in the rural markets and non-voice revenues

will give India’s telecommunications market another push. The
)U
rise of an affluent middle class is generating demand for the mobile
and internet segments.
Airnet Limited is a leading Indian telecommunications company

with its operations spread across all major cities in India. The head-
quarters of the company is in New Delhi. The company’s product of-
ferings include 2G, 3G and 4G wireless services, mobile commerce,
fixed-line services, high-speed DSL broadband and DTH services.
As of 2017, it has a customer base of around 10 million users, and
by the end of 2020, it is looking at a growth rate of 35%. Moreover,
it is looking for global expansion.
As the company is in its expansion mode, it has two lucrative cor-

porations to acquire. Below are the details of the two projects. Note
that the company has Rs. 25 Cr at its disposal to invest in one of
the two corporations.
(C
A. Corporation A
a. Revenues generated – Rs. 10 Cr and growing at the rate

of 8%
b. Expenses incurred – Rs. 2 Cr and increasing at the rate

of 12%
c. Depreciation Expenses – Rs. 50 Lacs

Contd....
142
S
B. Corporation B
Notes
a. Revenues generated – Rs. 15 Cr and growing at the
___________________
rate of 7%
___________________
b. Expenses incurred – Rs. 6 Cr and increasing at the rate
___________________ of 10%
___________________ c. Depreciation Expenses – Rs. 1 Cr
PE
___________________
Considering tax rate of 25% and a discount rate of 10%, find out
___________________ in which project should the company invest? Also, use the payback
period method, net present value methods, internal rate of return
___________________
method and probability index method to support your decision.
___________________
___________________
___________________
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(C
S
PEBLOCK–IV
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(C
Detailed Contents
S
UNIT 16: LEVERAGE ANALYSIS ll Pecking Order Theory
ll Concept of Leverages ll Factors Determining Capital Structure
ll Types of Leverages ll Capital Structure Theories
ll Combined Leverage ll Summary
ll Summary ll Review Questions
PE
ll Review Questions
UNIT 19: DIVIDEND DECISIONS
AND POLICIES
UNIT 17: EBIT–EPS ANALYSIS
ll Introduction: Dividend Decisions
ll Constant EBIT with Different Financing Patterns
ll Dividend Policy
ll Financial Break-Even Level
ll Dividend Relevance Theory
ll Indifference Point/Level
ll Dividend Irrelevance Theory
ll Summary
ll Summary
ll Review Questions
ll Review Questions
UNIT 18: CAPITAL STRUCTURE
ll Introduction UNIT 20: CASE STUDY: VELVET HANDS–
DESIGNING ITS OWN CAPITAL
ll Significance of Capital Structure
Patterns of Capital Structure

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ll
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139
Unit 16
S
Notes
___________________
Leverage Analysis ___________________
___________________
Objectives:
___________________
At the end of this unit, students will be able to:
PE
___________________
� Explain the concept of leverage
\\ Discuss the operating leverage and its Importance ___________________
\\ Discuss the financial leverage and its importance ___________________

\\ Describe combined leverage
___________________
___________________
Introduction
___________________
A firm raises its required finance by either equity or debt or both.
While determining an optimum capital structure, a firm can use
fixed cost carrying securities for maximization of shareholders’
wealth. Leverage implies using debt funding to complement invest-
ment. As leverage can help maximize gains or losses, companies em-
ploy it to enhance returns to stock. The relationship between debt
)U
financing and its impact on shareholder earnings would be covered
in this chapter.
Concept of Leverages
Leverage defines the link between two interrelated variables where
a modification in one variable is divided by alteration in another
variable. In simple words, Leverage is used to define a company’s ca-
pability to use fixed cost assets or fund sources to amplify the earn-
ings to owners.
Mathematically, leverage can be defined as:
% Change in dependent variable

Leverage =
% Change in dependent variable
(C
Types of Leverages
There are three types of leverages discussed below.
1. Operating Leverage: the relationship between levels of EBIT

and Sales revenue
140
2. Financial Leverage: relation between levels of PAT/EPS and
S
Notes EBIT
___________________
3. Combined Leverage: relation between sales revenue and
___________________ EPS using both operating and financial leverage.
___________________
Operating Leverage
___________________
Operating leverage (OL) is used for measuring the effects of changes
PE
___________________
in revenue from sales on the EBIT level. Mathematically, Operating
___________________ leverage can be defined as:
___________________
% Change in EBIT
Operating Leverage =
___________________ % Change in Sales Revenue
___________________
Operating leverage of 1 denotes that the percent change in EBIT
___________________ level is directly proportional to the percent change in sales level.
This means that EBIT will increase or decrease proportionally with
an increase or decrease in the sales revenue. This happens when the
total Cost is variable, without any fixed costs. In case, if some fixed
cost involved, the degree of operating leverage (DOL) will be more
than 1 every time.
)U
Refer to the below example to understand the variation of DOL
when the sales level changes from 1,000 units to 1,400 units.
Example 16.1
Table 16.1: Change in DOL when the Sales Level Changes
Sales Level 1000 Units 1400 Units

Sales @ Rs. 10 per Unit Rs. 10,000 Rs. 14,000
− Variable Cost @ Rs. 7 per unit 7000 9800
− Fixed Cost 1,000 1,000
EBIT 2,000 3,200

DOL= 3000/2000 4200/3200
1.5 1.31
When the sales level changes from 1,000 units to 1,400 units,the
(C
DOL changes from 1.5 to 1.31.Thus, the firm will have a different
DOL at different levels of operations. If the firm is operating above
the break-even level, the DOL will decrease with increasing sales
level. This is because the contribution of the fixed cost will become
relatively smaller when compared to the total sales revenue. More-
over, it should be noted that in case a company is operating at a
break-even level, the DOL is undefined.
Unit 16: Leverage Analysis
141
A firm should always avoid operating under high DOL. A high DOL
S
condition is a high-risk situation for the firm and an even marginal Notes
decrease in the sales will significantly affect the profits of the firm. ___________________
Moreover, the firm should operate at a DOL that is slightly higher ___________________
than the break-even point so that the effect of fluctuations of sales
___________________
can be minimized.
___________________
Financial Leverage
PE
___________________
The financial leverage (FL) describes the effects of variation in EBIT
___________________
levels on the level of EPS. Mathematically financial leverage can be
defined as: ___________________
___________________
% Change in EPS
Financial Leverage =
% Change in EBIT ___________________
___________________
We may note here that EBIT is the dependent variable when calcu-
lating OL and becomes an independent variable when considering
FL. Thus, EBIT is also called the linking point in the leverage study.
To understand the implication of debt in FL, consider the following

example continued from the OL.
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Example 16.2 Consider the same example of OL (Example 15.1) in
the absence and presence of debt financing.
1. In the absence of debt financing:

Table 16.2: Change in FL when the Absence of Debt Financing
1400
Sales Level 1000 Units Units
EBIT 2000 3200
− Interest – –
− Tax @ 50% 1000 1600
PAT 1000 1600
No. Of Shares 500 500
EPS Rs. 2 Rs. 3.2
% Change in EBIT = (3200 − 2000)/2000 = 60
% Change in EPS = (3.2 − 2)/2 = 60
(C
FL = 60/60 = 1
Thus, when the fixed interest charge in the form of interest on

debt financing is not there, both EBIT and EPS change by the
same percentages and FL = 1.
2. In the presence of debt financing: The firm raises Rs. 2,000 by

issuing 10% debentures to partly finance the capital requirements
142
Table 16.3: Change in FL When the Presence of Debt Financing
S
Notes
1400
___________________ Sales Level 1000 Units Units
EBIT 2000 3200
___________________
− Interest 200 200
___________________
PBT 1800 3000
___________________ − Tax @ 50% 900 1500
PE
PAT 900 1500
___________________
No. of Shares 300 300
___________________ EPS Rs. 3 Rs. 5
___________________ % Change in EBIT =(3200− 2000)/2000 = 60

% Change in EPS =(5 −3)/3 = 66.67
___________________
FL = 66.67/60 = 1.11
___________________
___________________ Thus, when a change in the fixed interest rate is included in the
shape of interest on debt-financing, Degree of financial leverage
is greater than one and both EPS and EBIT change by varying
percentages.
As results total earning to the shareholder’s increase because

the additional funds generated through debt financing are
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available to them. This fixed income charge is tax deductible
and provides a tax shield. This tax shield also increases the
earnings and, hence, proportionately increases the EPS.
Combined Leverage
Operating Leverage bears implications for operating risks and is
measured as the proportionate alteration in EBIT due to the pro-
portionate change in sales. Financial Leverage bears implications
for financial risk and is calculated as changes in EPS due to changes
in EBIT.
Combined leverage can be defined as the proportionate change in

EPS due to the proportionate change in sales. Combined leverage
(CL) is a product of OL and FL.
(C
The CL may also be described as percentage change in EPS for an

agreed percentage modification in sales levels and shall be calculat-
ed as follows:
CL = OL × FL
% Change in EBIT % Change in EPS

CL = × % Change in EBIT
% Change in Sales Revenue
Unit 16: Leverage Analysis
143
S
% Change in EPS
CL = Notes
% Change in Sales
___________________
The Degree of Combined Leverage (DCL) = DOL x DFL
___________________
Thus, the CL explains how OL and FL interact, and a change in
___________________
sales level produces a change in EPS level.
___________________
PE
Summary ___________________
Leverage can be described as the capability of a company to utilize ___________________
its immovable assets such that they yield the highest rate of return ___________________
in terms of revenue to the firm. It represents fixed cost portion of
___________________
a firm. Operating leverage refers to the measurement of operating
risk from the fixed operating costs. Financial leverage (FL) refers to ___________________
the measurement of risk associated with financing a part of assets ___________________

of a firm, including fixed financing charges. The higher the FL, the
higher the financial risk and the cost of capital. Operating leverage
for a defined level of sales is calculated by dividing proportionate
change in earnings before income and taxes (EBIT) to proportionate
change in sales. FL at a given level of sales is computed by dividing
percent change in EPS to percent change in EBIT.
)U
Review Questions
1. The following information for XYZ Company Ltd. is provided.
Calculate
(a) Operating leverage with 4,000 and 6,000 quantity of sales
(b) Operating breakeven point
Given, selling price Rs. 300 per unit, variable cost Rs. 200
per unit, fixed cost Rs. 2, 40,000
2. Analyse the importance of the financial leverage (FL) for a firm.
3. What is leverage? How does increase in leverage indicates an

increased risk?
(C
4. ABC Ltd. has an average selling price of Rs. 10 per unit. Its
variable cost is Rs. 7 per unit, and fixed cost is Rs. 1,70,000.
It finances all its funds through equity. XYZ Ltd. is identical
to ABC Ltd., except it finances 50% of its funds through debt
financing and pays an interest charge of Rs. 20,000. Determine
the degree of operating leverage (DOL), FL and combined lever-
age (CL) at Rs. 7,00,000 sales and tax of 50% for both the firms.
144
5. Examine the balance sheet and income statement of Sudeep
S
Notes Corp.
___________________ Balance Sheet
___________________
Liabilities Amount Assets Amount
___________________ Equity Capital (Rs 10 Rs. 8,00,000 Fixed Assets Rs. 10,00,000
per share)
___________________
PE
Retained Earnings 3,50,000 Current Assets 9,00,000
___________________
10% Debt 6,00,000
___________________ Current Liabilities 1,50,000
___________________
Income Statement
___________________
Sales Rs. 3,40,000
___________________ −Operating Expenses 1,20,000
___________________ EBIT 2,20,000

PBT 1,60,000
−Tax@50% 80,000
PAT 80,000
Calculate–
(a) OL, FL and CL

)U
(b) If total assets remaining constant and
(i) Sales increasing by 20%
(ii) Sales decreasing by 30%

(C
145
Unit 17
S
Notes
___________________
EBIT–EPS Analysis ___________________
___________________
Objectives:
___________________
After completion of this unit, the students will demonstrate knowledge of:
PE
___________________
\\ Constant and varying earnings before income and taxes (EBIT) with
the different financial pattern ___________________
\\ The connection of EPS and EBIT
___________________
\\ Financial break-even level
___________________
\\ Indifference point/level of EBIT
___________________
Introduction ___________________
As has been previously discussed, varying combinations of equity,

preference, and debt financing have distinct tax and cost conse-
quences. The financing pattern affects the apportionment of earn-
ings before income and taxes (EBIT) over different elements, espe-
cially, the returns to the shareholders.
)U
Unique EPS (earnings per share) will result from unique combina-
tions of various sources of finance which implies, thus, diverse levels
of EPS would be there for different patterns of financing. Therefore,
there is an interaction between varying levels of EBIT and financing
patterns, which affect the EPS in multiple ways. These implications
of financing patterns can be studied as ‘EBIT–EPS’analysis under
the following two categories:
Constant EBIT with diverse financing patterns
Varying EBIT with diverse financing patterns
Constant EBIT with Different Financing Patterns

The issue of bonds helps a firm enhance its leverage as the reve-
(C
nue so generated is used to issue new assets. This is accomplished

by differentiating the financial leverage and keeping EBIT at same
levels. The effects of a change in leverage on the EPS, keeping EBIT
constant, is discussed by using the below example:
Example 17.1 ABC Corporation expects the EBIT as Rs. 1,50,000

on an investment of Rs. 5,00,000 (which is the total funds available).
Funds are generated by the firm through the issue of equity share cap-
146
ital, preference shares at 12% or a combination of both. Below are four
S
Notes
options available for the company to determine the capital structure:
___________________
1. Equity Share Capital to be issued at Par.
___________________
2. Half of the funding is through equity shares, and the remaining
___________________
half is through preference shares.
___________________
3. Half of the funding through equity shares, one-quarter of
PE
___________________
funding through preference shares and the remaining quarter
___________________ through 10% debentures.
___________________ 4. Half of the funding through 10% debentures, a quarter of fund-
___________________ ing through preference shares and the balance through equity
___________________
share capital.
___________________ Solution: Assuming the tax rate to be at 50% the EPS the above
options is calculated in the following way:
Table 17.1: Change in EPS at Different Financing Levels
Option1 Option2 Option3 Option4

Equity Share Capital Rs. 5,00,000 Rs. 2,50,000 Rs. 2,50,000 Rs. 1,25,000
Preference Share Not
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Capital applicable Rs. 2,50,000 Rs. 1,25,000 Rs. 1,25,000
Not Not
10% Debentures applicable applicable Rs. 1,25,000 Rs. 2,50,000
Rs.
Total Funds Rs. 5,00,000 Rs. 5,00,000 5,00,000 Rs. 5,00,000
EBIT 1,50,000 1,50,000 1,50,000 1,50,000
Not Not
− Interest applicable applicable 12,500 25,000
PBT 1,50,000 1,50,000 1,37,500 1,25,000
− Tax 50% 75,000 75,000 68,750 62,500
PAT 75,000 75,000 68,750 62,500
Not
− Preference Dividend applicable 30,000 15,000 15,000
Profit for Equity
Shares 75,000 45,000 53,750 47,500
No. of Equity Shares
(of Rs. 100 each) 5,000 2,500 2,500 1,250
(C
EPS 15 18 21.5 38
We can see from above example that as the company increases the
financial leverage, there is a gradual increase in the EPS. Here, in
all the four options, the company is expecting a return of 30%. Using
equity financing in Option 1, the EPS is Rs. 15, which is same as the
post-tax investment returns. In Option 2, the EPS has increased from
Unit 17: EBIT–EPS Analysis
147
Rs. 15 to Rs. 18 because the shareholders have an extra benefit of 3%.
S
In Option 3, the additional benefit to shareholders enhances further Notes
when 10% debt is also introduced; thus, EPS increases to Rs. 21.5. In ___________________
Option 4, the EPS finally increases to Rs. 38. When preference shares ___________________
and debts are used more by the company to raise funds, the after-tax
___________________
return on investment of preference shares and debt is more than af-
ter-tax cost. This, in turn, causes the EPS to gradually increase. ___________________
PE
___________________
Example 16.2 Using the details from Example 16.1, the return on
investment is reduced from 30% to 18%. Find the effect on EPS, ___________________
when EBIT is reduced to 18%. ___________________
Solution ___________________
Table 17.2: Change in EPS When EBIT is Reduced ___________________
___________________
Option1 Option2 Option3 Option4
EBIT Rs. 90,000 Rs. 90,000 Rs. 90,000 Rs. 90,000
− Interest 12,500 25,000
PBT 90,000 90,000 77,500 65,000
− Tax 50% 45,000 45,000 38,750 32,500
PAT 45,000 45,000 38,750 32,500
− Preference Dividend 30,000 15,000 15,000
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Profit for Equity Shares 45,000 15,000 23,750 17,500
No. of Equity Shares(of Rs.
100 each) 5,000 2,500 2,500 1,250
EPS 9 6 9.5 14
In this case, the EPS under Option 1 is Rs. 9, which is equivalent to

the post-tax return on investment. Since in Option 1, the company
is using all the equity to finance the funds, in Option 2, the EPS
reduces to Rs. 6. This is because the firm uses 50% equity and 50%
preference shares for financing. Moreover, the company is expecting
a return of 9% but is paying 12% to preference shareholders. The
burden then lays on the equity shareholders, which results in the re-
duction of EPS. Further, in Options 3 and 4, the EPS will eventually
increase as after-tax cost using debt financing is less.
(C
It is evident from the above two instances that return on investment

of the firm lends changes to financial patterns which in turn is de-
picted on the behavior of EPS. The financial leverage is believed to
be favorable where the return on investment of the company is high-
er than debt cost and this lends the earnings of the shareholders to
be greater as the degree of financial leverage is higher. Same is true
the other way.
148
Varying EBIT with Different Financing Patterns
S
Notes
Practically, considering EBIT as constant is unrealistic. The EBIT
___________________
level varies with a change in financing patterns; therefore, the con-
___________________ sequence of financial leverage on EPS should be analyzed under the
___________________ hypothesis of variable EBIT. Refer to the below example for the same:
___________________ Table 17.3: Change in EPS at Different Financing Levels of EBIT
PE
___________________
Poor Economic Normal Economic Good Economic
___________________ Condition Condition Condition
Total Assets Rs. 2,00,000 Rs. 2,00,000 Rs. 2,00,000
___________________
ROI 5% 8% 11%
___________________ EBIT Rs. 10,000 Rs. 16,000 Rs. 22,000
A & Co.( No financial leverage)
___________________
EBIT 10,000 16,000 22,000
___________________ − Interest – – –
PBT 10,000 16,000 22,000
− Tax @ 50% 5,000 8,000 11,000
PAT 5,000 8,000 11,000
No. of Shares 2,000 2,000 2,000
EPS 3 4 6
B & Co.( 50% financial leverage)
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EBIT 10,000 16,000 22,000
− Interest 6,000 6,000 6,000
PBT 4,000 10,000 16,000
− Tax @ 50% 2,000 5,000 8,000
PAT 2,000 5,000 8,000
No. of Shares 1,000 1,000 1,000
EPS 2 5 8
C & Co.( 75% financial leverage)
EBIT 10,000 16,000 22,000
− Interest 9,000 9,000 9,000
PBT 1,000 7,000 13,000
− Tax @ 50% 500 3,500 6,500
PAT 500 3,500 6,500
No. of Shares 500 500 500
EPS 1 7 13
(C
From the above table it can be concluded that when EBIT levels
change according to financial patterns, it leads to changes in EPS
levels. This can be further explained by taking the EBIT levels of
‘Normal Economic Condition’ in the above example as 100 and then
calculating the percentage increase or decrease in the levels of EPS
when the levels of EBIT changes.
149
Table 17.4: Percentage Change in EPS at Different Financing Levels of
S
EBIT Notes
Normal Good ___________________

Poor Economic Economic Economic
Condition Condition Condition ___________________
EBIT 62.50 100 137.50 ___________________

A &Co.( No financial leverage)
___________________
EPS 62.50 100 137.50
PE
___________________
% Change from Normal −37.5% - +37.5%
B & Co.( 50% financial leverage) ___________________
EPS 40.00 100 160.00 ___________________

% Change from Normal −60% - +60%
___________________
C & Co.( 50% financial leverage)
___________________
EPS 14.30 100 185.70
% Change from Normal −85.7% - +85.7% ___________________
The table above helps us conclude that as the EBIT levels change, fi-
nancial leverage is enhanced with a magnifying effect on EPS. More-
over, note that if ROI is equal to the financial leverage, there is no
magnifying effect on EPS. This also means that firms leveraged or
)U
unleveraged have the same EPS when EBIT or ROI is the same as
the cost of debt.
Financial Break-Even Level

Break-even level is that stage of EBIT, where fixed financial charges
are barely covered by the EBIT, and the EPS is nil. In case the finan-
cial break-even level is higher as compared to the present EBIT, the
EPS shall be negative.
Below mentioned is the method to calculate break-even level:
llIn case the firm has employed only Debt:
Financial Break-even EBIT = Interest Charge

(C
llIn the case where the firm employs preferential share capital
along with the debt:
Financial Break-even EBIT = Interest Charge + Prefer-

ence Dividend (1 − t)
150
Indifference Point/Level
S
Notes
___________________ The point where EPS is fixed despite debt-equity combination, it

is called the indifference level of EBIT. In other words, it is the in-
___________________
stance where two or more financial plans of the firm provide the
___________________ same EPS at a given level of EBIT.
___________________
Indifference Point Analysis: When EPS from different financial
PE
___________________ plans is an independent variable and EBIT is a dependent variable,
___________________ the indifference point would be the level where ROI Is same as the
after-tax cost of debt because, at this juncture, the company would
___________________
be indifferent regarding the capital structure. The following exam-
___________________ ple will shed more light on the concept:
___________________
Example 17.3 Suppose after implementing an expansion plan for
___________________ Rs. 50,00,000 a company is expecting an EBIT of Rs. 55,00,000. The
fund’s requirement can be achieved either by issuing equity share
capital at the cost of Rs. 5,000 each or by issuing 10% debentures.
If the total number of shares is 10,000, calculate the EPS under the
two plans.
Solution
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Table 17.5: Calculation of Indifference Point
Financial Plan 1 Financial Plan 2

Number of existing Shares 10,000 10,000
Number of New Shares 1,000 -
Total Number of Shares 11,000 10,000
10% Debentures - Rs.50,00,000
EBIT Rs.55,00,000 Rs.55,00,000
−Interest - Rs. 5,00,000
PBT Rs. 55,00,000 Rs. 50,00,000
Tax@50% Rs. 27,50,000 Rs. 25,00,000
PAT Rs. 27,50,000 Rs. 25,00,000
EPS Rs. 250 Rs. 250
Therefore, in the above example, it clearly illustrates that the EPS

(C
is Rs. 250 irrespective of the composition of capital structure or how

the new funds are raised.
Thus, the indifference level for an all-equity plan and equity–debt

plan may be arrived using the following formula:
EBIT (1 – t) (EBIT – Interest(1 – t)

=
N1 N2
151
Here,
S
Notes
t is the tax rate.
___________________
N1 is the number of equity shares outstanding under the first alter- ___________________
native.
___________________
N2 is a number of equity shares outstanding under the second alter-
___________________
native.The value of EBIT in this equation is the indifference level of
PE
___________________
EBIT.
___________________
After learning about the EBIT and EPS analysis in detail, we will
learn about capital structure in the next unit. ___________________
___________________
Summary
___________________
For a given level of EBIT, a blend of diverse sources of finance will ___________________
have an outcome of specific earnings per share. The EBIT level var-
ies with a change in financing patterns; therefore, the consequence of
financial leverage on EPS is analyzed under the postulation of chang-
ing EBIT. Financial break-even point is achieved when fixed financial
charges of the company are barely met by the EBIT level. At the point
where EPS is fixed despite the type of debt-equity mix competition.
)U
Review Questions
1. Explain EBIT–EPS analysis and how it is dissimilar from lever-
age analysis?
2. What is financial break-even point? How is it calculated? Show

financial break-even point graphically.
3. Rs. 20 Lacs are required by a firm with two options:
(a) 100% equity
(b) 50% equity and 50% of 15% Debt
The expected EBIT of the company is Rs. 2,50,000 with a tax

rate of 40% and the equity shares are currently being issued at
(C
Rs. 100 per share. Find out the EPS for each of the options.
4. The operating income of a firm is Rs. 1,86,000 and tax is 50%.

Capital structure details are given below.
15% Preference Shares Rs. 1,00,000

Equity Shares (Rs. 100 each) 4,00,000
14% Debentures 5,00,000
152
(a) Determine the EPS of the firm.
S
Notes
(b) Determine the percentage change in EPS when there is a
___________________
30% change in EBIT.
___________________
(c) Determine the degree of financial leverage at the current
___________________
level of EBIT.
___________________
5. The following information about a firm’s capital structure is
PE
___________________
available:
___________________
Number of Shares Issued 10,000
___________________ Market Price of Shares Rs. 20
Interest Rate 12%
___________________
Tax Rate 46%
___________________ Expected EBIT Rs .15,000
___________________
The firm needs to raise additional capital of Rs. 1,00,000. What
should be the composition of financing by the firm to produce high
EPS? Also, find the indifference level of EBIT for the two alterna-
tives. What is the EPD for the EBIT?
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(C
153
Unit 18
S
Notes
___________________
Capital Structure ___________________
___________________
Objectives:
___________________
At the end of this unit, the students will be able to explain and identify:
PE
___________________
\\ The significance of capital structure in business
\\ Patterns of capital structure ___________________
\\ Pecking Order Theory ___________________

\\ Factors influencing capital structure ___________________
\\ Capital Structuring Theories
___________________
\\ Net Income Approach
___________________
\\ Net Operating Income Approach
\\ Traditional Approach
\\ Modigliani–Miller Approach
Introduction
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In order to sustain a business, in the long run, it is crucial to plan
regarding the capital structure. At first glance, you will notice that a
balance sheet has two sides Liability and Assets. The liability side is
inclusive of the finance that has been collected from multiple inter-
nal and external sources and shall be used for developing the busi-
ness or meeting unexpected exigencies.
While preparing a balance sheet for a company, the liabilities side is

under perfect capital structure planning making the balance sheet
correct and balanced. This shows that in order to make a strong
balance sheet capital structure planning is required which enhances
the ability of the business to face the losses and markets fluctua-
tions.
Significance of Capital Structure

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Capital structure’s significance can be described is as follows:
1. To decrease the business’ overall risk
2. To adjust according to the business environment
3. To find new sources of funds – idea generation

154
Patterns of Capital Structure
S
Notes
___________________ For a new company, any of the following four capital structure pat-
terns may apply:
___________________
llOnly with equity shares
___________________
___________________ llWith both equity and preference shares
PE
___________________ llWith both equity shares and debentures
___________________
llWith all three out of equity shares, preference shares, and de-
___________________ bentures
___________________
Pecking Order Theory
___________________
The pecking theory plays a great role in the capital structure. Ac-
___________________
cording to it, finance costs increase due to irregular information.
Following are three key sources of finance:
llInternal financing
llDebt financing
llEquity financing
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According to the Pecking Order Theory, sources of finance are duly
prioritized by companies where internal sources of finance are most
preferred. In case there is a need to resort to external sources of
finance, debt financing is preferred over equity financing. The the-
ory starts with asymmetrical information, as managers know more
about the risks, prospects, and values of the firm as compared to
outside investors. Asymmetric information is a situation that can
be termed at information failure. In this situation, one business
has more knowledge about the market as compared to others. This
asymmetric information influences the decisions to choose between
internal and external sources of financing and favors debt financing
over equity financing.
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Factors Determining Capital Structure:

The factors determining capital structure are explained as follows:
llTrading on equity: It refers to taking benefit of equity share

capital to borrow funds on favourable terms.
llThe degree of control: If a company wants maximum voting

rights only in their hands and do not want to raise capital
Unit 18: Capital Structure
155
by sharing the voting rights, they may influence the capital
S
structure. In this scenario, the company’s capital structure Notes
will consist of debenture holders and other loans. ___________________
___________________
llChoice of investors: In general, the company’s policy is to
diversify the category of investors for securities. It means ___________________
that the investor’s mix should include the ones that are bold ___________________
and risk-taking, which will prefer equity shares, while the
PE
___________________
conscious investors will include those who prefer loans and
debentures. ___________________
___________________
llCapital market conditions: During the whole lifecycle of
the company, the capital structure also gets influenced by ___________________
the prevailing market conditions. During the depression, the ___________________
company will prefer debentures/loans as a source of capital;
___________________
whereas, during inflation or a boon, the company will opt for
equity shares.
llPeriod of financing: If a company wants the capital for a

smaller period, they will prefer bank loans or internal financ-
ing. On the other hand, if the investment is required for a
longer period, the companies will prefer issuing debentures
)U
or equity shares.
llCost of financing: prior to deciding on a capital option, cost

of a factor should be analyzed by a company regarding the
capital structure.
llSize of the company: Bigger is the size of an organization,

more are its financing options. Big companies enjoy signif-
icant goodwill and can conveniently opt for issuing equity
shares or debentures, whereas small firms must use internal
finance or bank loans.
Capital Structure Theories

Relation amongst capital structure, company’s value and cost of cap-
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ital is determined by four different theories:
1. Net Income Approach (NI)
2. Net Operating Income Approach (NOI)
3. Traditional Approach
4. Modigliani–Miller Approach (MM)

156
Net Income Approach
S
Notes
According to this approach, by keeping a higher proportion of debt
___________________
in the capital structure, the firm can reduce the overall cost of cap-
___________________ ital (WACC/Weighted average cost of capital) which in turn would
___________________ lead to an increase in the firm’s value. Cost of capital is reduced
using debt because it is an economical finance source. WACC is that
___________________
average cost of equity and debts which has been weighted, where
PE
___________________ capital raised from each source is assigned a weight.
___________________
“WACC = (Required Rate of Return x Amount of Equity + Rate of In-
___________________ terest x Amount of Debt)/Total Amount of Capital (Debt + Equity)”
___________________
According to the NI approach, the value of a firm is affected by the
___________________ WACC which in turn is impacted by the firm’s financial leverage.
___________________
Assumptions of Net Income Approach
llFollowing are the main assumptions:
llInvestor confidence is not affected by an increase in debt
llDebt’s cost is lower than equity’s cost

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llThere is no tax burden
Cost
Ke, ko Ke
ko
kd
kd
Debt
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In the figure, as the percentage share of debt (kd) increases in the

capital structure, the WACC (Ko) reduces.
Net Operating Income Approach

Let us first know the assumptions of the Net Operating (NOI) Ap-
proach
157
Assumptions of Net Operating Income approach
S
Notes
The key assumptions of NOI approach are as follows:
___________________
llRegardless of the degree of leverage, the overall rate of capi- ___________________
talization remains fixed. For a given level of EBIT, value of a
___________________
firm would be: EBIT/Overall capitalization rate
___________________
ll“Value of Equity = Total Value of the Firm − Value of Debt.”
PE
___________________
Cost of equity surges and WACC remains fixed with an rise in debt.
___________________
If the amount of debt in the capital structure surges, there is an rise
___________________
in the risk for shareholders.
___________________
According to this approach, change in the debt-equity ratio of the
firm has no impact on its value based on the assumption that there ___________________
is an increase in the cost of capital for equity shareholders with a ___________________

corresponding increase in benefits derived from the increase in debt
results.
This can be clearly seen from Figure 18.1. If the debt to equity ratio
increases, there is a simultaneous increase in the cost of equity (Ke),
which keeps the WACC constant.
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cost of Equity, Ke
Weighted Average
Cost of
Capital (WACC)
Cost of Capital
Cost of Debt, Kd
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Degree of Leverage
Figure 18.1: NOI Approach to Capital Structure
Traditional Approach
Let us first discuss the assumptions of the traditional approach.

158
Assumptions of Traditional Approach
S
Notes
1. For a fixed period, the rate of interest on debt remains fixed,
___________________
and then it increased with an increase in leverage.
___________________
2. The anticipated rate of return for equity shareholders remains
___________________
fixed or increases gradually.
___________________
3. WACC initially reduced and thereafter increases due to the
PE
___________________
activity rate of interest and expected rate of return. Optimal
___________________ capital structure is the lowest point on the curve.
___________________
According to the traditional approach, the total cost of capital is the
___________________ lowest at a certain point of debt to equity ratio. Any change in both
___________________
these components will result in rise in the capital cost. Whereas NI
and NOI are two conflicting approaches, the traditional approach is
___________________
the ‘intermediate approach.’
Figure 17.2 clearly explains the traditional approach. There exists

a degree of leverage where WACC is the least. Beyond that range,
the WACC increases, which results in an upsurge in the capital cost.
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Cost of Equity, Ke
Weighted Average Cost of

Coast of Capital
Capital (WACC)
Cost of Debt, Kd
Optimal Level of
Degree of Leverage
D/E and WACC
Figure 18.2: Traditional Approach to Capital Structure

(C
Modigliani-Miller Approach
According to the Modigliani–Miller approach (MM approach), the

capital structure of a firm has no relation to its valuation and firm’s
value in the market is free from the leverage. According to this ap-
proach, it is the operating profits that have a direct bearing on a
firm’s market value.
159
According to the MM approach market value of a firm is affected by
S
its growth prospects and investment risks rather than the capital Notes
structure. It would be said that a company with high growth pros- ___________________
pects would have a higher market value and higher stock prices. In ___________________
case the investors feel that growth prospects of a firm are not good,
___________________
its market value would not be substantial.
___________________
Assumptions of the MM Approach
PE
___________________
llNo taxes are levied ___________________
llCost of transactions for sale and purchase of securities as well ___________________

as bankruptcy is nil.
___________________
llThe symmetry of information – The investor will have access to ___________________
the same information as what shareholders will have.
___________________
llBorrowing cost is similar for both investors and companies.
llEBIT is independent of debt financing.
Example 18.1 Consider a firm ABC with the following figures in

INR:
)U
Earnings before Interest Tax (EBIT) 1,00,000
Bonds (Debt part) 3,00,000
Cost of Bonds Issued (Debt) 10%
Cost of Equity 14%
(a) Use the NI approach to calculate the value of a firm
(b) What will be the change in the company’s value in case the debt
increases to Rs. 4,00,000 from Rs. 3,00,000.
Solution
EBIT 1,00,000
Less: Interest cost (10% of 300,000) 30,000

(C
Earnings after Interest and Tax (since the tax is

70,000
assumed to be absent)
Shareholders’ Earnings 70,000
Market value of Equity (70,000/14%) 5,00,000
Market value of Debt 3,00,000

160
S
Total Market value 8,00,000
Notes
EBIT/(Total value
___________________ of firm)
Overall Cost of Capital
___________________ 100,000/800,000
12.50%
___________________
___________________
If the debt portion increases to Rs. 4,00,000,
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___________________ EBIT 1,00,000
___________________ Less: Interest cost (10% of 300,000) 40,000
___________________
Earnings after Interest Tax (since the tax is
___________________ 60,000
assumed to be absent)
___________________
Shareholders’ Earnings 60,000
___________________
Market Value of Equity (60,000/14%) 428,570 (approx.)
Market Value of Debt 4,00,000

Total Market Value 8,28,570
EBIT/(Total value of
firm)
Overall Cost of Capital
100,000/828,570
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12% (approx.)
Thus, we can see that by increasing the leverage, the cost of capital
reduces.
Example 18.2 Consider a firm XYZ with the following figures. De-
termine in which case the WACC is the least.
Solution There are five scenarios of different possible mixes of debt

to equity proportions. We can see that the WACC is least for Case
3, where the debt and equity portion is 50% each. This supports the
traditional approach of capital structuring.
Particulars Case 1 Case 2 Case 3 Case 4 Case 5

Weight of debt 10% 30% 50% 70% 90%
Weight of
90% 70% 50% 30% 10%
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equity
Cost of debt 10% 11% 11% 14% 16%
Cost of equity 17% 18% 19% 21% 23%
WACC 16.30% 15.90% 15.50% 16.10% 16.70%
As per the above exercise only up to a particular level the WACC

is reduced due to increasing debt. When that level is breached any
subsequent rise in debt level would lead to an increase in the WACC
and a fall in the company’s market value.
161
Summary
S
Notes
Capital structure is defined as the proportion of equity and debt in a ___________________
company’s finances. It boosts a business’s power to withstand losses
___________________
and changes in the financial markets. It decreases the overall risk
of a business and adjusts according to the business environment. ___________________
There are four capital structure patterns. The pecking theory plays ___________________
PE
a great role in the capital structure. It states that the cost of financ-
___________________
ing increases with asymmetrical information. There are various fac-
___________________
tors that determine the capital structure, such as trading on equity,
the degree of control, choice of investors and period of financing. ___________________
___________________
Review Questions
___________________
1. Explain the traditional theory of cost of capital and capital
___________________
structure.
2. Explain the assumptions and implications of the net income

(NI) and net operating income (NOI) approaches?
3. Is there an optimal capital structure as per the NI and NOI

approaches?
)U
4. Critically examine how the Modigliani–Miller (MM) approach
to capital structure is an extension of the NOI approach.
5. ABC limited and XYZ limited are identical companies, except

that ABC Ltd. uses debt while XYZ does not. The levered firm
has issued 10% debentures worth Rs. 9,000,00. The total assets
of both the firms are Rs. 15,000,00 each, and EBIT is 20% of
total capital.
Assuming capitalization rate to be 15% for the all-equity firm,
(a) Use the NOI approach to calculating the value of two

firms.
(b) Use the NOI approach to calculate WACC of both firms.

(C
6. A company’s current operating income is Rs. 5,000,00. The firm

has Rs.1 0,000,00 of 8% debt outstanding. The cost of equity is
15%.
(a) Calculate the current value of the firm using the tradi-
tional valuation approach.
(b) Compute the overall capitalization rate of the firm.

162
(c) If the firm raises the leverage by raising an additional Rs.
S
Notes 5,00,000/- debts and uses the debts to retire an equivalent
___________________ amount of equity. Thereafter the cost of equity becomes
___________________ 18%, and the cost of debt becomes 12%. Should this ap-
proach be selected by the company?
___________________
(d) For the second plan, in (c), calculate the value of the firm
___________________
using the MM approach. Assume that all the assumptions
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___________________
of the MM theory are met.
___________________
___________________
___________________
___________________
___________________
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(C
163
Unit 19
S
Notes
___________________
Dividend Decisions ___________________
and Policies ___________________
___________________
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Objectives: ___________________
After completion of this unit, the students shall:
___________________
\\ Understand the notion and significance of dividend decisions
___________________
\\ Understand Dividend Policy and know its Relevance
\\ Explain dividend relevance theory– Walter Model and Gordon Model ___________________
\\ Explain dividend irrelevance theory– Modigliani–Miller Approach ___________________
___________________
Introduction: Dividend Decisions
It is one of the most crucial decisions that must be taken by the fi-
nance manager as it relates to total amount that must be paid to the
equity holders as a pay-out. The pay-out made to the shareholders
is categorized in terms of earnings per share (EPS) and is given as
)U
dividend. The optimal dividend decision results in an increase of
wealth of shareholders with a simultaneous increase in the price
of company’s shares. Maximization of shareholder’s wealth is the
essence of financial management; it is all the more essential for the
finance manager to arrive at a mutually beneficial solution for both
the company as well as shareholders.
Dividend Policy
It is a purely financial decision that decides the percentage of com-
pany’s income to be paid to shareholders so that their confidence in
the firm receives a boost. It is very critical to decide what portion
of the profits should be paid back as dividends and what should be
retained as a portion of retained earnings. According to different
dividend models, some models believe that shareholders do not have
(C
any concerns with the dividend policy, whereas others believe that
dividends have a great impact on share prices. These views gave rise
to following theories:
1. Dividend Relevance Theory
2. Dividend Irrelevance Theory

164
Dividend Relevance Theory
S
Notes
___________________ As the name suggests, this theory believes that dividends are im-
portant and have a substantial impact on the share price of the com-
___________________
pany. There are two models, which are based on this theory:
___________________
___________________ Walter’s Model
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___________________ This model was proposed by Prof. James E Walter, which states that
dividends do hold significant relevance and impact the firm’s share
___________________
prices.
___________________
The model explicitly defines the relations between the ROI or inter-
___________________
nal rate of return (r) and the cost of capital (k) through the following
___________________ probable scenarios:
___________________
(a) If r > k, that implies that there are better internal opportuni-
ties and more can be gained compared to what shareholders
gain by reinvestment. In such a scenario, the firm should retain
100% of the earnings. These types of firms are called ‘Growth
firms’ and have ‘Zero Pay-out.’
)U
(b) If r < k, it means shareholders have better investment oppor-
tunities outside the firm. In such a scenario the payout ratio
is 100% meaning that the firm should pay all its income as a
dividend.
(c) If r = k, the firm’s dividend policy will not have any impact on
the firm’s value. Here, the firm can retain anything between 0%
and 100%.
Mathematically, Walter’s model can be represented as follows:
æ r ö
* (E - D)
D çè Ke ÷ø
P= +
Ke Ke
(C
Where, P = Price of the share
D = Dividend per share paid by the firm
r = Rate of return on investment of the firm
Ke = Cost of equity share capital
E = Earnings per share of the firm

Unit 19: Dividend Decisions and Policies
165
Assumptions of Walter’s Model
S
Notes
llInternal sources of finance only are used and no requirement
___________________
for external sources.
___________________
llIndependent of any changes in investments, the rate of return
___________________
(r) and the cost of capital (K) remain constant.
___________________
llEntire income of the firm is either retained or evenly distribut-
PE
___________________
ed to shareholders
___________________
llThe EPS and dividend per share (DPS) remain constant.
___________________
llThe firm has an ongoing tenure.
___________________
Gordon’s Model ___________________
Proposed by Myron Gordon, this model also substantiates the fact ___________________
that dividends are vital and have an impact on the share prices. In
order to understand the effects of dividend policy, this model propos-
es usage of dividend capitalization.
As per Gordon’s model, firm’s market value is equal to the future

dividends current value.
)U
P = {E * (1 − b)/Ke − br}
Where, P = Price of a share
E = Earnings per share.
b = Retention ratio
1 – b = Proportion of earning which is distributed as dividends
Ke = Capitalization rate
br = Growth rate
Assumptions of Gordon’s Model
llThe firm is an all-equity firm; no external finance is needed, but

only internal income is used for financing the investment .
(C
llThe cost of capital (K) and rate of return (r) remain fixed.
llThe life of the firm is indefinite.
llRetention ratio remains fixed after it has been decided.
llGrowth rate is constant (g = br).
llCost of capital is greater than br.

166
Example 19.1 The key details for ABC limited are as follows:
S
Notes
EPS or E = Rs. 10
___________________
___________________ Cost of capital Ke = 0.1
___________________ Find out the diverse market prices of the share under the different
___________________ rate of return, r, of 8%, 10% and 15% for the different pay-out ratio
of 0%, 40%, 80% and 100% using Walter’s Model and Gordon Model.
PE
___________________
___________________ Solution
___________________ For Walter Model,

___________________ æ r ö
* (E - D)
D çè Ke ÷ø
___________________ P= +
Ke Ke
___________________
DPS is calculated as Pay-out ratio * EPS
r = rate of return on investment

D/P Ratio Values of D 8% 10% 15%
0% 0 80 100 150
40% 4 88 100 130
)U
80% 8 96 100 110
100% 10 100 100 100
For Gordon Model,
P = {E * (1 − b)/Ke − br}
r = rate of return on investment

D/P Ratio Values of b 8% 10% 15%
0% 1 0 0 0
40% 0.6 76.93 100 400
80% 0.2 95.24 100 114.28
100% 0 100 100 100
From the calculation of price per share from both the methods, we
(C
can state that
llFor r >ke, the share price is maximum if the payout ratio is

minimum, that is if the company retains entire earnings.
llFor r < ke, the share price is maximum if the payout is 100%,
implying that all retained income has been paid back to the
shareholders.
Unit 19: Dividend Decisions and Policies
167
Dividend Irrelevance Theory
S
Notes
As the name suggests, this theory believes that dividends are not ___________________
important and do not affect the share price. There is one theory,
___________________
Modigliani–Miller who is based on this.
___________________
Modigliani–Miller Approach on Dividend Policy
___________________
PE
As per the Modigliani–Miller approach, the dividend has no effect on ___________________
the company share price and suggests that the investment policy in-
___________________
creases the share capital. Moreover, according to it the satisfaction
level of investors is always high if ROI is more than equity capital- ___________________
ization rate ‘Ke.’ ___________________
Equity capitalization rate can be defined as the rate at which eq- ___________________
uity of the firm is created by capitalization of income, revenue or ___________________
dividends. If ROI is lower than this rate, shareholders will prefer to
receive more dividends from firm’s earnings.
Assumptions of Modigliani–Miller Approach
llThe market is a perfect capital market

)U
llEntire relevant market information readily available
llNo floatation or transaction costs
llNo investor is large enough to influence the market price
llSecurities are infinitely divisible.
llThere are no taxes. Dividends and the capital gains are taxed
at the similar rate.
llThe company follows a constant investment policy.
llNo uncertainty about the future profits
llDue to no risk factor, Investors are certain regarding the divi-

dends, future investments, and profits of the firm
(C
Summary
Dividend Policy is a purely financial decision that decides what
percentage of the firm’s income is to be paid back to investors to
enhance their confidence in the future of the firm. It involves two
forms of theories, the ‘Dividend Relevance Theory’ and the ‘Dividend
Irrelevance Theory.’
168
Review Questions
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Notes
___________________ 1. List out the assumption under Gordon’s Model of dividend ef-
fect? Is the value of the firm affected by dividend policy under
___________________
this model.
___________________
2. “Models proposed by Walter and Gordon Models are based on
___________________
the similar assumptions. and therefore there is no elementary
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___________________ variance between them. Do you agree? Why?
___________________
3. ‘Irrelevance hypothesis proposed by Miller and Modigliani is
___________________ based on unrealistic assumptions.’ Explain.
___________________ 4. A company has total investments of Rs. 5,00,000 assets and
___________________ 50,000 outstanding shares of Rs. 10 each. It earns a rate of
15% on its investments and has a policy of retaining 50% of the
___________________
earnings. If the appropriate discount rate for the firm is 10%,
determine the price of its share using the Gordon Model. What
will happen to the price of the share if the company has a pay-
out of 80% or 20%?
5. The Earning per Share of a company is Rs. 10. It has an inter-

nal rate of return of 15%, and the capitalization rate of the risk
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class is 12.5%. If Walter’s model is used,
(a) Calculate the best pay-out for the company?
(b) At this pay-out what would be the price per share? and
(c) In case a different pay-out is used, how it will affect the

price of shares?
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Unit 20
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Notes
___________________
Case Study: Velvet Hands– ___________________
Designing Its Own Capital ___________________
___________________
Velvet Hands Ltd. is an interior designing and home décor firm. It
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is newly incorporated and is a listed company. It started its busi- ___________________
ness in 2015 and is experiencing tremendous growth. Its headquar-
___________________
ters are based in Mumbai, India.
___________________
Overview of the Industry
___________________
Interior designing and home décor is largely an unorganized sector.
Interior designing firms specialize in designing and decorating in- ___________________
terior spaces. A recent study indicates that the interior designing ___________________
market in India is growing at a whopping 60%.
Earlier, Interior designing used to be a part of the architecture,

but in 1980’s it started to be considered as a separate discipline.
With more corporates and luxury lifestyles coming up, this field has
grown tremendously.
What is helping this industry grow?

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llModern construction in all major cities and small towns in
India.
llThe increment in the disposable income of people in India.
llNeed to make smaller spaces more practical, comfortable and

multi-functional.
Velvet Hand’s has an all-equity capital with Earning before income

and taxes of Rs. 2 Cr. The company appoints a new finance man-
ager, Mr. Sudeep, to look into its financials and provide an optimal
capital structure such that the cost of overall capital is minimized
and the company can increase its earning by leveraging on taxa-
tion. The firm has 10 lakh shares outstanding.
As per Mr. Sudeep’s discussion with the company’s business heads,

he explains that ‘an ideal capital structure would be the best
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debt-equity ratio for a firm that maximizes its value. Being tax de-
ductible, debt financing generally offers the lowest cost of capital’.
He also recommends for the purpose of analysing the cost of debt,
short-listing a few of the best-performing companies in the indus-
try. Mr. Sudeep was then asked to pursue the idea and develop an
optimal capital structure for the company. At first, he obtains the
following estimated cost of debt for the firm at the different capital
structure:
Contd....
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Notes Percentage of Capital
Financed with Debt Cost of Debt Rd
___________________ 0% -
___________________ 20% 8%
30% 8.5%
___________________ 40% 10%
___________________ 50% 12%
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___________________ The company gives out dividends at a constant growth rate of 10%
and pays a dividend of Rs. 2 per share to its shareholders. The com-
___________________
pany wants to maintain total capital (Equity + Debt) of the firm at
___________________ Rs. 25 Cr.
___________________ Mr. Sudeep has to use the above data and his knowledge of capital
structure theories and cost of capital to formulate an optimal capi-
___________________
tal structure for Velvet Hands Ltd.
___________________
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Detailed Contents
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UNIT 21(A): WORKING CAPITAL MANAGEMENT UNIT 23: INVENTORY MANAGEMENT
ll Introduction ll Introduction
ll The Concept of Working Capital ll Inventory
ll Summary ll Components of Inventory
ll Review Questions ll Inventory Management Motives
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ll Techniques of Inventory Management
UNIT 21(B): RECEIVABLES
MANAGEMENT ll Objectives of Inventory Control
ll Introduction ll Functions of Inventory Control
ll Estimation Process ll Types of Manufacturing Inventories
ll Summary ll Inventory Costs
ll Review Questions ll Factors Affecting Inventory
ll Summary
UNIT 22: ESTIMATION AND CALCULATION
OF WORKING CAPITAL ll Review Questions
ll Introduction
UNIT 24: CASH MANAGEMENT
ll Characteristics of Accounts Receivables
ll Introduction
ll Classifications/Types of Accounts Receivable
ll Objectives of Cash Management
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ll Accounts Receivables Management
ll Factors Determining Cash Requirements
ll Objectives of Accounts Receivable Management
ll Role of planning, control and cash budget in cash man-
ll Costs Involved in Accounts Receivable Management agement
ll Benefits of Accounts Receivable Management ll Controlling Cash Flows
ll Credit Policies ll Accelerating Cash Collections
ll Credit Standards ll Summary
ll Credit Analysis ll Review Questions
ll Credit Terms
UNIT 25: CASE STUDY: INVENTORY
ll Summary MANAGEMENT BY TULIPS LTD
ll Review Questions
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171
Unit 21(a)
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Notes
___________________
Working Capital Management ___________________
___________________
Objectives:
___________________
After completion of this unit, the students shall demonstrate following skills:
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___________________
\\ Define Working Capital and its management
\\ Describe the Working Capital Cycle ___________________
\\ Explain Operating Cycle ___________________

\\ Analyse the Working Capital determinants
___________________
\\ Define the Advantages of Adequate Working Capital
___________________
\\ Describe the Excessive and Inadequate Working Capital
\\ Evaluate the Disadvantages of Inadequate Working Capital ___________________
Introduction
The funds which are invested in business are of two types- long-
term and short-term. The long-term investments are meant for more
than a year. They generally include fixed assets, such as debentures,
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capital equipment, etc., and are recorded in the books of account for
earning profits during their life period of two or more years.
Funds required to meet the daily expenses of the business opera-

tions are called working capital, which includes current assets and
current liabilities. The working capital management decisions in-
volve cash flow within a year.
The Concept of Working Capital

Working capital is categorized into quantitative and qualitative con-
cepts.
According to the quantitative concept, the amount of total current

assets is considered as the working capital. Thus, working capital
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includes the liabilities that need to be paid off. Such a working cap-
ital asset is called gross working capital.
According to the qualitative concept, the amount by which the cur-

rent asset is more than the current liability is considered as working
capital. Thus, it is the amount left after all the liabilities are paid.
This type of working capital asset is called networking capital.
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Current Liabilities Current Assets
Notes
Bank Overdraft Cash and Bank Balances
___________________ Creditors Raw, Material, Work-in-progress
Outstanding Expenses Spare Parts
___________________
Bills Payable Accounts Receivable
___________________ Proposed Dividends Accurued Income
___________________ Provisional Taxation e.t.c., Prepaid Expense, Short-term
Investments
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___________________
Figure 21(a).1: Structure of Working Capital
___________________
___________________ The net working capital and gross working capital are extremely
important in a firm when it comes to financial planning. The gross
___________________
working capital is considered if you need to ascertain the extent to
___________________ which the current assets are to be utilized. Whereas, if you analyse
___________________ the liquidity of a company, you will have to consider the net working
capital.
Classification of Working Capital

Classification of working capital can be done on the basis financial
reports and variability. The classifications are explained as follows:
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1. Based on Financial Reports: Working capital can be catego-
rized based on the financial reports of a firm. A firm may gather
information related to working capital through financial state-
ments like the Balance Sheet or P&L Account. Working capital
can be categorised on the following basis:
(i) Cash Working Capital: The cash working capital can

be determined from analysing the profit and loss account.
Working capital defines the competence and capabilities
of a firm’s cash flow based on the ‘Operating Cycle Con-
cept.’
(ii) Balance Sheet Working Capital: The necessary data for

this can be obtained from a firm’s balance sheet. Working
capital is of three types- net working capital, gross work-
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ing capital and working capital deficit.
2. Based on Variability: On the basis of variability working

capital can be divided into two key categories: fixed and vari-
able working capital. Working capital when classified based on
variability is very useful in taking hedging decisions. The two
categories of working capital made based on variability are dis-
cussed below:
Unit 21(a): Working Capital Management
173
(i) Temporary working capital: is also known as seasonal
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or fluctuating working capital, refers to the supplementa- Notes
ry investment required by firms during busy season of the ___________________

year. Temporary working capital is expected to increase ___________________
with the business’s growth.
___________________
It can also be defined as the extra assets required by a ___________________
firm to cope up with the sales variations above the per-
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___________________
manent level. The formula used to calculate temporary
working capital is given as follows: ___________________
___________________
“Temporary Working Capital = Total Current Assets
− Permanent Current Assets” ___________________
___________________
(ii) Permanent Working Capital: it refers to a portion of
the entire current assets that does not change with the ___________________
variation in sales in the market. In general, a business

maintains a minimum level of cash, accounts receivables
and inventories even when the sales decrease to the min-
imum level. Such an investment with the business is
termed as permanent working capital.
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It can also be defined as the working capital that is unaf-
fected by market fluctuations. Hence, it is also called as
regular working capital.
WORKING CAPITAL
Based of Financial Reports Based on variability
Cash Working Balance Sheet Temporary Permanent Working

Capital Working Capital Working Capital Capital
Figure 21(a).2: Classification of Working Capital
Working Capital Cycle

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It enables you to understand the basic requirements and func-

tioning of working capital. The cycle begins with the cash out-
flow, followed by several activities, such as buying raw materials,
manufacturing of goods and distribution of finished products, and
ultimately ends with cash inflow. Refer to the working capital cycle
illustrated below.
174
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Purchase
Notes
___________________ Raw
Cash
Materials
___________________
Realizaion of Production
___________________ Income Process
___________________
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___________________ Debt Collection/Credit Work-in-progress
Payment
___________________
___________________ Proudction
Finished
Sales Process
Goods
___________________
___________________ Figure 21(a).3: Displaying Working Capital Cycle
___________________
The current assets and current liabilities remain available at every
point of a business. These assets and liabilities remain circulated
throughout the business process. If the circulation ceases in the pro-
cess, it becomes a threat to the existence of the business. That is
why working capital has also been termed as circulating capital.
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The cycle of working capital depicts that cash is used for the pro-
curement of raw materials and fixed assets or making payment to
creditors. Processing of raw material is done to produce finished
goods for sale. The workers involved in the operation are paid wages
as well as all the overhead expenses. The sale of finished goods re-
sults in cash or credit payments. If the cash is not received, it will go
into cash receivable account and collected from debtors later.
Upon realization of cash, the cash is further used for acquisition

of fixed assets, raw materials and for payment of debts, dividends,
taxes, and interests. Thus, this cycle continuously remains active
through the life of the business.
Operating Cycle
The profits earned from the business depend upon the magnitude of
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sales, thereby, restricting the maximization of shareholders’ wealth.

In simple words, an excellent sales effort is the only key that gener-
ates huge profits. However, the sales do not generate cash immedi-
ately. There is always a virtual time lag between the realization of
cash and sale of goods. This creates the requirement of additional
working capital to sustain the operation of the business until the
cash is received.
175
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Notes
Overhead
Expenses
___________________
Finished ___________________
Wages
Goods
___________________
___________________
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___________________
Materials Sales
___________________
___________________
___________________
Creditors Debtors ___________________
___________________
Cash
Funds from Operation Tax
Issuance of shares Interest

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Borrowing Dividend
Figure 21(a).4: Operating Cycle
An operating cycle refers to the period between the procurement of

raw materials and final compensation. It involves the following stag-
es before the raw material is converted into cash:
llPurchase of raw material from available cash
llProcessing raw materials for work-in-progress
llProcessing of work-in-progress into completed goods
llSelling finished goods on credit to create debtors and accumu-

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late bills receivables
llGenerating cash through conversion of debtors and bills receiv-

ables
The length of the cycle varies from business to business. It may be

long for a manufacturing firm and short for others, as they may not
have raw materials and work-in-progress.
176
Duration of the Operating Cycle
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Notes
The time required for the individual stages of the operating cycle
___________________
minus credit period allowed by the firm’s suppliers is equal to the
___________________ operating cycle’s total duration. It can be represented as,
___________________
O=R+W+F+D–C
___________________
In the above expression,
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___________________
O = the total length of the operating cycle
___________________
___________________
R = the raw material storage time
___________________ W = the time consumed during work-in-progress
___________________ F = the duration for which the finished goods were stored
___________________ D = Collection period for debtors
C = Collection period for creditors
The different elements of the operating cycle can be calculated as

follows:
Average Stock of Raw Materials and Stores

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R=
Average Raw Material and Stores Consumption Per Day
Average Work-in-Progress Inventory

W=
Average Cost of Production Per Day
Average Finished Goods Inventory

F=
Average Cost of Goods Sold Per Day
Average Book Sales

D=
Average Credit Sales Per Day
Average Trade Creditors

C=
Average Credit Purchase Per Day
Determinants of Working Capital

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While there are no definite parameters that point out the determi-
nants of a firm’s capital, here is a list of factors that have an influ-
ence on the quantum of a firm’s capital. These factors are elaborated
below:
1. Nature of industry: The configuration of an asset is directly

associated with the size of a business and the industry to which
177
it belongs. Smaller enterprises have a comparatively smaller
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amount of inventory, cash, and other requirements. Hence, the Notes
nature and size of business directly influence the working cap- ___________________
ital of a firm. For example, automobile manufacturer will need ___________________
a lot of working capital to keep his manufacturing unit going,
___________________
whereas, a small tea vendor would not need much capital to
conduct daily business activities. ___________________
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___________________
2. The demand of creditors: The creditors of a business are usu-
ally concerned about the security of loans. They anticipate from ___________________
the business that the advances paid by them to the business are ___________________
adequately and fully covered. They prefer that liabilities should
___________________
be lower than assets.
___________________
3. Cash requirements: Cash is a significant current asset that
___________________
contributes to the successful and effective operations of the pro-
duction of a firm. For the smooth functioning of a firm, it must
have adequate cash and must be utilized appropriately.
4. Time: Time is a major determinant of working capital. The

amount of time required by a business to manufacture goods
also affects the level of working capital. The working capital
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amount required would be greater when the time required is
longer, and it would be lesser when the time required is com-
paratively shorter. Moreover, the level of working capital is also
dependent on the unit cost of merchandise sold and inventory
turnover. The greater the cost, the larger would be the amount
of working capital.
5. The volume of sales: The level of sales is an essential deter-

minant that affects the working capital’s composition and size.
Current assets are usually maintained by business for the op-
erational activities, thereby, resulting in profitable sales. The
sales volume and size of the working capital share a direct rela-
tionship with each other. An increase in the inventories, receiv-
ables, cost of operations and the investment of working capital
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is evident with an increase in the volume of sales of a business.
6. Purchases and sales terms: In case a business’s purchase

terms on an advantageous credit basis, and those of sales are
less, inventory would attract more cash investment. The work-
ing capital requirements are possible to be reduced when the
credit terms are favorable as, in such cases, a business gets
enough time to make payment to creditors and suppliers.
178
7. Inventory turnover: The working capital requirements are
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Notes expected to be low when the inventory turnover is high. A busi-
___________________ ness can minimize its working capital requirements with the
___________________ help of an effective inventory control system.
___________________ 8. Receivables turnover: A firm must necessarily have good

___________________ control over its receivables. Low working capital requirements
are highly influenced by better facilities for payables and time-
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___________________
ly collection of receivables.
___________________
9. Business cycle: It is common for any business to expand
___________________
during economic growth and prosperity and decline during the
___________________ depression. As a result, a business would require more working
___________________ capital when the business is in the phase of prosperity. Similar-
ly, it would require less working capital during the depression.
___________________
10. Variation in sales: A seasonal type of business would require
a greater amount of working capital for a moderately lesser
period.
11. Production cycle: We have already discussed that the oper-

ating cycle is the time required to transform raw materials into
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finished products. The more the time taken to complete the pro-
duction cycle, the greater the working capital requirement. A
firm must ensure to reduce the period of the operating cycle to
reduce their working capital requirements.
12. Liquidity and profitability: If a business anticipates taking

a higher amount of risk to earn more profits or face losses, it
automatically minimizes the size of the working capital with
respect to its sales. If the business anticipates increasing its
liquidity, it raises the amount of its working capital. However,
this strategy would expectedly reduce the volume of sales and
profitability of the business. Hence, a business must select be-
tween profitability and liquidity and then settle upon its work-
ing requirements.
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13. Profit planning and control: The management of a compa-

ny decides the amount of working capital required by taking
into consideration its policies and strategies for planning and
control. The presence of sufficient cash contributes to cash gen-
eration. This makes it possible for the company’s management
to retain a part of its profits and significantly increase the in-
ternal financial resources of the business.
179
14. Activities of the firm: A business that is involved in the sup-
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ply of heavy inventory or is involved in selling goods and ser- Notes
vices to customers on easy credit conditions, requires a higher ___________________

amount of working capital than a business that sells services or ___________________
makes cash sales.
___________________
Advantages of Adequate Working Capital ___________________
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1. Business with sufficient working capital can make timely pay- ___________________
ments to the suppliers for the raw materials they purchase. ___________________
This, on the other hand, helps in getting regular supplies of
___________________
raw materials from the suppliers without any delay and inter-
rupting in the production process. ___________________
___________________
2. Adequacy of working capital helps a business to make the max-
___________________
imum utilization of its fixed assets regularly. For instance, if
a factory has insufficient stock of raw materials, the machines
in the factory will not be used justifiably, thereby, affecting the
productivity.
3. If the working capital of a business is adequate, it can enjoy

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the benefit of cash discount by buying raw materials for cash
or through the method of making payment prior to the due
date.
4. A firm can consider purchasing an adequate quantity of raw

materials if it has adequate working capital. This is beneficial
when the prices of raw materials are expected to rise in the fu-
ture. Similarly, if a company gets a bulk order for goods, it can
make the most of this opportunity if it has adequate working
capital.
5. In spite of making enough profits, a business might face prob-

lems in making payments to its shareholders at an appropri-
ate rate due to the paucity of cash. This problem of payment of
dividend can be easily resolved through the adequate working
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capital.
6. Financial institutions, especially banks, are always ready to

provide even an unsecured loan to firms having sufficient work-
ing capital. This is mainly because having an more current as-
sets in comparison to current liabilities is considered a sign of
good security.
180
Excessive and Inadequate Working Capital
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Notes
A business should always consider maintaining sufficient working
___________________
capital as per the needs of its activities. However, the amount of
___________________ working capital must neither be too much nor be too less. Excess
___________________ of working capital would imply idle funds that add to the cost of
capital without earning any profits for the business. On the other
___________________
hand, when working capital is inadequate, it reduces sales, thereby,
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___________________ affecting the profitability of the business. The disadvantages of ex-
___________________ cessive working capital are discussed below:
___________________ 1. Excessive working capital leads to the needless and redundant
___________________ collection of large inventory. Moreover, it also increases the
risks of theft, waste, and misuse.
___________________
2. Excessive working capital leads to the implementation of liber-
___________________
al credit policy, thereby, resulting in higher debts and higher
chances of bad debts.
3. These are idle funds to the business, adding to the firm’s cost
without earning any profits. This has a negative effect on the
firm’s profitability.
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4. Due to the presence of excessive working capital, the manage-
ment of the firm becomes carefree and careless, thereby, result-
ing in negligence in the control of cash and expenses.
Disadvantages of Inadequate Working Capital

1. If a firm has inadequate working capital, it has to face the prob-
lem of being unable to pay its creditors on time. This affects the
credit purchase of goods from the suppliers. Moreover, such a
firm is not availed any cash discount.
2. Due to the regular disruption in the process of acquiring raw

materials and scarcity of stock, the machines in the firm cannot
be used optimally, which in turn affect productivity.
3. Due to a lack of sufficient working capital, the machinery and

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equipment are not maintained properly, thereby, resulting in a

halt in the production in several cases.
4. Due to inadequate working capital, a firm is usually not able to

pay the short-term dues within the stipulated time. This nega-
tively affects the relationship of the firm with banks, creditors,
etc. It also creates a problem for the firm to arrange for funds
when in need.
181
5. Due to inadequate working capital, the firm often fails to keep
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adequate stock of final goods. This leads to a significant de- Notes
crease in the sales of the firm. Moreover, the firm would also be ___________________
compelled to limit its credit sales. ___________________
___________________
Summary
___________________
Working capital is the short-term investment that a business must
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___________________
make to handle the daily operational expenses. Working capital can
be segregated as net working capital and gross working capital. They ___________________
can be classified based on financial reports and variability. Operat- ___________________
ing cycle is the duration between the acquisition of raw materials
___________________
and realization of cash is called the. Working capital is affected by
various other determinants. ___________________
___________________
Review Questions
1. Define working capital management.
2. Why is working capital management crucial to a business?
3. What do you mean by working capital deficit?

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4. What are the stages involved in the working capital cycle?
5. Discuss the operating cycle.
6. What do you mean by the duration of operating cycle?
7. How can working capital be classified based on financial re-

ports?
8. Distinguish between permanent and temporary working capi-

tal?
9. Explain any five determinants of the working capital of a firm.
10. What are the various factors that would affect the working cap-
ital decisions of a fast food retailer?
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11. Is it beneficial for a company to have adequate working capital?

Give reasons in support of your answer.
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183
Unit 21(b)
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Notes
___________________
Estimation and Calculation ___________________
of Working Capital ___________________
___________________
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Objectives: ___________________
After completion of this unit, the learners will be able to :
___________________
\\ Apply Procedures to Estimate Working Capital
___________________
\\ Define Working Capital as a ratio of Net Sales
\\ Describe Working Capital as a ratio of Total Assets ___________________
\\ Explain Working Capital Based on Operating Cycle ___________________

\\ Analyse the Requirement of Cash and Bank Balance, Inventories, and ___________________
Receivables
Introduction
The efficiency of a firm’s planning and management is always subject
to the correct estimate of the working capital requirement. Hence,
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the estimation procedures play a very important role.
Estimation Process
It is important that a firm estimates the net working capital in ad-
vance, to ensure smooth operations of the business. After this is
done, the net working capital can be categorised as temporary and
permanent working capital. This process helps in identifying the fi-
nancing pattern and helps in ascertaining the amount of working
capital that needs to be financed from short-term sources and the
amount that needs to be financed from long-term sources.
Here are the different ways through which working capital require-
ments of a firm can be estimated:
1. Working Capital as a Percentage of Net Sales: This ap-

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proach is based on the assumption that a company’s working

capital requirements are proportional to the firm’s net sales
volumes. The estimation process consists of three steps:
llApproximating total current assets as a percentage of projected

net sales
llApproximation of the total liabilities as a percentage of project-

ed net sales
184
llNet working capital will be the difference between both of them
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Notes
2. Working Capital as a Percentage of Total Assets or Fixed
___________________
Assets: This approach works around the principle that work-
___________________
ing capital requirements are related to a firm’s total assets (in-
___________________ cluding both current assets and fixed assets).
___________________ Another approach mentions the relationship of working capital
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___________________ requirement with the total fixed assets. Both these approaches
are relatively simple but difficult to calculate. The main short-
___________________
coming of these approaches is that they require establishing
___________________
the relationship of current assets or total assets with the net
___________________ sales or fixed assets, which is quite difficult to calculate.
___________________
3. Working Capital based on Operating Cycle: The operating
___________________ cycle helps in determining the time scale over which the cur-
rent assets are maintained. The operating cycle for different
components of working capital gives the time for which an as-
set is maintained.
According to this method, an analysis of different elements of

working capital is done, and subsequently a separate approxi-
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mation is done for every single one of these components. These0
different components include:
Current Assets
llCash in Hand and at Bank
llRaw Material Inventory
llInventory of Work-in-progress
llInventory of Finished Goods
llReceivables
Current Liabilities
llCreditors for Purchases

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llCreditors for Expenses
The different components of current assets require funds depending

upon the respective operating cycle and the cost involved. The cur-
rent liabilities, on the other hand, provide finance depending upon
the respective operating cycle or the period of payment. The estima-
tion of working capital can be made as follows:
Unit 21(b): Estimation and Calculation of Working Capital
185
(a) Need for Cash and Bank Balance: This is least productive
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of all current assets; hence, a minimum balance must be main- Notes
tained. It is also important as it provides liquidity to the firm, ___________________

which is of utmost importance to any firm. ___________________
(b) Need for Raw Materials: Every manufacturing maintains an ___________________

inventory of raw materials to meet the needs of the production.
___________________
The numbers of units required of different materials depending
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___________________
on various factors, such as raw materials consumption rate, the
time lag in procuring fresh stock, contingencies and other fac- ___________________
tors. ___________________
(c) Need for Work-in-progress: In any manufacturing firm, the ___________________

production process is continuous and generally consists of sev-
___________________
eral stages. At any particular time, there will be a different
___________________
number of units in different stages on completion. The value
of raw materials, wages and other expenses locked up in these
work-in-progress goods is the working capital requirement for
work-in-progress.
(d) Need for Finished Goods: In almost all the firms, the fin-
ished goods are not immediately sold after purchase/procure-
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ment/completion of the production process. The goods remain in
the storage house for some time before they are sold. The cost
that is incurred in procuring, producing or purchasing these
units is locked up and, hence, working capital is required for
them.
(e) Need for Receivables: The term receivables include the debt-
ors and bills. When the goods are sold on a cash basis, the sales
revenue is realized immediately. When the sales are done on
credit basis there would be a time gap between completion of
sales and collection of the revenue.
Summary
For the efficient functioning of a firm, it is important to have the
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correct estimate of the working capital requirement. It is a must

for a firm to estimate in advance the net working capital that will
be required for smooth operations of the business. Once estimated,
it can be bifurcated into short term and fixed working capital. The
different ways of estimating working capital requirements are con-
sidering working capital as a percentage of net sales or a percentage
of total assets. These are based on the operating cycle.
186
Review Questions
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Notes
___________________ 1. Discuss the method of estimation of working capital require-

ments based on sales.
___________________
___________________
2. Explain the factors considered while determining the need for
working capital.
___________________
PE
3. How can the value of work-in-progress be estimated? What are
___________________
the relevant factors?
___________________
4. The administration at Royal Industries has asked for a state-
___________________
ment that shows working capital requirements necessary for
___________________ manufacturing 1,80,000 units every year. Following is the cost
___________________ structure for the company’s manufacturing for the above men-
tioned product:
___________________
Category Cost per unit
Raw Materials Rs. 20
Direct Labour Rs. 5
Overheads (including depreciation of Rs. 15
Rs. 5 per unit)
Profit Rs. 10
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Selling Price Rs. 50
Additional information
(a) Expected cash balance is minimum Rs. 20,000
(b) Raw materials holding period is 2 months
(c) Work-in-progress (assume 50% completion stage) would be

equivalent to production during half a month
(d) Inventory holding period in the warehouse is a month
(e) Good are purchased on a month’s credit, sales are done on a

credit basis of two moths; Ou of total sales 25% are cash sales
(f) Payment of wages for a month observe a time lag, and in case
of overheads the lag is for a month and a half
(C
From the above mentioned facts, prepare a statement showing

working capital requirements.
187
Unit 22
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Notes
___________________
Receivables Management ___________________
___________________
Objectives:
___________________
After completion of this unit, the students will be able to:
PE
___________________
\\ Explain the concept of accounts receivable.
\\ Describe the characteristics and types of accounts receivable. ___________________
\\ Discuss the concept of accounts receivable management. ___________________

\\ Discuss the objectives of accounts receivable management.
___________________
\\ Explain the cost and benefits of accounts receivable management.
___________________
\\ Describe the credit policies, credit terms, credit standards and credit
analysis. ___________________
Introduction
The term receivables refer to the debt owed to the company by cus-
tomers that arise from the sale of goods and services in the normal
course of business.
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Receivables management is also termed as trade credit manage-
ment. This is because a company creates accounts receivable by
granting trade credit to be collected from its customers on a future
date. It can also be called as an extension of credit provided to its
customers, thereby, allowing them a rational time within which
they can pay their debts to the company for the goods they have
already received.
Characteristics of Accounts Receivables

Knowing the significant features of accounts receivables will help
you in understanding and identifying a company’s accounts receiv-
ables. The major features of accounts receivable are as follows:
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llThe payments that arise from accounts receivable are fixed in

nature and are measurable.
llThe period of maturity of accounts receivables may or may not

be fixed.
llSuch trade usually does not occur in an active security market.

188
llThere is a certain level of risk involved with accounts receiv-
S
Notes ables.
___________________
llThe holder of accounts receivables can considerably recuperate
___________________ all their investments made, excluding some credit deterioration.
___________________
llThe concept of accounts receivables is based on fiscal value.
___________________
llThe concept of accounts receivables implies futurity.
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___________________
___________________ Classifications/Types of Accounts Receivable

___________________ Accounts receivables are classified into two types:
___________________
(i) Trade Receivables
___________________
(ii) Non-trade Receivables
___________________
Trade receivables refer to the claims arising from the sale of goods
and services in the regular course of business. It can also be said that
trade receivables are open accounts of the customers, in which the
customers buy goods but the business does not receive cash from the
customer for those goods. In such cases, cash is either not collected
or the services provided to customers are not yet billed. Examples of
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trade receivables include accounts receivable and notes receivable.
Non-trade receivables refer to the claims arising from events that

do not include the sale of goods or services in the regular course of
business.
Examples of non-trade receivables include advances paid to employ-

ees or officers, claims against dealers or suppliers, rent deposit, div-
idends receivable and subscriptions receivable.
Accounts Receivables Management

Accounts receivables management is a result of taking effective
decisions that are related to the investment of the current assets
of a company, with the objective of maximizing the returns on in-
vestment in receivables. The primary objective of any commercial
(C
business is to make profits. Credit is a significant tool to enhance

the sales of a company; however, it must be considered that sales
are profitable to the company. The process of granting credits to the
customers must not only focus on maximizing sales, but must also
lead to an increase in the overall return on investment. Therefore,
management of accounts receivables should consider the function-
ing of sound credit policies, procedures and practices.
Unit 22: Receivables Management
189
Objectives of Accounts Receivable Management
S
Notes
As discussed earlier, accounts receivables are a marketing tool ___________________
that helps in the promotion of the sales of a business, thereby,
___________________
leading to profits. Thus, it can be said that the major purpose of
receivables is to maximize the amount of sales in a business. Many ___________________
successful businesses use accounts receivables to reduce the cost ___________________
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of credit and lead to higher investments in receivables. Increasing
___________________
the credit sales is also an important part of accounts receivables
___________________
management. It covers various areas of an organization, including
credit analysis, credit terms, credit collection, and credit receiv- ___________________
ables as well as financing and monitoring of receivables. Moreover, ___________________
accounts receivables management concentrates on making opti-
___________________
mum investment in sundry debtors and helps maintain effective
control of the cost of trade credit. It is also useful in the creation of ___________________
a balance between profitability of a business and the costs incurred
by the business.
It can be summarized that the objective of accounts receivables man-

agement is to promote and contribute to the sales of an organization.
However, this is applicable only until it reaches a point where the
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return on investment (ROI) in funding receivables in the future is
lesser than the cost of funds that are increased to finance the ad-
ditional credit, which is the cost of capital. The costs and benefits
that play an important role in achieving the objectives of receivables
management are discussed below.
Costs Involved in Accounts Receivable Management

The main categories of costs that are related to the extension of cred-
it and accounts receivables are as follows:
(i) Collection cost
(ii) Capital cost
(iii) Delinquency cost

(C
(iv) Default cost
Collection Cost
Collection costs are referred to all types of administrative costs that
are incurred in the collection of receivables from the customers who
owe debts to the business. Collection costs include the following:
190
(a) Additional expenses incurred in creating and maintaining a
S
Notes credit division in a company, which includes employees, ac-
___________________ counting records, stationery, etc.
___________________
(b) Expenses incurred in obtaining credit related information from
___________________ customers, either through external specialist groups or by the
___________________ company’s internal staff. However, such expenses are usually
not incurred when a company does not indulge in selling on
PE
___________________
credit.
___________________
___________________
Capital Cost
___________________ An increase in the accounts level reflects an investment in acom-

pany’s assets. These assets have to be financed, thereby, incurring
___________________
costs. Usually, a time lag exists between the time of sale of goods to
___________________ customers and time of payment made by the customers. However,
during this lag, the company has to remunerate its employees for
services rendered to the company. Similarly, the suppliers have to
be remunerated for the provision and regular flow of raw materials.
This implies that the company has to maintain additional funds to
meet their daily obligations, while waiting for their customers to
clear their dues.
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Delinquency Cost
Delinquency costs refer to those costs that crop up when certain
customers fail to repay their debts or meet their obligations. These
costs arise when payment on credit sales granted by the company
is due, subsequent to the expiration of the credit period. Some of
the important components of delinquency costs include the follow-
ing:
(i) Blocking-up of funds up to a future date
(ii) Cost associated with collection of dues, including reminders,

legal charges, etc.
(C
Default Cost
Default costs refer to those costs that businesses are unable to re-
cover from their customers. Sometimes, businesses are unable to
recuperate the dues due to the inability of their customers to do so.
These debts are recorded as bad debts and are written off, as they
cannot be realized on a future date. Default costs are usually related
to accounts receivables and credit sales.
191
Benefits of Accounts Receivable Management
S
Notes
Apart from the costs, the benefits are yet another feature having a ___________________
bearing on accounts receivables management. Benefits come from
___________________
credit sales. They refer to the rise in sales and expected profits due
to a more liberal policy. When a business allows trade credit, which ___________________
means when it invests in receivables, it aims to increase its sales. A ___________________
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liberal trade credit policy influences a company in two ways. First,
___________________
benefits are sales-expansion oriented. This means a company may
___________________
allow a trade credit either to induce more sales to existing customers
or to attract new and prospective customers. The objective of invest- ___________________
ing in receivables is generally termed as growth oriented. Second, ___________________
the company may extend the credit facility to its customers to secure
___________________
their present sales against competitors. In this case, the primary
objective is sales retention. With the increase in sales, the profits of ___________________
a firm also increase.
Thus, it can be said that investments made by a company in receivables

consider both cost and benefit. It is equally important to know that the
extension of trade credit highly influences the sales, profitability and
costs of a business. Moreover, a moderately liberal policy and higher
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investments in receivables yields more sales. However, costs will in-
crease with liberal policies as compared to more rigorous policies. Here,
you can conclude that accounts receivable management must seek for
a trade-off between cost and benefit. This summarizes that the decision
made toward the commitment to funds to receivables will depend on
the comparison of costs and benefits. Thus, this will help to determine
the maximum level of receivables. The costs and benefits that are tak-
en into consideration for comparison are marginal costs and benefits.
The company must consider the additional costs and benefits that lead
to a change in the trade credit policy or receivables.
Credit Policies
The objectives of a company are not merely related to the receivables
(C
management, but are also involved in the immediate collection of

receivables. However, the company must simultaneously focus on
the benefit–cost trade-off involved in the different areas of accounts
receivable management. Credit policies are the firm’s decision area.
The credit policy of a firm acts as a framework to find out and assess
whether to extend credit to a customer and how much. There are two
broad dimensions of the credit policy decision taken by a firm:
192
(i) Credit analysis
S
Notes
(ii) Credit standards
___________________
___________________ A company is required to set up and utilize credit standards while

making credit decisions or while developing suitable sources of cred-
___________________
it information and techniques of credit analysis.
___________________
PE
___________________ Credit Standards
___________________
Credit standards refer to the primary requisites to extend customer
___________________ credit. The various quantitative factors that help to establish credit
___________________
standards include a list of factors, such as financial ratios, credit
references, credit ratings and average payments period. For better
___________________
understanding, the overall standards are categorized as restrictive
___________________ and non-restrictive.
The trade-off in relation to credit standards includes the following:
(i) Collection cost
(ii) Average collection period

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(iii) Level of bad debts
(iv) Level of sales
The critical changes and effects on the profits earned by a business

occur due to the reduction of credit standards. This is showed in
Table 22.1. It indicates that when the credit standards are tight,
the opposite effects would apply. The opposite are given in brack-
ets.
Table 22.1: Effect of Standard’s Relaxation
Item Increase (I) or Positive (+) or

decrease (D) in negative (-) effect on
directions profits earned
Average collection period I (D) + (−)
Sales volume I (D) − (+)
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Bad debt I (D) − (+)
Example 22.1: A producer is selling an item at Rs 10 per unit. He

sold 30,000 units on credit during recent yearly sale. The average
cost per unit is Rs. 8, variable cost per unit is Rs 6 and the total fixed
cost is Rs 60,000. He has assumed the average time for collection as
30 days.
193
The producer is considering a reduction in the credit standards,
S
which is anticipated to lead to an 15 % increase in unit sales. With- Notes
out affecting the bad debt expenses, the average time for collection ___________________
is expected to increase to 45 days. The increase in sales would also ___________________
lead to an increased net working capital up to the limit of Rs 10,000.
___________________
The increase in expenses incurred in collection maybe considered
negligible. The required ROI is15 %. ___________________
PE
Decide whether the credit standard must be relaxed. ___________________
___________________
Solution: Calculation of Marginal Profits
___________________
Table 22.2: Calculation of Marginal Profits
___________________
Particulars Debit Credit
A. Proposed Plan ___________________
1. Sales Revenue (34,500 × Units Rs. 10) 3,45,000
___________________
2. Less: Costs
a. Variable cost (34,500 × Units Rs. 6) 2,07,000
b. Fixed 60,000 2,67,000
3. Profits from sales 78,000
B. Current Plan
1. Sales Revenue (30,000 × Units Rs. 10) 3,00,000
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2. Less: Costs
a. Variable (30,000 × Rs. 6) 1,80,000
b. Fixed 60,000 2,40,000
3. Profits 60,000
C. Marginal Profits with New Plan 18,000
Credit Analysis
Apart from setting credit standards, a firm must find ways to eval-
uate credit applicants. Credit analysis is another aspect of credit
policies of a firm. The main steps of the credit analysis process are
categorized below:
(i) Obtaining credit information
(ii) Analysis of credit information

(C
The decision of granting credit to a consumer and the amount of

credit is decided using credit analysis.
Credit Terms
Credit term is another significant decisional area in receivables man-
agement. After the establishment of the credit and assessment of the
creditworthiness of the consumers, the business is required to find
194
out the various conditions based on which trade credit will be provid-
S
Notes ed to the customers. The various terms and conditions introduced by
___________________ the business under which goods and services are sold to customers on
___________________ credit are called credit terms. It includes three major parts:
___________________ (i) Credit period: Credit periods are the time for which trade
credit is provided and the period within which the customer
___________________
must repay the overdue amounts.
PE
___________________
(ii) Cash discount: Cash discount is an offer provided by the busi-
___________________
ness to the customer under which the amount due by customer
___________________ to the business is reduced.
___________________
(iii) Cash discount period: It is time during which a discount is
___________________ availed.
___________________
Table 22.3 shows how an increase in cash discounts affects various
items:
Table 22.3: Increase in Cash Discounts
Increase (I) or Positive (+) or negative

decrease (D) in (-) effect on profits
Item directions earned
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Average Collection Period I +
Sales Volume D +
Bad Debt Expenses D +
Profit Per Unit D −
Example 22.2 Consider a company, which is planning to announce

2% discount to customers, on terms that the overdue amount is paid
within 10 days of the credit purchase. If discounts were given, the
sales of the company would go up by 15 %. The average time of col-
lection would reduce by 15 days. The ROI expected by the company
is 15 % and total sales that would be on discount are 60 %. More-
over, it will not affect the bad debt expenses of the company. Do you
think the company must execute the plan?
Solution: First, let us find the profit earned on sales by the company.
(C
Profit earned = 45,000 (Rs. 10 – Rs. 6)
= 45,000 × Rs. 4
= Rs. 18,000
Now, after knowing the profit on sales made by the company, you find
the amount saved on average time for collection. Moreover, the addi-
tional investment in accounts receivables also needs to be deduced.
195
S
Proposed plan = Cost of Sales
Notes
Turnover of receivables
___________________
(Rs. 8 × 30,000) + (Rs. 6 × 4,500) ___________________

=
360 ÷ 75
___________________
= Rs. 55,625 ___________________
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(Rs. 8 × 30,000) ___________________
Present plan =
340 ÷ 75 ___________________
= 30,000 ___________________
___________________
Thus, the additional amount invested in accounts receivable will be,
___________________
= Rs. 55,625 – 30,000
___________________
= Rs. 25,625
Now, you must find the cost of additional investment made at 15%.
The additional bad debt expenses can be obtained by finding the dif-
ference between bad debts with respect to the proposed and present
plan.
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æ Additional investment ö
ç ÷ = Rs. 55,625 - Rs.30, 000
è in accounts receivable ø
= Rs. 25, 625
The bad debt expense in relation to the present plan can be calculat-
ed as follows:
(Bad debt with present credit period) = 0.01 × 45,000
= Rs. 10,350
Therefore,
Additional bad debt expenses = Rs. 10,350 – Rs. 3,000
= Rs. 7,350
(C
Therefore, the additional cost connected to the credit period exten-

sion is Rs. 11,193.75(3,843.75 + 7,350). As per this, the benefit will
be Rs. 18,000.
The net profit will be Rs 6,806.25 (18,000 – 11,193.75). In this case,

the company must extend the period of credit from 30 to 60 days.
196
Summary
S
Notes
___________________ Accounts receivables have a great role to play in the formation of

a company’s assets. The continuous growth in the credit sales, al-
___________________
lowed by the companies to their customers, leads to the creation of
___________________ accounts receivables. Any credit sale is recorded in the account of
___________________ sundry debtors, also known as ‘Bills receivables’ or ‘Trade debtors’.
PE
One of the most important forces that induces the growth and devel-
___________________
opment of a modern-day business is trade credit. For most success-
___________________
ful businesses, trade credit is the most effective marketing tool that
___________________ acts as a bridge between the producers and consumers. Credits are
___________________
granted by companies to protect and secure their sales from their
rivals and attract prospective customers. It is not possible for any
___________________
business to enhance their sales without using credit facility. The in-
___________________ crease in sales further leads to an increase in the company’s profits.
However, any investment made on the accounts receivable by a com-
pany involves a huge amount of risks and incurs additional costs.
Hence, accounts receivables form an important aspect of a business,
due to which companies need to pay a lot of attention toward effec-
tive and efficient management of accounts receivables.
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Review Questions
1. What is trade credit?
2. State the characteristics of accounts receivables.
3. What do you mean by accounts receivables management?
4. What are the different types of cost?
5. What do you mean by benefits and credit policies?
6. Distinguish between credit analysis and credit standards.
7. A change in credit policy has led to an increase in the sales of

a product. It also led to an increase in the discount given, a de-
(C
crease in investment in accounts receivable and a decrease in

the doubtful accounts. What does this signify?
8. N.M.P. Corporation disclosed its latest annual report in mil-

lions as follows:
197
S
Particulars 2016 2017
Notes
Net sales 61,050 71,532
___________________
Net beginning accounts receivables 4,764 5,100
Net ending accounts receivables 3,100 4,600 ___________________
___________________
(a) Find the corporation’s accounts receivables turnover ratio for
the two years. ___________________
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___________________
(b) Find the average collection period for the two years.
___________________
(c) Is the corporation’s account receivables getting better or weak-
___________________
ening?
___________________
___________________
___________________
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(C
(C
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199
Unit 23
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Notes
___________________
Inventory Management ___________________
___________________
Objectives:
___________________
Post completion of this unit, learners shall be capable of:
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___________________
\\ After completion of this unit, the students will be able to:
___________________
\\ Elaborate the concept of inventory management.
\\ Explain the components of inventory. ___________________
\\ Discuss the motives and objectives of inventory management. ___________________
\\ Discuss the techniques of inventory management.
___________________
\\ Discuss the objectives and functions of inventory control.
___________________
\\ Discuss the types of manufacturing inventories.
\\ Explain the costs incurred in maintaining inventory.
\\ Describe the factors affecting inventory management.
Introduction
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Inventory management is defined as the sum total of the actions es-
sential for the procurement, storing, clearance or usage of materials.
It is one of the key components of current assets and working capital
management, which plays an important role in the organization’s
smooth operation.
Efficient inventory management requires a substantial number of

assets. Inventory management is one of the challenging tasks of a fi-
nance manager. Efficient management of inventory reduces the cost
of production and, hence, increases the company’s profitability by
minimizing the overall cost of the firm.
Inventory
The American Institute of Accountants defined the term ‘inventory’
(C
as the collection of those items of tangible assets that
(a) Are held for sale in the ordinary course of business,
(b) Are in the production process or
(c) Are to be consumed currently for the production of goods or

services.
200
For a business, inventories are the product stocks, which are manu-
S
Notes
factured for sale, and the raw materials used to manufacture those
___________________ products.
___________________
Components of Inventory
___________________
___________________
The various forms of inventories that exist in a manufacturing busi-
ness are raw materials, work-in-progress, finished goods, and stores
PE
___________________
and spares. Figure 23.1 gives the list of components:
___________________
___________________
Inventory
___________________
___________________
___________________
Work-in-
Raw materials Finished products Stores and Spares
progress
Figure 23.1: Components of Inventory
1. Raw Materials: Raw materials are those inputs from which

the finished product is manufactured through conversion pro-
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cess.
2. Work-in-progress: It is the stage between raw materials and

finished products.
3. Finished Products: When the product is completely manufac-

tured and ready for sale, it is called a finished product.
4. Stores and Spares: It includes office and plant cleaning mate-

rials such as soap, brooms, oil, fuel, light bulbs, etc., which are
purchased by the firm and stored for the purpose of machinery
maintenance.
Inventory Management Motives

There are three main motives for holding inventories:
(C
1. Transaction Motive: It includes goods production and goods

sale. It deals with the continuous production of goods as well as
delivery of goods at a given time.
2. Precautionary Motive: It deals with the holding of some

amount of inventory for the unexpected demand and supply
gap.
Unit 23: Inventory Management
201
3. Speculative Motive: It deals with the holding of some amount
S
of inventory to take the advantage of price changes and getting Notes
the discounts on quantity. ___________________
___________________
Techniques of Inventory Management
___________________
All types of organizations maintain inventory in one or the other ___________________
form:
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___________________
llMake to Order (MTO): It allows customers to purchase prod-
___________________
ucts that are customized as per their specifications. The ‘MTO’
___________________
strategy increases the wait time for the customers, as the prod-
uct will be manufactured only once the customer places the or- ___________________
der. ___________________
llAssemble to Order (ATO): In this production strategy, the man- ___________________

ufactures keep the basic parts of the product ready beforehand.
The final product is quickly assembled or manufactured once
the customer places the order.
llMake to Stock (MTS): It is a traditional business strategy

where the manufacture produces the products beforehand as
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per the product’s demand forecasts.
Objectives of Inventory Control

The basic objective of inventory control is to keep overall invest-
ments at a minimum level. Moreover, inventory control should try to
ensure that items are available at right place and right time. Some
of the other objectives are mentioned below:
llTo minimize waste and surplus
llTo minimize holding and shortage cost
llTo increase efficiency of production
Functions of Inventory Control

(C
There are many functions of inventory in a business. The primary

function is to use it in production to increase the profitability, that
is, to achieve maximum benefit out of investment cost. The key func-
tions of inventory are as follows:
llIt helps to achieve return on investment.
llIt acts as safety stock for the business.

202
llDecoupling of operations: The inventory accumulated be-
S
Notes tween two inter-dependent operations is to reduce the output
___________________ synchronization.
___________________ llIt aid in smoothening the operations process.
___________________
llInventory helps the business to minimize the material han-
___________________ dling cost.
PE
___________________
Types of Manufacturing Inventories
___________________
___________________ Various stages of inventory constitute the manufacturing inventory

as a whole. The different types of manufacturing inventories are as
___________________
follows:
___________________
llRaw material: The raw materials constitute the materials
___________________
that are used in the manufacturing of the final product. Thus,
every company maintains some level of raw materials.
llWork-in-progress inventory: The Work-in-progress inven-

tory includes partially produced or partially completed prod-
ucts.
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llFinished material: These are products that are purchased or
manufactured by a firm. These are ready for sale and available
tithe customers for purchase.
llSpares and consumables: These products are used during

the manufacturing process. An adequate amount of inventory
needs to be maintained for this so as the production process is
not delayed.
Inventory Costs
Inventory costs include the following costs:
llCost of procuring items: It is the basic expenditure that is

incurred in procuring the raw materials.
(C
llCost of carrying items in inventory: It is the maintenance

cost that is incurred while carrying items in inventory.
llStock out cost: It is the cost associated with the opportunity

cost lost by exhaustion of inventory.
llSystem cost: The cost associated with the usage of procure-

ment and usage of systems that are used to manage inventory.
Unit 23: Inventory Management
203
Factors Affecting Inventory
S
Notes
As inventory management plays an important role in deciding the ___________________
firm’s business results, it is very important to learn about the factors
___________________
that affect inventory. The key factors that influence the inventory in
any business are mentioned below. ___________________
___________________
llEconomic parameters: Various economic parameters affect
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inventory. For example, the price of inventory, procurement ___________________
costs, carrying costs, shortage costs, etc. ___________________
llDemand: If the demand for a product is more, the inventory ___________________

required will be more. This, in turn, will affect the inventory ___________________
management mechanisms.
___________________
llOrdering cycle: It is the time gap between placing one set of
___________________
order and the next order.
llLead time: It is the time that a supplier takes to deliver the

goods once an order is placed.
llNumber of supply echelons: Echelon inventory is the in-

ventory between a stage in the supply chain and the final cus-
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tomer.
llNumber of stages of inventory: It is the total number of

stages between the first stages of procurement of raw materials
to the final stage of delivering goods.
Summary
The nature of inventory is always dynamic. Inventory manage-
ment calls for steady and rigorous assessment of external and in-
ternal factors. In any enterprise or company, all capabilities are
interlinked and related to each other and are often overlapping.
The major domains like inventory, supply chain management and
logistics act as the backbone of any business delivery chain. There-
fore, these functions are extraordinarily vital to marketing and fi-
(C
nance managers.
Inventory control is a vital feature that determines the efficiency of

the supply chain and its impacts on the financial position of the busi-
nesses. Every enterprise continuously looks to hold optimum level of
inventory so that they can meet the demand and tries to encounter
with situations like over or under inventory level, thereby improving
the financial figures.
204
Review Questions
S
Notes
___________________ 1. What are the objectives of inventory management? Explain the

costs and benefits associated inventory management.
___________________
___________________
2. Explain the Economic Order Quantity model of inventory con-
trol. What are its shortcomings?
___________________
PE
3. Discuss the techniques of inventory management.
___________________
___________________ 4. What are the benefits from Inventory control?
___________________ 5. XYZ and company buy a component for production at Rs. 10

___________________
per unit. The annual requirement is 2000 units, carrying cost
of inventory is 10% per annum and the ordering cost is Rs. 40
___________________
per order. Find the EOQ.
___________________
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(C
205
Unit 24
S
Notes
___________________
Cash Management ___________________
___________________
Objectives:
___________________
At the completion of this unit, the students shall be able to understand and
PE
explain: ___________________
\\ The cash management concepts ___________________
\\ The aims of cash management
___________________
\\ The factors affecting cash requirements
___________________
\\ Role of planning, control and cash budget in cash management
\\ Planning ___________________
\\ Control ___________________
\\ Cash Budget
\\ Explain how to manage cash outflows and inflows
\\ Accelerate cash collections
Introduction
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Cash is used as a medium to exchange goods and services and dis-
charging the debts, and is one of the most important components
for a firm. It is used to run the business, manage the operations and
under working capital management cycle, management of cash is an
important area.
Efficient management of the inflow and the outflow of cash improves

the overall performance of the organization. Cash management
involves the proper balance between liquidity and profitability be-
cause the insufficient cash funds affect the production process while
an excess of cash does not mean higher profits.
Nature of Cash
Cash is required to meet the regular operations of the business. In
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cash management, the term cash is used in two diverse senses:
1. Narrow Sense: Narrow Sense considers cash as a currency,

and the other accepted equivalents are demand drafts, cheques
and demand deposits.
2. Broad Sense: Broad sense does not only include the compo-
nents of narrow sense, but they also include cash assets, mar-
206
ketable securities and bank’s time deposits. These securities
S
Notes
can be conveniently converted into cash through sale.
___________________
Significance of Holding Cash
___________________
As every transaction results in either an inflow or outflow of cash in
___________________
an organization, cash becomes one of the key components. Some of
___________________
the motives of holding cash are discussed as follows:
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___________________
1. Transaction Motive: It is due to the need of keeping cash
___________________ for various expenses such as procurement of raw materials and
___________________ payment of business expenses, taxes, dividend, etc.
___________________ 2. Precautionary Motive: Cash may be required by the Organi-
___________________ zations for payment of unexpected expenses. Such short-no-
tice unforeseen cash requirements may warrant firms to hold
___________________
cash.
3. Speculative Motive: Certain companies desire to hold cash

for speculative transactions such as purchase of raw materi-
als at low prices or if the firm deals in bulk sale and purchase
of products according to the rates. Hence, organizations
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having such speculative dealings may warrant additional
liquidity.
Objectives of Cash Management

An essential function of the financial manager requires mainte-
nance of ideal cash balances. Ideal level of cash means that it is nei-
ther surplus nor insufficient. In other words, upkeep of cash reserve
holding additional cash should meet the requirements while not
having excess cash that will remain idle. From this, we can analyse
the objectives of cash management as follows:
1. Meeting needs of cash payment
2. Maintaining a minimum cash balance
Aspects of Cash Management

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The aspects of cash management can be examined under three

heads:
1. Cash inflows and outflows,
2. Cash flow within the organization
3. Cash in Hand
Unit 24: Cash Management
207
Surplus cash arises when the cash inflows exceed cash outflows. On
S
the other hand, the deficiency will arise when the cash inflows are Notes
less than the cash outflows. The balance of cash is known as syn- ___________________
chronization. The organization should look into various factors to re- ___________________
solve the uncertainties involved in cash flow predictions and create
___________________
a balance between cash receipts and payments.
___________________
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Factors Determining Cash Requirements ___________________
As discussed, an organization has to decide the cash balance based ___________________

on their needs, which is determined after taking into consideration ___________________
the following factors:
___________________
llNature of the business: This involves the type of activities
___________________
performed by the business. A firm having short operating cycle
___________________
will have a requirement for less cash, while a giant manufac-
turer would need substantial cash.
llSeasonality of operations: Businesses that have significant

seasonality in their activities have fluctuating requirements for
cash. A ceiling manufacturer would need a lot of cash during
peak summer season and less during the winter.
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llProduction policy: A firm having seasonal fluctuations in its
sales will have significant variations in their requirement for
cash.
llMarket conditions: The requirement for cash is also affected

by the degree of competition in the market. A firm would need a
lot of cash to meet demand when competition is high. The case
would be the opposite when competition is low.
Role of Planning, Control and Cash Budget in Cash

Management
Cash Planning or Cash Budget
One of the main finance functions is cash planning and control of
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cash. One of the key responsibilities of a finance manager is mainte-

nance of adequate cash which can be realised only through method-
ical cash planning.
Cash planning involves planning and controlling the cash usage. A

projected cash flow statement which has been readied on the ba-
sis of expected receipts of cash and payments provides an insight
into financial condition of an organization’s. Cash planning can be
208
done as per the policy of the company on the daily, weekly, monthly
S
Notes or quarterly basis, for example big organizations opt for daily and
___________________ weekly forecasts whereas medium size organizations create weekly
___________________ and monthly forecasts.
___________________ Cash Forecasting and Budgeting

___________________ Because Cash forecast deals with approximation of cash flows, it is
PE
___________________ employed as a technique to predict future cash flows at dissimilar
stages. It also provides the management with information to enable
___________________
timely and necessary actions.
___________________
For maintenance of the cash flow in any organization, a cash budget
___________________
is a crucial tool. In simpler words, it presents approximated inflows
___________________ and outflows of cash during a planning period in a statement form.
___________________ The cash budget is also known as short-term cash forecasting since
it highlights the surplus or deficit cash in an organization.
Purpose of Cash Budget
1. Cash requirement approximation
2. Finance planning for short-term

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3. For acquisition of capital goods, scheduling payments.
4. Procurement of raw materials in a planned manner
5. Credit policy evolution and implementation
6. Long-term cash forecasting’s accuracy verification
Preparation of Cash Budget or Elements of Cash Budget
The main purpose of cash budget preparation is estimation of cash

surplus or deficit on basis of estimated cash flows during a given
period and consists of following steps:
Step 1: Period Selection
The planning horizon is the period for which the cash budget is pre-
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pared and may differ for different organizations. The cash budget
period is defined based on the organization’s size. It is determined
by the requirement of a specific case. Monthly cash budgets are pre-
pared by organizations facing seasonal variations in its business. If
there are fluctuations in cash flow, preparation of daily or weekly
cash budgets shall be pursued. If the cash flows are stable in nature,
longer period cash budgets may be used.
209
Step 2: Selection of factors that affect cash flows
S
Notes
Factors affecting cash flows are separated into two major categories:
___________________
(a) operating cash flows and (b) financial cash flows.
___________________
Operating Cash Flows: Operating cash inflows are cash sales, a col-
___________________
lection of accounts receivables and disposal of fixed assets. Whereas,
the operating cash outflows are billed payables, procurement of raw ___________________
PE
materials, wages, factory expenses, administrative expenses, main- ___________________
tenance expenses and procurement of fixed assets.
___________________
Financial Cash Flows: Financial cash inflows are loans and borrow- ___________________
ings, the sale of securities, dividends received, refund of taxes, rent
___________________
received, interests received and issue of new shares and debentures.
On the other hand, cash outflows include redemption of loans, pro- ___________________
curement of shares, income tax payments, interests paid and divi- ___________________
dends paid.
Selection of
Selection of time
factors that
period
affect cash flows
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Figure 24.1: Preparation of Cash Budget
Controlling Cash Flows

After estimation of cash flows, the financial manager must ensure
that there is not any significant deviation between the actual cash
flows and the projected cash flows.
That financial manager will have control over the collection of cash
receipts and cash disbursements. Both collection and disbursement
have a combined impact on cash management’s overall proficiency.
The idea is to speed up a collection of accounts receivables so that
the organization can use the money. In contrast, organizations want
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to delay accounts payables without affecting their credit standing

with suppliers.
Hence, to maintain effective cash management, a firm needs to
(A) collect accounts receivables as early as possible and
(B) Delay the accounts payables without affecting their credit

standing.
210
Accelerating Cash Collections
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Notes
___________________ Accelerating cash collection will increase the cash availability and
reduce the company’s dependency on borrowings. Systematic plan-
___________________
ning can be involved to accelerate cash inflow process. Here are the
___________________ methods which can be used to accelerate cash collections:
___________________
1. Prompt Payment of Customers: Prompt payment by cus-
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___________________ tomers will be possible by prompt billing. The seller needs to in-
___________________ form the customers in advance about the amount and period of
payment. Automation of billing and enclosure of self-addressed
___________________
envelope will be helpful for quick payment of cash.
___________________
2. Early Conversion of Payments into Cash: The process of
___________________
conversion of cheques into cash should be faster. The time lag
___________________ between when the cheque is prepared by a customer and is
credited to the organization’s account should be minimized. It
is also known as cash cycle. The time taken to convert raw ma-
terials into cash is called cash cycle.
There are three steps involved in the cash cycle:

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(i) Mailing Time: in known as “Postal Float” and signifies the
time taken to transfer the cheques from the customer to the
organization.
(ii) Lethargy: The time taken between sending the cheques to

bank and processing inside the business.
(iii) Bank Float: Collection within the bank or the time taken
by the bank in collecting the payment from the customer’s
bank.
The postal float, lethargy and bank float are collectively known as
‘deposit float.’ Faster collection of cash is possible when an organiza-
tion reduces the transit, lethargy and bank float.
Summary
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One of the critical areas of the working capital management cycle

is cash management. It is the most liquid asset as well as the basic
input required for continuous operation of a business. The aspects of
cash management can be examined under three heads: cash inflows
and outflows, cash flow within the organization and cash balanc-
es held at the point of time. Cash planning provides a system for
211
planning the usage of cash. A cash budget is an important tool for
S
the maintenance of the cash flow in any organization over a period. Notes
Cash budget is prepared to estimate cash flows during a period and ___________________
establish the likelihood of surplus or deficit. ___________________
___________________
Review Questions
___________________
1. What are the objectives of cash management? Explain the fac-
PE
___________________
tors affecting the cash needs of a firm.
___________________
2. It has been observed in your organization that a substantial
cash surplus is available for a short period that is not utilized ___________________
properly to generate maximum yield. How would you plan for ___________________
short-term investment of funds?
___________________
3. ‘Cash Budget is an important technique for cash management.’ ___________________

Explain the statement. What are the different methods of pre-
paring the cash budget?
4. What are the reasons for uncertainty in cash budget and how
can these be handled?
5. Explain the statement ‘Cash Management always attempts at

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minimizing cash balances.’
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PE
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213
Unit 25
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Notes
___________________
Case Study: Inventory ___________________
Management by Tulips Ltd ___________________
___________________
Tulips Ltd. manufactures and sells air purifiers in India. It is one
PE
of the foremost manufacturers of air purifiers in the country. Air ___________________
purifiers remove impurities from the air and make it clean. It elec-
___________________
tronically removes impurities such as smoke, dust particles, pollen,
and other airborne irritants. ___________________
An air purifier comprises an outer plastic body, three filters made ___________________
of different materials that trap air impurities and a motor that in- ___________________
takes air and releases purified air.
___________________
As the company manufactures air purifiers, it is considering the
option of purchasing motor parts from a supplier. The supplier will
deliver the components in the required quantities at Rs. 9 per unit.
Assume that the transportation and storage cost is negligible. The
company has been manufacturing the component from a single raw
material in cost saving lots of 2,000 units at the cost of Rs. 2 per
unit.
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– The demand is 20,000 units per year
– Holding cost is Re 0.25 per unit per annum
– Lowest stock level is 400 units.
– Direct labor cost is Rs. 6 per unit
– Fixed manufacturing overheads are Rs. 3 per unit based pro-

duction of 20,000 units.
– Cost of Hiring machine is Rs. 200 per month.
– The company also avails services of an analyst to provide the

best alternative so that the total inventory cost is reduced.
– Analyse the above inventory problem and state whether the

company should purchase or produce the motor part.
(C
(C
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S

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(C

Dr. S J Chopra Dr. Deependra Kumar Jha

Dr D N Pandey Dr Kamal Bansal Dr Tabrez Ahmad

SLM Development Team

Dr. Rajesh Gupta Dr. Meenakshi Sharma Dr. Rakhi Dawar

Mr. Rahul Sharma Mr. Shantanu Trivedi Ms. Aparna

Mr. Shantanu Trivedi/Mr. Rahul Sharma

Course Code: MBOF 912D

Course Name: Financial Management

Version: January 2018

Unit 1: Financial Management–Introduction...........................................................................3

Unit 6: Types of Financial Statements....................................................................................39

Unit 11(a): Short-Term Sources of Finance...................................................................................87

Unit 16: Leverage Analysis......................................................................................................139

Unit 21(a): Working Capital Management..................................................................................171

ll Objectives of Financial Management UNIT 3(B): DISCOUNTING TECHNIQUES

ll Summary ll Present Value of Growing Perpetuity

ll Review Questions ll Summary

UNIT 3(A): COMPOUNDING TECHNIQUES ll Capital Recovery

ll The FV of a Series of Equal Cash Flows or UNIT 5: CASE STUDY: AN ANALYSIS OF

\\ understand Financial Management’s key functions and the overall ___________________

Role of a Financial Manager

1. Procuring the right amount of funds whenever necessary

2. Investing funds to gain maximum profits

3. Distributing funds to the shareholders to ensure wealth maxi-

Objectives of Financial Management

2. Profit Maximization: This involves ensuring that the firm

3. Wealth Maximization: Wealth maximization is the maximi-

Some other objectives of financial management include the ­following:

1. Confirming reasonable return to the shareholders

2. Ensuring growth and expansion in the firm’s business and value

3. Utilising funds efficiently and effectively to ensure maximum

4. Maintaining financial control in the firm

The scope of financial management is very vast. It is related to ___________________

It is the duty of the financial manager to utilise the sources of the

Therefore, financial management is necessary to maintain the over-

Functions of Financial Management

The key to a successful business processes is financial management

While looking into the different requirements of a firm, the finance

___________________ Investment Decision

___________________ Financial Function Decision Financing Decision

Figure 1.1: Types of Financial Function Decisions

1. Current Assets or Short-term Assets (for example, raw mate-

Financing Decision: The financing decision determines how to ___________________

The above-mentioned decisions cannot be taken in isolation as they

For example, assume there is a company which has taken a de-

cision to make an investment of INR 10 Crores to be put as a

For example, any member participating in a financial process, any

Although every member in an organization contributes to the fi-

1. Management of the company’s finances and its future planning

2. Taking decisions according to the objectives of the firm and con-

and increase the wealth of the shareholders. Some of the functions

1. Financial planning and analysis

2. Management of the asset structure of the firm

3. Management and balancing of the financial structure of the

ital structure, portfolio management, risk appetite, diversification, ___________________

1. Controller: As a controller, the CFO mainly focuses on budget- ___________________

tion of financial function. ___________________

Chief Finance Officer

Capital Budget Fund Raising

Portfolio Manger Internet Auditor

Figure 1.2: Organization of Finance Function

Financial Goal–Maximization of Profit versus

Advantages of Profit Maximization

Some other objectives of financial management include the following:

FV = PV (1 + r)n ... (3.1)