Financial Management 3RD Degree Acctn

UNIT 1: FINANCIAL PLANNING AND CAPITAL STRUCTURE
Content
1.0 Aims and Objectives
1.1 Introduction
1.2 Need for Funding
1.3 Terms of Funding
1.4 Sources of Funds
1.5 Forecasting Models
1.5.1 Proforma Income Statement
1.5.2 Proforma Balance Sheet
1.5.3 Proforma Cash Flow Statement
1.6 Cost of Capital
1.6.1 Significant of Cost of Capital
1.6.2 Determination of Cost of Capital
1.6.3 Computation of Specific Costs of Capital
1.6.3.1 Dividend Price Approach
1.6.3.2 Dividend Price Plus Browth Approach
1.6.3.3 Earning Price Approach
1.6.3.4 Realized Yield Approach
1.7 Cost of Preference
1.8 Cost of Debt Capital
1.9 Computation of Siple Average Cost of Capital
1.10 Leverages
1.10.1 Operating Leverage
1.10.2 Financial Leverage
1.10.3 Composite Leverage
1.10.4 Leverage Analysis Using For Decision Making Process
1.11 Indifference Point
1.12 Capital Structure
1.12.1 Optimum Capital Structure
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1.13 Summary
1.14 Answers to Check Your Progress
1.15 Reference
1.0 AMES AND OBJECTIVES
After completion of this unit, on should be in a position to:

 understand the need and concept of financial planning
 able to determine financial planning
 explain the risk factors involved in financial planning
 determine the cost of capital
 demonstrate and explain the features and objectives of capital structure
 apply the concepts of leverage in capital structure
 attain the optimum capital structure of an organization.
1.1 INTRODUCTION
Financial planning is the processes of estimating the required finance of a firm for its business
decisions. Every business unit requires funds for its various applications, like incorporation,
expansion and diversification decisions. If a company mobilizes funds for its incorporation, it
will be called as the initial investment funding and for the expansion and diversification, it will
be called as the additional investment funding. The process of identifying the need of funding
(either initial or additional) and provision of such funds in time for effective business decisions
is called financial planning of a business. A hypothetical financial planning model is illustrated
below.
MODEL FINANCIAL PLANNING

NEED OF TERM OF SOURCE OF
FUNDING FUNDING FUNDING
 Initial phase  Long-term  Issue of Common
 Expansion for 5 to 10 shares
phase years  Issue of Preference
 Development  Short-term shares
phase for 3 to 5  Issue of Debt
 Diversification years securities
phase
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1.2 NEED FOR FUNDING
Business needs, is the triggering point of every funding decision in the world. It arises with the
commencement of the business and extends in the form of expansion and diversification in the
latter stage. Commencement of the business is called the initial phase where every firm
requires funds for its business investments like, assets mix, incorporation and initialization
expenses. Expansion phase and the diversification phase arise after the initial phase where
business exhibits the characteristic features of growth. Expansion phase is the internal growth
feature while the diversification phase is the external growth feature. Both the expansion and
diversification derive their inferences from the diversification, the first being internal
diversification called product or/and location diversification, and the second being the external
diversification called as the business or industry diversification.
1.3 TERMS OF FUNDING
Funding of investment proposal basically dependent on the conditions of the business needs.
Conditions like the nature of project, amount of the funds involved and activities involved with
the funding are the deciding factors of the terms of funding. As the factors being more
complex and crucial in terms of investment, the project desires and attracts only long-term
funds like equity shares or preference shares, while the needs of lower complexities will
demand debt investments. Projects basically dependent on uncertainty will attract only owner’s
funds, like research and development cost, as there is no specification of the term of the project,
outcome of the research and applicability of the principles in the business world.
1.4 SOURCES OF FUNDS
Financial planning starts with the estimation of the business needs with fixation terms, and
comes to end with arrangement of the desired funds by the firm. Sources of funds are the
essential in this area so as to identify the various businesses needs so as to arrange the funds
suitable for the said needs. It is in this context one has to know about the financial markets,
which provide the funds required by every firm. Financial markets are the markets where the
funds are available for the business investment in the form of the common shares, preference
shares, bonds and/or debentures. A market where share is sold by the firm to an investor or
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investors for the first time is called the primary market or new issue market or simply, a capital
market. On the other hand, a market where an investor of the shares, who holds the shares of
some firm, sells to the new prospective buyer is called as the secondary market or the stock
market. In a financial market a firm may acquire a financial security in the following three
ways:
 Issue of common shares
 Issue of preference shares
 Issue of bond/debenture.
Issue of common share is the most common phenomenon is the financial market at the time of
the initial phase of the firm. It is to known at this point that no business in this world starts
with the debt capital, but it is the ownership capital, which brings the business into existence
for the first time. Common shares when for the first time issued is called public issue, where
the public without any restrictions can apply for the subscription in the open market and
acquire the shares of the given firm. If the firm goes for the expansion phase and issues the
additional shares to the existing list, then it can do so by free unconditional issue called public
issue, or conditional issue called the rights issue to the existing shareholders, or convert the
existing surplus reserves into shares in the form of bonus issue. In either of the situations, i.e.
rights issue or bonus issue, a firm has to decide the terms of issue called as the swap rate/ratio
through the shares are exchanged in the market. The only difference between the rights and
bonus issue is the first being issued in cash and the other being issued in kind.
Issue of the preference shares is the second type of source, which can accumulate the desired
funds by the firm. Preference shares are issued to the public in the open market conditions
where issue of common shares may not be profitable or possible (due to the capital
restrictions). A preferential share is a share, which is defined as the share certificate, which
brings two preferential rights to holders over common shareholders. The first being the
payment of dividends well before the common share holders are paid, and the second being the
payment of capital before the common shareholders are paid. Issue of preferential shares are
also done in the same form as that of the common shares issue, i.e., public issue and rights
issue. Preferential shares does not entitle for the issue of the bonus shares, as they do not come
under the category of the ownership rights. Preferential shares are also classified into two
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major types. The first being the issue of preferential shares as cumulative or non-cumulative
shares, and second is issue of convertible and non convertible preference shares. Cumulative
shares are entitled for the repayment of default dividends the latter years, while the convertible
preference shares have the option of conversion into common shares after the maturity period.
Issue of the bond/debenture is the third source available to the firm in raising the additional
capital. A bond or a debenture brings the condition of charge to the holders, which compels the
firm to repay the principle as well as the interest due or default legally. Hence the debt holders
have more advantage is investing in the firm when compared to the shareholders, as their
repayment is more secured. Issue of bond/debenture will bring the charge to the firm as the
interest is to be paid from the first day the firm borrow the funds. It is the firm’s business
needs, which fix the risk factors to decide which source is more suitable for the firms prevailing
situations. Sometimes common shares are more profitable, while sometime debt will be more
suitable. Hence it is essential to know the underlying risk factors to identify the best suitable
financing mix.
Risk in financing decisions is very simple to define, as the mix of the internal and external
factors, which influence the business activities. Internal factors are those factors, which are
under the control limits of a firm, where a firm can take effective decisions to improve the
performance. External factors are those factors which are beyond the control of the business
scope as they bear more influence by macro economic indicators like inflation, income level,
tax structure and so on. Decisions like purchase of material price, quantity, labor volume, fixed
assets and so on come under the internal factors which have more flexibility in expansion or
reduction of financing needs. Basically the risk defined as the external factor is more
qualitative rather than quantitative aspect as per the business decisions are concerned. It is
required to convert the qualitative information into the quantitative information, which is
simply done by the forecasting techniques. Forecasting is the technique, which gives the
financial information derived from the qualitative factors. Financial forecasting is the basis for
the effective financial planning the financing decisions.
Financial forecasting is the simple process of identifying the opportunities in the future in terms
of market size, customer base or business strategies. Market size or the customer base is
expressed in terms of number of units (market can absorb, or customers are expected to buy).
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Number of units identified can be converted into the dollar value by multiplying with selling
price per unit or cost price per unit and the external data will become the internal data as the
selling price is determined by the market conditions, which is known and cost price and profit
per unit can be determined with the internal process. Hence the external source of information
which is unpredictable will expressed into useful business information helping the finance
manager in taking the effective decisions for the financial planning. Financial forecasting will
be constructed using the macro indicators like, inflation interest rate, tax rate that are applicable
in the real world situations with minor deviations to the reality, as they are also predicted for
the planning period. Therefore the financial planning with financial forecasting will convert
the future uncertainty information into the possible certainty information, which is called as the
process of identifying the risk underlying with the financing decisions.
Check Your Progress Exercise 1

1. Explain the following terms
a. Terms of funding.
b. Source fund.
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1.5 FORECASTING MODELS
Forecasting models are basically classified into three categories, and they are:
1) Proforma Income Statement,
2) Proforma Balance Sheet, and
3) Proforma Cash Flow Statement.
Proforma income statement is the model of forecasting of income statement with projected
increase in sales for the future period. Usually proforma income statement is constructed with
projection of sales affecting all the components on the income statement by adopting the
historic ratios’ using sales as the dependent factor for all the components called sales ratios. A
proforma income statement can also be constructed using both the financial statements i.e.,
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income statement and balance sheet. The following illustration explains both the statements
with the projected sales.
Illustration 1: A firm provides the following financial statements to you. Assist the firm is
determining projected income statement and balance sheet for next period. Assume the sales
increase for Year 20X2 as 25 %.
1.5.1 Income Statement
FOR THE YEAR ENDED DECEMBER 31 20x1

Sales revenues $ 1,000
Less: cost of goods sold 600
Profits before taxes 400
Less: Taxes 160
Profits after taxes 240
Dividends 120
Retained earnings 120
1.5.2 Balance Sheet
As on date December 31 20X1

Assets $ Liabilities $
Current assets 300 Current liabilities 100
Net Fixed assets 340 Long-term debt 270
Owners equity 270
Total: 640 Total: 640
Sol:
Income statement Ratios

Sales $1,000
Costs 600 $0.60
Profits 400 $0.40
Taxes 160 40%
Profits after taxes 240 $0.24
Dividends 120 $0.12
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Retained earnings 120 $0.12

Balance sheet
Assets
Current assets $ 300 $0.30
Fixed assets 340 $0.34
Total assets 640 $0.64

Liabilities and owners equities
Current liabilities $ 100 $0.10
Long term debt 270 -
Owners equities 270 -
Total: 640
Revised income statement and balance sheet with increased sales as 25 %.

Income statement
Sales $1,250.00
Costs $750.00
Profits $500.00
Taxes $200.00
Profits after taxes $300.00
Dividends $150.00
Retained earnings $150.00
Balance sheet
Assets
Current assets $375
Fixed assets $ 425
Total assets $ 800
Liabilities and owners equities
Current liabilities $ 125
Long term debt * ?
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Owners equities * ?
Total: $ 800
From the above solution it is clear that all the events are directly related to sales can easily be
forecasted based on the historic ratios. But long-term debt and owners equities do not have any
relation with the sales, therefore they cannot be forecasted, if we assume the same conditions,
then the new funds required will be $ 675, as the historic ratio specify 50: 50 ratio so new
structure with change in sales should be $ 337.50 and owners equities of $ 337.50. Here one
face the basic problem, that is, increase in owners equity should be $ 67.50 as compared to the
funds available as $ 120 from retained earnings. This should result as increase in dividends
from $ 120 (existing) to $ 172.50 (with additional distributions). This will revise the dividends
pay out ratio to 13.8 percent. This if one try to settle from the reverse approach that is keeping
the owners equity as increase by $ 120, the debt ratio will decline as the amount of additional
funds required equal to $ 135. $120 additional funds are contributed by the owner’s funds as
retained earnings, therefore the remaining $ 15 by outside funds as borrowings. One adopts
this criteria, the debt equity ratio will be revised and the new ratio will be equal to 42 .22
percent. This will lead to the imbalance in the existing ratios. This is the basic limitation of this
method.
1.5.3 Proforma Cash Flow Statement
Cash flow model is the model of estimating the resources of cash and payments of cash over a
period of time, based on the cash operating cycle.
A simple financial forecasting model is illustrated below:

Initial investment is $200000+$70000 270,000
Number of units sold: 10,000
Selling price per unit $10
Cost price per unit
Material price per unit $3
Labor cost $2
Overheads per unit $2
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$7
Fixed cost per annum 40,000
External factors
Inflation rate 5%
Interest rate 8%
Tax rate 40%
Solution
Initial investment is $200000+$70000 270,000
Number of units sold: 10,000 12000 14400 17280 20736
Selling price per unit $10 $10.50 $11.03 $11.58 $12.16
Cost price per unit
Material price per unit $3 $3.15 $3.31 $3.47 $3.65
Labor cost $2 $2.10 $2.21 $2.32 $2.43
Overheads per unit $2 $2.10 $2.21 $2.32 $2.43
Total variable cost per nit $7 $7.35 $7.72 $8.10 $8.51
Fixed cost per annum 40,000
External factors
Inflation rate 5%
Interest rate 8%
Tax rate 40%
Additional funds required 18200 41132 70026. 106433
Financial planning of the a period of 5 years
Particulars 1 2 3 4 5
1. Sales volume $100,000 $126,000 $158,760 $200,038 $252,047
2. Cost price 70000 88200 111132 140026 176433
3. Contribution $30,000 $37,800 $47,628 $60,011 $75,614
4. Fixed cost
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Depreciation 40,000 40,000 40,000 40,000 40,000
PBIT ($10,000) ($2,200) $7,628 $20,011 $35,614
Interest charge 0 1456 3290 5602 8515
Profits before tax ($10,000) ($3,656) $4,337 $14,409 $27,100
Taxes $1,734 $5,763. $10,839
Profits after tax Nil Nil $2,602 $8,645 $16,259
NOTE: The present solution is a simple format without tax adjustments and the depreciation
adjustments of the financial model.
ILLUSTRATION 2: Financial forecasting model is illustrated below to make the business

planning understand properly for the effectiveness of the business decisions. ABC
Incorporation is planning to buy a fixed asset whose investment value is expected to be
$250,000; with 5 years useful life. It is also expected that the fixed asset will contribute a
capital allowance at 40% over the life of the assets useful life and will be salvaged at the end of
5 years for book value. ABC requires the following variable expenditure for the production of
the output called as ZEGA, which can be sold for $30 per unit. It is also expected that the
company can produce 10,000; 20,000; 40,000 units with 25 %, 50% and 100 % capacity of
production in the next five years, which is absorbed by the market in the came capacity.
Prepare the financial forecasting plan for the five years period taking into effect the following
additional information provided.
Additional information:
Variable Cost price
Material price per unit $5
Labor cost $5
Overheads per unit $5
Administrative Expenses per annum $10,000 at
20%
Inflation rate 4%
Interest rate 6%
Tax rate 40%
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Solution:
Financial planning of the a period of 5 years
Particulars 1 2 3 4 5
1. Sales volume $300,000 $624,000 $1,297,920 $1,349,837 $1,403,830
2. Cost price 150000 312000 648960 674918 701915
3. Contribution $150,000 $312,000 $648,960 $674,918 $701,915
4. Fixed cost 200,000 180,000 180,000 194,400 220,320
PBIT ($50,000) $132,000 $468,960 $480,518 $481,595
Interest charge 0 10920 26419 15878 15773
Profits before tax ($50,000) $121,080 $442,541 $464,641 $465,822
Tax Adjustment $71,080 $513,621
Taxes Nil $28,432 $205,449 $185,856 $186,329
Profits after tax Nil $42,648 $237,093 $278,785 $279,493
Working Notes:
Initial investment
Fixed assets $250,000 Depreciation rate: 40%
Variable cost
Production capacity 25% 50% 100% 100% 100%
Number of units sold: 10,000 20,000 40,000 40,000 40,000
Selling price per unit $30 $31.20 $32.45 $33.75 $35.10
Cost price per unit
Material price per unit $5 $5.20 $5.41 $5.62 $5.85
Labor cost $5 $5.20 $5.41 $5.62 $5.85
Overheads per unit $5 $5.20 $5.41 $5.62 $5.85
Total variable cost per nit $15 $15.60 $16.22 $16.87 $17.55
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Fixed asset value at the beginning of the
year 250,000 150,000 90,000 54,000 32,400
Fixed cost per annum Depreciation 100,000 60,000 36,000 21,600 12,960
Fixed cost per annum Administrative
expenses 100,000 120,000 144,000 172,800 207,360
Total Fixed Expenses for the year 200,000 180,000 180,000 194,400 220,320
External factors
Inflation rate VC 4% 20% FC
Interest rate 6%
Tax rate 40%

Additional funds required 432,000 792,960 847,718 909,275
Adjustment from depreciation 100,000 60,000 36,000 21,600
Internal funds available 150,000 150,000 150,000 150,000
Actual funds required 182,000 440,312 264,626 262,891
Additional funds required for the
year 258,312 -175,686 -1,735
1.6 COST OF CAPTAL
Business requires funds for its investment decisions, and every investment requires a return to
be payable. The term cost of capital refers to the return a firm intends to pay to its members
who contribute the capital to the firm. The rate of return a firm pays to the investors so as to
retain the market value of the shareholding capacity of the investors which in-turn protects the
liquidity option of the investor. If a firm pays the expected return to the investors of the firm
then the firm, will retain its marketability of the share value in the secondary markets, and if it
is unable to pay, then it looses its market value.
A firm’s cost of capital is defined, as 1“the rate of return the firm requires earning for the
investment in order to increase the value of the firm in the market place”. From the above
definition, it is to be noted that, (i) the firm’s cost of capital is simply a real rate of return that is
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required on the projects investment. It is not actually a cost as suck, but merely a hurdle rate to
the firm, which it has to achieve in order to fulfill its objectives. (ii) A firm’s cost of capital is
merely the minimum rate of return that will result in minimizing cost of equity and increasing
the value of the equity share. (iii) cost of capital comprises three components, and they are (1)
return at zero level risk – also referred as risk free return; (2) premium of the business risk –
referred as the variability in operating profits with change in sales; and (30) premium in
financial risk – referred to the variability caused by patterns of capital structure. Empirically the
above concepts are expressed as follows:
K = Rf + Rb + Rfr
Where K = Cost of capital
Rf = risk free rate of return
Rb = business risk
Rfr = financial risk
1.6.1 Significance of Cost of Capital
Cost of capital is useful for the firm in evaluating the capital budgeting decisions and capital
structure decisions. A capital budgeting decision is considered with the discounting factor that
is used to evaluate the appraisal of a project. Cost of capital is the required rate of return
usually used in evaluation of the capital project appraisal as discounting factor. A wrong
estimation of the cost of capital may lead to in-effective capital budgeting decisions. Cost of
capital plays important role in capital structure decisions. It is used in raising capital required,
so as to keep the cost of funds at optimum level. It Is always required for the firm to determine
the market value of the firm and keep the liquidity option of the share or bond value in the
market high. Hence it is always essential for a firm to ascertain the higher cost of capital to
keep the market value. It is explained through the following diagram:
Increasing cost
Cost of
capital
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Constant cost
Diminishing cost
Market value of the Common share
1.6.2 Determination of Cost of Capital
Cost of capital is determined by taking into account the cost of each component of capital,
known as a specific cost of capital. Specific cost of capital of the given firm is defined as the
cost of equity (returns paid to the equity share holders) or cost of preference (returns paid to
preference shareholders) or cost of debt (returns paid to the debt holders). The over all cost of
the capital is determined by taking into average value of the specific cost of capital. The
average cost of capital is identifies as the simple average and the weighted average method.
Simple average method is the simple arithmetic mean of the specific costs of the capital, while
the weighted average is the weights multiplied by the specific costs and the whole divided by
the total weights of the capital components.
Calculation of simple average cost of capital:
Ko = (Ke + Kp + Kd)/3
Weighted average cost of capital (WACC) is calculated as follows:
Ko = (We Ke + Wp Kp + Wd Kd)/ (We + Wp + Wd)
1. Explain the significant of cost of capital.
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2. How do you determine the cost of capital.
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1.6.3 Computation of Specific Costs of Capital
Cost of equity refers to the minimum rate of return that a company must earn on the portion of
equity capital employed. In other words, it is the rate of return, which the common
shareholders expect form the firm in return to their investment the firm’s capital. Hence it is
required to quantify the expectations of the common shareholders in determining the cost of
equity. It is not always possible to identify all the factors accurately, which effect the
shareholders expectations, so as to determine the required rate of return. It is also essential to
know at this point, that the common shareholders are the ultimate owners of the firm who are
entitled for the undistributed profits is called retained earnings of the firm. Cost of retained
earnings is also equal to the cost of equity share in computation of the cost of capital of the
firm. Cost of equity can be computed in the following ways:
1. Dividend price (D/P) approach.
2. Dividend price plus growth (D/P + g) approach.
3. Earning price (E/P) approach.
4. Realized yield approach.
1.6.3.1 Dividend Price Approach
The value of the common share may be interpreted by the shareholder as the present value of
the expected stream of future dividends. Although in the short-run stockholders may be
influenced by a change in earnings or other variables, the ultimate value of any holdings rests
with the distribution of earnings in the form of dividend payments. Though the stockholders
may benefit from the retention and reinvestment of earnings by the corporation, at some point
the earnings must be translated into cash flows for the stockholders. A stock valuation model
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based on future expected dividends, which is termed as dividend valuation model, can be
ascertained as follows:
D1 D2 Dœ
Po = -------- + --------+…+ ---------
(1+Ke)2 (1+Ke)(1+Ke) œ
1
Where Po = Price of the Equity/Common share

D = Dividend for each year
Ke = Cost of equity or required rate of return or discounting rate
1.6.3.2 Dividend Price Plus Growth Approach
A firm that increases dividends at a constant rate is more likely circumstances. As per this
mode the growth is expressed in dividends for valuation is always assumed to be constant.
Market price of the common share is ascertained as follows:
D1
Ke = ------- + g
P0
Where P0 = Price of common shares

D1 = Dividend for year
g = growth rate
Ke = required rate of return.
Market value of the common share can be ascertained by transposing the above equation. This
can be done as follows:
D1
P1 = ------------
Ke - g
1.6.3.3 Earnings Price Approach
According to this method market price per share is determined by capitalizing the future
dividends per share, derived from the earnings per share. The cost of capital according to this
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method remains constant as the earnings percentage keeps to the share price constant. Cost of
equity is estimated using this method as follows:
Ke =
where E = Earnings per share

NP= Net proceeds per share.
1.6.3.4 Realized Yield Approach
According to this approach the cost of equity capital is determined on the basis of return
actually realized by the investor in a given firm on their investment. Cost of equity is
computed based on the past records of the given firm according to this approach.
E.g.: A purchased 10 shares of ABC Incorporation for $20 each three years back. The current
price of each common share at present day trading is $25. Mr. A received a dividend for the
three years as $2, $2.4, and $2,9. Then the present value of the common share is equal to:
Sol:
Market value of the common = $2+$2.4+$2.9+$20
=$27.3
1.7 COST OF PREFERENCE
Is the return paid or payable to the preferred stock holders of the firm. A firm can issue
preference shares of two types, and they are (i) permanent preference shares, and (ii)
Redeemable preference shares. Permanent preference shares are the shares issued with a
condition of non-payment of the capital to the shareholders, and if at all the payment of the
capital arises it will be in the situation of the winding up of the firm. Redeemable preference
shares being issued with a condition to repay after certain period, say after 10 years or 15 years.
Both the types differ with each other in only one way, i.e., in repayment of the capital.
Preference shareholders are entitled for the payment of dividends every year, which will be the
cost for the firm, identified as the cost of preference.
(i) Cost of Irredeemable preference shares (Kp):
Kp = Pd/Po
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Where Kp = cost of preference share
Pd = Preferential dividend for the year
Po = Issue price of the preference share
(ii) Cost of Redeemable preference shares (Kp):

Pd + [(RV-SV)/n]
Kp = ------------------------
[RV + SV]/2
Where Kp = Cost of preference share

Pd = Preferential dividend for the year
RV = Redeemable value of the preference share
SV = Sales proceeds of the preference share
n = Maturity period in years.
It is essential to know at this point that, when a firm issues cumulative preference shares, then
the value of the cost of preference share should be changed with the cumulative value of the
preferential dividend i.e., current year dividend with default dividend from the past years.
1.8 COST OF DEBT CAPITAL
Or simply the cost of debt is the return paid to the debt holders of the firm who are entitled for
a return called interest on the loan advanced to the firm. It is required to know at this point that
the debt capital brings charge to the firm, which is essential, and payable before payment of the
taxes. Hence payment of interest to the debt holders will save tax payment of the firm;
therefore cost of debt should be evaluated showing the tax saving benefit to the firm. Debt
capital can also be issued in two types, and they are (i) Irredeemable debt, and (ii) Redeemable
debt. Computation of debt capital cost is done as follows:
Cost of Irredeemable Debt (Kd):
Kd = {Int (1-t)}/Po
Where Int = Interest on the debt capital
t = corporate tax rate applicable to the firm
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Po = Issue price of the debt capital
Kd = cost of the debt
Cost of Redeemable Debt (Kd):
Int (1-t) + [(RV-SV)/n]

Kd = ------------------------
[RV + SV]/2
Where Kd = Cost of debt

Int = Interest paid/payable on the debt
RV = Redeemable value of the debt
SV = Sales proceeds of the debt
n = Maturity period in years.
t = corporate tax rate applicable to the firm.
Illustrations: Find the cost of the equity from the following information given to you: Div 1 = $12;
g = 6%; and Po = $ 100; then Ke =?
Sol:
D1
Ke = ------- + g
P0
Where P0 = $100
D1 = $12
g = 6% or 0.06
$12
Ke = ------- + 0.06
$100
Ke = 0.12 + 0.06 = 0.18 or 18 %
2. : Find the cost of the preference from the following information given to you:
Pd = $7; and Po = $ 100; then Kp =? What will the cost of preference when the share is
redeemed after 5 years at (i) 10 % premium and (ii) 5 % discount?
Sol:
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Kp = Pd/Po
Where Kp = cost of preference share
Pd = $ 7
Po = $ 100
Kp = $ 7/$ 100
Kp = 0.07 or 7 %
When the preference share is redeemable, then Kp will be:

(i) With 10 % premium
Pd + [(RV-SV)/n]
Kp = ------------------------
[RV + SV]/2

Pd = $ 7
RV = $ 100 + 10 % on $ 100 = $100 + $ 10 = $ 110
SV = $ 100
n = 5 years
$ 7+ [($ 110-$ 100)/5 years]
Kp = -----------------------------------
[$ 110 + $ 100]/2
$ 7+ [($10)/5 years]
Kp =----------------------------
[$ 210]/2
$ 7+ $2
Kp = ----------------
$105
$9
Kp = --------------- = 0.0857 or 8.57 %
$105
21
(ii) With 5 % discount
Pd + [(RV-SV)/n]
Kp = ------------------------
[RV + SV]/2

Pd = $ 7
RV = $ 100 - 5 % on $ 100 = $100 - $ 5 = $ 95
SV = $ 100
n = 5 years
$ 7+ [($ 95-$ 100)/5 years]
Kp = -----------------------------------
[$ 95 + $ 100]/2
$ 7+ [(-$5)/5 years]
Kp =----------------------------
[$ 195]/2
$ 7- $1
Kp = ----------------
$97.50
$6
Kp = --------------- = 0.0615 or 6.15 %
$97.50
3. Find the cost of DEBT from the following information given to you:
Int = 9%; tax rate = 40 % and Po = $ 1000; then Kd =? What will the cost of Debt when it is
redeemed after 5 years at (i) 15 % premium and (ii) 10 % discount?
Sol:
Kd = Int (1-t)/Po
Where Kd = cost of debt
Int = 9 % of $1000 = $ 90
22
Po = $ 1000
T = 40 %
Kd = $ 90 (1-.4)/$ 1000
Kd = $54/$1000
Kd = 0.054 or 5.4 %
When the debt is redeemable, then Kd will be:
(iii) With 15 % premium
Int (1-t)+ [(RV-SV)/n]
Kd = ------------------------
[RV + SV]/2
Where Kd= Cost of debt

Int= 9 % on $ 1,000
RV = $ 1000 + 15 % on $ 1,000 = $1000 + $ 150 = $ 1,150
SV = $ 1000
n = 5 years
T = 40 %
$ 90 (1 – 0.04) + [($ 1,150-$ 1,000)/5 years]
Kd= ---------------------------------------------------------
[$ 1,150 + $ 1,000]/2
$ 54 + [($150)/5 years]
Kd =----------------------------
[$ 2,150]/2
$ 54+ $30
Kd = ----------------
$1,075
$ 84
Kd = --------------- = 0.0781 or 7.81 %
$1,075
(ii) With 10 % discount
23
Int (1-t) + [(RV-SV)/n]
Kd = -------------------------------
[RV + SV]/2
Where Kd= Cost of debt

Int= 9 % on $ 1,000
RV = $ 1000 - 10 % on $ 1,000 = $1000 - $ 100 = $ 900
SV = $ 1000
n = 5 years
T = 40 %
$ 90 (1 – 0.04) + [($ 900-$ 1,000)/5 years]
Kd= ---------------------------------------------------------
[$ 900 + $ 1,000]/2
$ 54 + [(-$100)/5 years]
Kd =----------------------------
[$ 1,900]/2
$ 54- $20
Kd = ----------------
$950
$ 34
Kd = --------------- = 0.0357 or 3.57 %
$950
1.9 COMPUTATION OF SIMPLE AVERAGE COST OF CAPITAL
From the following information supplied to you calculate the overall cost of capital of the firm.
Cost of equity is given as 15%; cost of preference is 8 %; and cost of debt is 7 %.
Sol:
Ko = (Ke + Kp + Kd)/3
Where Ke = 15 %
Kp = 8 %
24
Kd = 7%
Ko = (15% + 8 % + 7 %)/3
Ko = (30%)/3
Ko = 10 %
Illustration 2: From the following information calculate the cost of capital Ko?
Ke = 12 %; Kd = 6%; and Kp = 8%.
Sol:
Ko = (Ke + Kp + Kd)/3
Where Ke = 12 %
Kp = 8 %
Kd = 6%
Ko = (12% + 8 % + 6 %)/3
Ko = (26%)/3
Ko = 8.66 %
Illustration 3: Computation of cost of capital using weighted average cost of capital using
illustrations 1, with the following weights (1) Ke :: Kp : : Kd in 2:1:2 proportions. (2) Ke : : Kp
: : Kd in 2:3:2 proportions.
Sol (1):
Ko = (2 X 15 % + 1 X 8 % + 2 X 7 %)/ (2 + 1 + 2)
Ko = (30 % + 8 % + 14 %)/ (5)
Ko = (52 %)/ (5)
Ko = 10.4 %
Sol (2):
25
Ko = (2 X 15 % + 3 X 8 % + 2 X 7 %)/ (2 + 1 + 2)
Ko = (30 % + 24 % + 14 %)/ (5)
Ko = (68 %)/ (5)
Ko = 13.6 %
Illustration 4: From the following Statement given to you calculate the cost of capital using (i)
SACC; (ii) WACC using the Book values; and (iii) WACC using market values.
Particulars Book Values in $ Market values in $ Specific costs

Common Share $ 200,000 $ 500,000 Ke = 13.5 %
Capital
Retained Earnings 250,000
Preference Share 150,000 150,000 Kp = 7.9 %
capital
Bonds 150,000 100,000 Kd = 5.8 %
Sol (i):
Ko = (Ke + Kp + Kd)/3
Where Ke = 13.5 %
Kp = 7.9 %
Kd = 5.8%
Ko = (13.5 % + 7.9 % + 5.8 %)/3
Ko = (27.2 %)/3
Ko = 9.33 %
26
(iii) Calculation of cost of capital using Book weights:
Particulars Book values Specific Cost Book weights Cost X weights
Common Share $ 200,000 13.5 % 0.267 3.6045 %
capital
Retained earnings 250,000 13.5 % 0.333 4.4955 %
Preferred share 150,000 7.9 % 0.200 1.5800 %
capital
Bond capital 150,000 5.8 % 0.200 1.1600 %
Total: $ 750,000 1.000 10.8400 %
Ko= 10.84 %
(iii) Calculation of cost of capital using market weights:

Particulars Book values Specific Cost Market weights Cost X weights
Common Share $ 500,000 13.5 % 0.667 9.00 %
capital
Preferred share 150,000 7.9 % 0.200 1.58 %

capital
Bond capital 100,000 5.8 % 0.133 0.77 %
Total: $ 750,000 1.000 11.35 %
Ko= 11.35 %
Illustration 5: From the following information given to you related to Beta Incorporation, find
the cost of capital.
Particulars Amount in $ Specific costs
Common Share Capital $ 1,500,000 Ke = 12.5 %
Retained Earnings 700,000 -
Preference Share capital 350,000 Kp =9 %
Bonds 500,000 Kd = 4.8 %
8 % secured loans 250,000 -
27
Sol:
Calculation of cost of capital using book values given:
Particulars Amount Cost Cost * Amount
Common Share $1,500,000
Capital 12.50% $187,500.00
Retained Earnings 700,000 12.50% 87500
Preference Share 350,000
capital 9% 31500
Bonds 500,000 4.80% 24000
8 % secured loans 250,000 4.80% 12000
$3,300,000 $342,500.00
$ 342,500
Kd = --------------- = 0.1037 or 10.37 %
$3,300,000
1.10 LEVERAGES
Every business requires additional capital for its operational performance, which is financed
through issue of common shares or by increase the debt by the creditors. Issue of additional
common shares will extend the owner’s equity base, while issue of debt increases the claims by
the creditors. Capital structure decision is the decisions determining the composition of the
debt-equity mix in the firm’s capital sources. Employment of additional funds from outsiders
increases the earnings of equity shareholders on one hand, and also increases the risk of
shareholders on the other hand. Leverage is defined as “the processes of employment of an
asset or funds for which the firm pays a fixed cost or fixed return” 2 . According to the above
definition leverage results from the employment of additional funds, which carry fixed cost
(called as interest charges). It is to be noted that, fixed cost or return or debt capital is incurred
irrespective of size, volume, and output of the firm. Financial charges bear considerable effect
on the firm’s shareholders interest in profits contribution.
Leverage helps finance manager in knowing the effect of change in sales over profits and
earnings per share. It is also defined as the relative change in profits due to change is sales. A
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high degree of leverage implies that there will be a large change in profits due to a small
change in sales and vice versa. Leverage is classified into three components and they are (1)
Operating leverage, (2) financial leverage, and (3) composite (or combined) leverage.
1.10.1Operating Leverage
It is always observed that changes in sales volume or value bear direct effect of the operating
profits of the firm. Operating leverage is defined as “the process of operating profits varying
proportionately with change in the sales”. An increase in sales will bring more operating
profits, and a decrease in sales volume reduces the operating profits. A firm is said to have a
high degree of operating leverage, if it employs greater amount of fixed cost than variable
costs. Therefore it is essential to know that operating leverage is dependent on the employment
of proportion of fixed cost by the given firm. Operating leverage can be calculated by the
following formula:
Contribution C
Operating leverage = ------------------------ or -------
Operating profits EBIT
Alternatively operating leverage can be calculated using the following formula:
Percentage change in profits

Degree of operating leverage =--------------------------------------------
Percentage change in Sales
Decision rule: Operating leverage may be favorable or unfavorable. A favorable leverage

arises due to higher contribution over fixed cost and unfavorable leverage arises due to lower
contribution over fixed cost. The operating leverage indicates the impact of changes in sales on
operating income. A high degree of operating leverage indicates a small change in sales will
have drastic effect on the operating profits of the firm. Higher operating leverage is a risky
situation for firm, as the small drop in salves volume or value; there can be excessive damage
to profits of the firm.
Illustration: A firm can operates with a production capacity of 1,000 units per annum. Its actual
production of the current year was 400 units, selling each unit at a price of $ 10, and variable
cost being $ 6. Calculate the operating leverage of the firm, when
(1) The fixed cost of the firm is $ 400, per annum.
29
(2) The fixed cost of the firm is $ 1,000 per annum.
(3) The fixed cost of the firm is $ 1,200 per annum.
Sol (1):
Financial Cost sheet of the given firm
Sales Volume 400 units per annum
Selling price $ 10 per unit
Sales value $ 4,000
Less:
Variable cost (60 %) $ 2,400
CONTRIBUTION $ 1,600
Less:
Fixed cost per annum 400
OPERATING PROFITS $ 1,200
(Earnings before interest and tax)
Contribution $1,600
Operating leverage = ------------------------ = ------------
Operating profits $ 1,200
Operating leverage = 1.33 times.

Sol (2):
Financial Cost sheet of the given firm
Sales value $ 4,000
Less:
Less:
Fixed cost per annum $ 1,000
OPERATING PROFITS $ 600
30
Contribution $1,600
Operating profits $ 600
Operating leverage = 2.66 times.

Sol (3): Financial Cost sheet of the given firm
Sales value $ 4,000
Less:
Less:
Fixed cost per annum $ 1,200
OPERATING PROFITS $ 400
Contribution $1,600
Operating profits $ 400
Operating leverage = 4 times.
1.10.2Financial Leverage
Financial leverage is defined as “the tendency of the residual net income to vary
disproportionately with operating profits”. It explains the changes in the taxable income with
the changes in operating profits. Employment of debt capital involves interest charges, which
are paid before taxes. The use of fixed charge bearing securities like, debt capital and preferred
capital along with the owner’s equity in the capital structure of the company is described as the
financial leverage. A firm is said to levered largely when larger portion of debt is employed,
and weakly levered when fewer debt capital is employed. Financial leverage is calculated
using the following formula:
31
Financial leverage = ------------------------ or -------
Profits before taxes EBT
Alternatively financial leverage can be calculated using the following formula:
Percentage change in earnings per share

Degree of financial leverage =--------------------------------------------------------
Percentage change in operating profits
Decision rule: Financial leverage may be favorable as well as unfavorable depending upon the
earnings made by the fixed returns bearing securities. A favorable leverage is resultant factor
when a firm earns more than the fixed cost bearing securities. Favorable leverage is also
termed as “trading on equity’. Unfavorable or negative leverage occurs when the firm does
not earn as much as the fixed cost bearing securities.
Illustration: A firm has the following capital structure, using this information calculate the
financial leverage of the firm.
Common share capital $ 100,000
10 % preferred capital 100,000
8 % Debt capital 125,000
Earnings before interest and tax of the firm is $ 50,000, and tax rate applicable to the firm is
40%.
Sol:
FINANCIAL COST SHEET OF THE GIVEN FIRM
Earnings before interest and tax (EBIT) $ 50,000
Less:
Interest charges 10,000
EARNINGS BEFORE TAX 40,000
Less:
Taxes @ 40 % 16,000
Earnings after Tax 24,000
Less:
Preferential dividends 10,000
Earnings available to equity share holders 14,000
32
Financial leverage = ------------------------ or -----------
Profits before taxes $ 40,000
Financial leverage = 1.25 times
1.10.3 Composite Leverage
Composite leverage or combined leverage explains the relationship between revenue on

account of sales and taxable income. It is simply the product of operating leverage and
financial leverage. Combined leverage is calculated using the following formula:
Contribution C
Combined leverage = ------------------------ or -------
Alternatively combined leverage is calculated using the following formula:

Degree of combined leverage =--------------------------------------------------------
Illustration: A firm provides to you the following information in the form of income statement.
Calculate operating leverage; financial leverage and composite leverage.
INCOME STATEMENT OF THE GIVEN FIRM FOR THE
YEAR ENDED 200X
Sales $ 1,000,000
Less: Variable cost (40 %) 400,000
CONTRIBUTION 600,000
Less: Fixed operating expenses 300,000
EARNINGS BEFORE INTEREST AND TAXES 300,000
Less: Interest expenses 100,000
EARNINGS BEFORE TAX 200,000
33
Sol:
Contribution $ 600,000
Operating leverage = ------------------------ or -----------
= 2 times
Financial leverage = ------------------------ or -----------
= 1.5 times
Contribution $ 600,000
Composite leverage = ------------------------ or -----------
= 3 times
1.10.4 Leverage Analysis Using for Decision-Making Process
From the following information find the degree of operating leverage, degree of financial
leverage and degree of composite leverage.
Sales $ 900,000 $ 1,200,000
Less: Variable cost (40 %) 360,000 480,000
CONTRIBUTION 540,000 720,000
Less: Fixed operating expenses 300,000 300,000
EARNINGS BEFORE INTEREST AND TAXES 240,000 420,000
Less: Interest expenses 100,000 100,000
EARNINGS BEFORE TAX 140,000 320,000
Less: Taxes 56,000 128,000
EARNINGS AFTER TAX 84,000 192,000
Number of common Shares 10,000 shares 10,000 shares
34
Sol: calculation of leverages using direct formulas:
Leverage Formula Year - 1 Year - 2
Operating leverage = Contribution/EBIT =$540,000/ 240,000 =$720,000/$420,000
= 2.25 times = 1.714 times
Financial leverage = EBIT/EBT =$240,000/$140,000 =$420,000/$320,000
= 1.714 times = 1.312 times
Composite = Contribution/EBT =$540,000/$140,000 =$720,000/$320,000
leverage
= 3.857 times = 2.25 times
Why this is happening like this?
This is because:
6 6
1 1
4
4
3 2 2
3
1 = Variable cost; 2= contribution; 3= Fixed cost; 4= EBIT; 5= Interest charges and 6= EBT
If you see the graph carefully, it is clearly observed that 2 (contribution) increased from year-1
to year-2. Increase in the contribution but the fixed cost is constant, thereby the ratio reduced
which is affecting the operating leverage from first year and second year. The same is true with
other leverage ratio. Hence in case of multiple year financial statements, relative formula
should be used which will give more consistent information for the decision makers. The
relative formulas are:
Percentage change in earnings before interest and tax
Degree of operating leverage =-----------------------------------------------------------
35
Degree of combined leverage =-----------------------------------------------------------
Percentage change in Earnings before interest and tax

Degree of combined leverage =--------------------------------------------------------
Therefore for the given illustration the required leverages are:

{($ 420,000 – $ 240,000)/$ 240,000} X 100
{($ 1,200,000 – $ 900,000)/$ 900,000} X 100
= 2.25 times
{($ 19.20 – $ 8.40)/$ 8.40} X 100

Degree of financial leverage =------------------------------------------------------------
{($ 420,000 – $ 240,000)/$ 240,000} X 100
= 1.71 times
{($ 19.20 – $ 8.40)/$ 8.40} X 100

{($ 1,200,000 – $ 900,000)/$ 900,000} X 100
= 3.86 times
Using the above leverages, finance manager can make effective financial planning in simple
way and within quick time. If the given firm is planning to expand its production by 25 % over
the coming 10 years period, it will be easy calculation to find out the Expected EBIT and EPS
for the 10 years period, using the leverage ratio’s calculated above.
Percentage change in earnings before interest and tax
36
Therefore: % change in EBIT = Degree of operating leverage X % change in sales
% Change in earnings per share

Degree of combined leverage =-----------------------------------------------
Therefore: % change in EPS = Degree of combined leverage X % change in sales

DOL = 2.25 times
DFL = 1.71 times
DCL = 3.86 times
%Change 25 50 75 100 125 150 175 200

in sales
%Change
in EBIT 56.25 112.5 168.75 225 281.25 337.5 393.75 450
% 96.43 192.86 289.29 385.71 482.14 578.57 675.00 771.43
Increase in the Sales (%) Increase in the EBIT in $ Increase in the EPS in $
25 375,000 16.5
50 510,000 24.6
75 645,000 32.7
100 780,000 40.8
125 915,000 48.9
150 1,050,000 57
175 1,185,000 65.1
200 1,320,000 73.2
225 1,455,000 81.3
250 1,590,000 89.4
Using the above information related to EBIT and EPS the following graph can be constructed
for the decision making process.
37
1.11 INDIFFERENCE POINT
Capital structure is the mix of various components of different sources. It is always difficult to
identify the desired composition of various sources of capital. It is the indifference point,
which brings the desired combination of source of capital. It is the level of earnings before
interest and tax (EBIT) where earnings per share (EPS) remains constant irrespective of the
source of capital. Indifference point is also referred as financial break-even point of various
financial plans. The point of indifference can be calculated with the help of the following
formula:
(X)(1 – t) (X - Int)(1 – t) (X)(1 – t) – Pd (X - Int)(1 – t) - Pd
------------ = ------------------- = ------------------- = -------------------------
N N1 N2 N3
Where N =Number of common shares with only Equity
N1 =Number of common shares with Equity and Debt
N 2=Number of common shares with Equity and Preferred Capital
N 3=Number of common shares with Equity, Preferred capital and Debt
X = Earnings before interest and taxes (EBIT)
Pd = Preferential dividends
Int = Interest on the debt capital
t = Tax rate applicable to the given firm.
38
Decision rule: Financial break-even point is used in evaluation of decision related to the
additional capital requirements. Any amount of EBIT below financial break-even point is good
for issue of common shares, and above financial break even point is good for the issue of
additional debt or preference shares.
Illustration: A new project under consideration requires a capital investment of $ 150,000;

interest on the long-term loan will be 8 % and tax rate is 45 %. The debt – equity ratio of the
existing the capital ratio is 1:1. The existing common shares or the firm is 5,000 shares in
numbers with each share for $ 10. Which option is profitable, when the firm anticipates a
return of 20 % on the additional funds invested?
Sol:
Financial indifference point of the given firm is selection either debt or equity for the new
investment, which is evaluated as follows:
(X)(1 – t) (X - Int)(1 – t)
------------ = -------------------
N N1
Where N =Number of common shares with only Equity = 5,000 shares +15,000 shares (new)
N1 =Number of common shares with Equity and Debt = 5,000 shares
X = Earnings before interest and taxes (EBIT)=?
Int = Interest on the debt capital = 8 % on $ 150,000 = $ 12,000
t = Tax rate applicable to the given firm = 45 % or 0.045
Substituting the above values in the equation:

(X)(1 – 0.45) (X - $ 12,000)(1 – 0.45)
----------------- = -----------------------------
20,000 shares 5,000 shares
39
Solving the above equation we get
(X) (0.55) = 4 [X-$12,000](0.55)
0.55 X= 2.20 X -$ 26,400
(2.2 – 0.55) X = $26,400
X = $ 26,400 ÷ 1.65
X = $ 16,000
Required EBIT is $ 16,000 where EPS with either option remains one and the same.
Decision rule: As the firm return on investment is 20 % on $150,000 is much higher than the
financial break-even point $ 16,000, the firm has to go for mobilizing debt, which will give,
high EPS.
Verification of the above:
Particulars Only Equity option Debt-Equity option
EBIT $ 30,000 $ 30,000
Less: Interest charges Nil 12,000
EBT 30,000 18,000
Less: Taxes @ 45 % 13500 8100
EAT 16,500 9,900
Number of common shares 20,000 5,000
Earnings per share $ 0.825 $ 1.98
Therefore, it can be concluded that, issue of Debt for $ 150,000 additional capital will give
earnings per share equal to $ 1.98, which is higher than issue of equity, by $1.1.
1.12 CAPITAL STRUCTURE
Capital structure refers to the makeup of the firm’s capitalization. It represents the mix of
different sources of long-term funds in the capitalization of the company. The term capital
structure differs form financial structure. Financial structure refers to the way the firm’s assets
are financed. It includes both long-term as well as short-term sources of funds. Capital
structure is the permanent finance of the company represented primarily by long-term debt and
shareholder’s funds but excluding all short-term sources. It is evident from this, that capital
structure is only a part of its financial structure. Capital structure of a firm ma be of any of the
following patters:
40
 Capital structure with issue on only common share.
 Capital structure with common shares and preference shares.
 Capital structure with common shares and debt capital.
 Capital structure with equity shares, preference shares and debt capital.
The choice of an appropriate capital structure depends on a number of factors like regularity of
earnings, nature of the firm’s business conditions, capital markets, investor’s perceptions and
so on. Firm interested in mobilizing funds should always keep the following points in bringing
additional funds for its investment needs. Issue of common shares is considered as the variable
yield bearing securities, as the dividend payment on these shares varies from year to year.
Issue of preference shares or debt capital (bonds/debenture) is called as the fixed yield
securities, as the interest payment or dividend payment on these remains constant thought out
the life period of security.
CAPITAL
STRUCTURE
VARIABLE YIELD FIXED YIELD BEARING

BEARING SECURITIES
SECURITUES
 Preference shares
 Bonds or Debentures
Common Shares
1.12.1 Optimum Capital Structure
Optimum capital structure is the state of capital structure every firm desires to maintain so as to
attain financial stability. Financial stability is obtained when the market value of the common
share is high. Optimum capital structure is defined as the relationship of debt and equity,
which maximize the value of share. The value of equity share is high while the average cost of
capital is minimum at the optimum capital structure.
41
Features of optimum capital structure:
 Profitability: The capital structure should be devised so as to maximize the profits of
the firm. The most profitable capital structure is that minimizes cost of financing and
maximizes earnings per share.
 Solvency: Capital structure is said to be optimum, when the firm is free of becoming
insolvent. Use of debt in excess capacity may result as insolvency situation for a firm
in long run.
 Flexibility: Capital structure of the firm should be flexibility, so as to mobilize
additional funds whenever required by the firm.
 Conservatism: Capital structure should be such tat it should generate future cash flows
desirable by the firm.
 Control: Capital structure should be devised in such a way that it minimizes risk of loss
of control over the firm financial operations.

1. Explain the two types of capital structure.
……………………………………………………………………………………………………
……………………………………………………………………………………………………
…………………………………………………………………………………………………….
1.13 SUMMARY
Financial planning is the processes of estimating the required finance of a firm for its business
decisions. Every business unit requires funds for its various applications, like incorporation,
expansion and diversification decisions. Risk in financing decisions is very simple to define, as
the mix of the internal and external factors, which influence the business activities.
Business requires funds for its investment decisions, and every investment requires a return to
be payable. The term cost of capital refers to the return a firm intends to pay to its members
who contribute the capital to the firm. Cost of capital is determined by taking into account the
cost of each component of capital, known as a specific cost of capital. Specific cost of capital
of the given firm is defined as the cost of equity (returns paid to the equity share holders) or
42
cost of preference (returns paid to preference shareholders) or cost of debt (returns paid to the
debt holders).
Every business requires additional capital for its operational performance, which is financed
through issue of common shares or by increase the debt by the creditors. Issue of additional
common shares will extend the owner’s equity base, while issue of debt increases the claims by
the creditors. Capital structure decision is the decisions determining the composition of the
debt-equity mix in the firm’s capital sources. Employment of additional funds from outsiders
increases the earnings of equity shareholders on one hand, and also increases the risk of
shareholders on the other hand. Leverage is defined as “the processes of employment of an
asset or funds for which the firm pays a fixed cost or fixed return”.
It is always observed that changes in sales volume or value bear direct effect of the operating
profits of the firm. Operating leverage is defined as “the process of operating profits varying
proportionately with change in the sales”. Financial leverage is defined as “the tendency of the
residual net income to vary disproportionately with operating profits”. It explains the changes
in the taxable income with the changes in operating profits. Composite leverage or combined
leverage explains the relationship between revenue on account of sales and taxable income.
Capital structure refers to the makeup of the firm’s capitalization. It represents the mix of
different sources of long-term funds in the capitalization of the company. The term capital
structure differs form financial structure. Financial structure refers to the way the firm’s assets
are financed.
1. Explain the significance of financial planning the business decisions?

2. “Financial planning is considered as strategic function”. Discus?
3. Briefly list out the various risk factors, which are incidental to the financial planning.
4. Define briefly Cost of capital and explain its significance in financial planning?
5. “Capital leverage is useful for business processing”. Justify your answer?
6. What is meant by Capital structure? How is it different from optimum capital structure?
43
Problems
1. K P Incorporation is having the following capital structure in the market value term.
The common share sells for $25 a share, and the company has a marginal tax rate of 40 %.
The current year dividend of the firm is $2.80 with a growth rate in the payments of
dividends of 4 percent. Compute the simple average cost of capital, and weighted average
cost of capital.
13 % debentures issued 3 years back $ 600,000
12 % preferred stock 200,000
Common shares (100,000 shares) 800,000
2. ABC Incorporation is having the following capital structure in the market value term.
The common share sells for $125 a share with $5 per share as flotation cost, and the
company has a marginal tax rate of 34 %. The current year dividend of the firm is $12
with a growth rate in the payments of dividends of 7 percent. Compute the simple average
cost of capital, and weighted average cost of capital.
11 % debentures issued 3 years back repaid after 5 years at 10% $ 500,000
premium
14% preferred stock 300,000
3. ZETA Limited is having the following capital structure. The company has a marginal
tax rate of 40 %. The current year dividend of the firm is $16 with a growth rate in the
payments of dividends of 6 percent. Compute the simple average cost of capital, and
weighted average cost of capital.
10 % debentures $ 700,000
4. A firm is having the following capital structure in the book value term. Compute the
simple average cost of capital, and weighted average cost of capital, when tax rate is 50
percent. Cost of equity is given as 12.5 %.
13 % debentures $ 300,000
44
Retained earnings 200,000
5. Compute the simple average cost of capital, and weighted average cost of capital.
Debt capital $ 600,000 Kd = 6.3 %
Preferred stock 200,000 Kp = 8.5 %
Common shares 800,000 Ke = 14.8 %
6. Using the following information of a new firm, determine the appropriate capital
structure. It can issue 16 % debt or 15 % preferred stock. Common stock can be sold at
$20 per share. Capital required by the firm in all cases is $5 millions, and is expected to
earn a return on its investment as 18 %. /Tax rate applicable to the firm is 35 %.
Plan
Debt % Preferred Equity %
%
1 0 40 60
2 40 0 60
3 30 30 40
a. Construct an EBIT-EPS chart for the three plans.
b. Determine the relevant indifference points.
c. Which plan is best?
1.14 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. A. See Section 1.3 B. See Section 1.4

1. See Section 1.6.1
45
1. See Section 1.12

1. See Section 1.2
2. See Section 1.3
3. See Section 1.4
4. See Section 1.6
5. See Section 1.10
6. See Section 1.12
Practice Problems:
1. Sol: calculation of cost of equity (ke):
D1
Ke = ------- + g
P0
Where P0 = Price of common shares =$ 25

D1 = Dividend for year = $ 2.80
g = growth rate = 4 %
Ke = required rate of return. = ?
$ 2.80
Ke = ------- + 4 %
$ 25
Ke = 0.152 or 15.2 %
Cost of preference is given as 12 %
Cost of debt (before tax) is given a 13 %
Tax rate is given as 40 %
Cost of debt (after tax) will be = I (1-t) = 13 % (1-0.4) = 7.8 %
Simple average cost of capital (SACC) =
Ko = (Ke + Kp + Kd)/3
Where Ke = 15.2 %
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Kp = 12%
Kd = 7.8%
Ko = (15.2% + 12 % + 7.8 %)/3
Ko = (35%)/3
Ko = 11.33 %
Weighted average cost of capital (WACC) =
Ko = (0.5 X 15.2 % + 0.125 X 12 % + 0.375 X 7.8 %)/ (0.5 + 0.125 + 0.375)
Ko = (7.6% + 1.5 % + 2.925 %)/ (1)
Ko = 12.025 %
D1
Ke = ------- + g
P0
Where P0 = Price of common shares =$ 125 - $ 5 = $ 120

D1 = Dividend for year = $ 12
$ 12
Ke = ------- + 7%
$ 120
Ke = 0.17 or 17 %
Cost of debt (before tax) =
Int (1-t) + [(RV-SV)/n]

Kd = ------------------------
[RV + SV]/2
where Kd = Cost of debt

Int = Interest paid/payable on the debt = $11
RV = Redeemable value of the debt = $ 110
SV = Sales proceeds of the debt = $ 100
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n = Maturity period in years. = 8 years
t = corporate tax rate applicable to the firm= 34 %.
$ 11 (1-0.34) + [($ 110-$ 100)/8]

Kd = ------------------------
[$ 110 + $ 100]/2
Kd = 0.081 or 8.1 %

Ko = (Ke + Kp + Kd)/3
Where Ke = 17 %
Kp = 14%
Kd = 8.1%
Ko = (17% + 14 % +8.1 %)/3
Ko = (39.1%)/3
Ko = 13.03 %
(iv) Calculation of cost of capital using Book weights:

Particulars Book values Specific Cost Cost X weights
Common Share $ 600,000 17 % $ 102,000
capital
Preferred share 300,000 14 % $ 42,000
capital
Bond capital 700,000 8.1 % $ 56.700
Total: $ 1,600,000 $ 200,700
Ko= $ 200,700/$ 1.600,000

= 0.1254 or 12.54 %
48
D1
Ke = ------- + g
P0
Where P0 = Price of common shares =$ 100

D1 = Dividend for year = $ 16
$ 16
Ke = ------- + 6 %
$ 100
Ke = 0.22 or 22 %
Cost of debt (before tax) is given a 10 %
Tax rate is given as 40 %
Cost of debt (after tax) will be = I (1-t) = 10 % (1-0.4) = 6 %
Ko = (Ke + Kp + Kd)/3
Where Ke = 22 %
Kp = 11%
Kd = 6%
Ko = (22% + 11 % + 6 %)/3
Ko = (39%)/3
Ko = 13 %
Ko = (0.45 X 22 % + 0.2 X 11 % + 0.35 X 7.8 %)/ (0.45 + 0.2 + 0.35)
Ko = (9.9% + 2.2 % + 2.1 %)/ (1)
Ko = 14.2 %
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4. Sol: Simple average cost of capital (SACC) =
Ko = (Ke + Kp + Kd)/3
Where Ke = 12.5 %
Kp = 9%
Kd = 6.5%
Ko = (12.5% + 9 % + 6.5 %)/3
Ko = (28%)/3
Ko = 9.33 %
Ko = (0.6 X 12.5 % + 0.1 X 9 % + 0.3 X 6.5 %)/ (0.6 + 0.1 + 0.3)
Ko = (6.25% + 0.9 % + 1.95 %)/ (1)
Ko = 9.1 %
5. Sol: Simple average cost of capital (SACC) =

Ko = (Ke + Kp + Kd)/3
Where Ke = 14.8 %
Kp = 8.5%
Kd = 6.3%
Ko = (14.8% + 8.5 % + 6.3 %)/3
Ko = (29.6%)/3
Ko = 9.86 %

Ko = (0.5 X 14.8 % + 0.125 X 8.5 % + 0.375 X 6.3 %)/ (0.5 + 0.125 + 0.375)
Ko = (7.4% + 1.0625 % + 2.3625 %)/ (1)
Ko = 10.825 %
50
6. Sol:(a) Chart shown in the illustration of theory.
(b)
(X- Int)(1 – t) (X)(1 – t) - Pd (X - Int)(1 – t) - Pd
------------ = ----------------------- = ------------------------
N1 N2 N3
Where
N1 =Number of common shares with Equity and Debt = 150,000 shares
N 2=Number of common shares with Equity and Preferred Capital = 150,000
N 3=Number of common shares with Equity, Preferred capital and Debt =100,000 shares
X = Earnings before interest and taxes (EBIT)
Pd = Preferential dividends = 15 % on $ 2,000,000 = $ 300,000
Int = Interest on the debt capital = 16 % on $ 2,000,000 = $ 320,000
t = Tax rate applicable to the given firm = 35 %
(X- $ 320,000)(1 – 0.35) (X)(1 –0.35) – 300,000 (X - $240,000)(1 – 0.35) – 225,000

-------------------------- = ------------------------------- = -------------------------
150,000 shares 150,000 shares 100,000 shares
By dividing denominator with 100,000, and finding the single line equation
X- $ 320,000)(0.65) = (X)(0.65) – 300,000 = (1.5X - $360,000)(0.975) – 337,500
0.65 X – 208,000 = 0.65 X – 300,000 = 1.4625 X – 351,000 – 337.500
1.4625 X = 780.500
X= $ 533.675
Therefore the combined financial break-even point is equal to $ 533,675.
(c) Alternative ‘c’ is the best option that maximizes the shareholders returns.
1.15 REFERENCE
 Hampton, John J., Financial Decision-Making.

 James C. Van Horne, Financial management policy, 12th Edition.
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UNIT 2: ADVANCED INVESTMENT DECISIONS (LEASING DECISIONS)
Contents
2.1 Introduction
2.2 Definition
2.2.1 Operating or Service Lease
2.2.2 Direct Leasing
2.2.3 Leverage Lease
2.2.4 Sale and Lease Back
2.2.5 Advantage of Leasing to the Lessee
2.2.6 Disadvantages of Leasing to the Lessee
2.2.7 Advantages of Leasing to the Lessor
2.2.8 Disadvantages of Leasing to the Lessor
2.3 Decision on Leasing Lessor /Lessee and Illustration
2.4 Summary
2.5 Answer to Check Your Progress Exercise
After completion of this unit one should be able to explain the following:
 meaning and need for leasing
 types of leasing options
 lease evaluation for lessee
 lease evaluation for lessor
 net income method of lease evaluation
 total expenditure method of lease evaluation
2.1 INTRODUCTION
Leasing is an arrangement that provides a firm with the use and control over the assets without
buying and owning the same. It is a form of hiring assets. With only condition is that the hiring
52
is for the longer period. In a leasing agreement two or more persons are involved one the
owner of asset who offer the service, two the user of the asset who accept and three the
mediator between the owner and user. The owner of the asset called lesser offers the service
benefits of the asset to the user of the asset called lessee for an agreed price called lease rent
payable in advance in months/years. The lessee pays the rent periodically to the lessor, in return
to the benefits derived from the use of asset. In a lease agreement after the expiry of the lease
period, the asset is reverted back to the lessor, as the lessor is the official owner. In simple
terms, the lessor after retaining the ownership rights transfers the service rights to the user
through a lease agreement.
2.2 DEFINITIONS
Leasing is “the process of transferring the rights of using an asset form the owner is called
lesser to the user of the asset is called lessee, through an agreement for valuable consideration
is called lease rent”.
Leasing defined by Miller. M. H. along with C. W. Uptron, as “Leasing separates ownership

and use as two economic activities, and facilitates asset use without ownership”.
Types of leasing: Leasing is classified into two major categories, the first being the
classification based on the terms of lease and the second being the classification based on the
numbers of persons involved in the leasing. Based on the persons leasing is reclassified into
three types and they are (1) Direct leasing, (2) Leverage leasing and (3) Sale and lease back.
Based on the time period of leasing contract, lease can further classified into two types, (1)
Operating lease or Service lease, and (2) Financial lease or Capital lease.
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TYPES OF LEASING
PERIODIC LEASE AGREEMENTS PERSONAL LEASE AGREEMENTS
OPERATING LEASE DIRECT LEASE
FINANCIAL LEASE LEVERAGE LEASE
SALE AND LEASE BACK
2.2.1Operating or Service Lease
An operating is a short-term lease agreement, usually for a period less than 3 years. Operating
lease is common to the equipments which require expert technical staff for maintenance and are
exposed to technological developments, examples like, computers, vehicles, data processing
equipments, communication systems an so on. Operating lease is also called as service lease,
and characterized with the following features:
 It is a short-term lease on a period basis. The lease period is such a contract is less than
the useful life of the asset.
 The lease is cancelable at short notice by the lessee.
 Amortization of the original cost of the asset is not possible in an operating lease, as the
period is less than the assets useful service life.
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 Operating lease will always carry an option of renewing the lease agreement after the
expiry of the term, for the benefit of the lessee.
 Lessor is the person responsible for the maintenance of the asset in case of operating
lease.
 Operating lease will imposes high degree of risk to the lessor, as the term is very short.
Financial or Capital lease
A lease agreement can be called as the financial lease when the lessor has an option of
amortization of the entire cost of investment plus the expected return on the capital outlay
during the term of the lease (depreciation and interest). Financial lease usually extend for
longer period and are non-cancellable.
non-cancellable. Financial lease is considered as an alternative to debt
financing of the capital projects. Commonly land, buildings, machinery and fixed equipment
are widely used in financial lease. Financial lease is also called as the capital lease, and is
characterised with the following features:
 Financial lease is a long-term period lease usually extends from 5 years to 20 years.
 Financial lease is non-cancelable without prior intimation by the lessee before expiry
period.
 Lessee is responsible for the maintenance cost in financial lease.
 In a financial lease the renewal of agreement does not arises, as after the expiry of the
term, lessee will have an option of buying the asset from the lessor.
 Financial lease will have a low degree of risk to the lessor.
2.2.2 Direct Leasing
Under direct leasing a firm acquires the use of an asset that it does not already own. A direct
lease may be arranged either from the manufacturer supplier directly or through a leasing
company. In the first case, the manufacturer/supplier acts as the lessor while in the second case
the lessee firm arranges the purchase of the asset for the leasing company (lessor) from the
manufacturer or the supplier and also enters into an agreement with the lessor for the lease of
the asset.
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2.2.3 Leverage Lease
A lease agreement will be called as leveraged lease, when the lessor borrows funds to purchase
the asset from the lender and makes an agreement from the lessee for the transfer of service
benefits of the asset. The loan amount is secured by the mortgage out of the lease rental
income. In a leveraged lease lessor will act as the owner of the asset and also the borrower.
2.2.4 Sale and Lease Back
A sale and lease back arrangement involves the sale of an asset already owned by the firm
(vendor) and leasing of the same asset back to the vendor form the buyer of the asset. This
form of lease arrangement enables a firm to receive cash from the sale of asset and also retain
the economic use of the asset in consideration of periodic lease payment. A sale and lease back
agreement will favor the businessmen suffering from the shortage of funds.
2.2.5 Advantages of Leasing to the Lessee
 Leasing enables the firm to acquire the asset without investing the capital value of the
asset.
 Process of lease agreements will be quick when compared to the loan agreement
processing.
 Lessee can shift the risk arise due to the obsolescence of the purchasing the asset.
 Tax advantage in planning for the tax payments, which minimize the payments
systematically annually.
2.2.6 Disadvantages of Leasing to the Lessee
 The lease rentals include a margin for the lessor, as opportunity cost is included in the
lease rent.
 The lessee may be deprived of the use of the asset due to the deterioration in the
financial position of the lessor or winding up of the leasing company.
 Alteration or modification is not possible to the lessee as the owner of the asset is the
lessor.
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 Loss of ownership incentives and salvage value, which are available to the real owner
of the assent and not to the user of the asset.
2.2.7 Advantages of Leasing to the Lessor
 The lessor can make high profits form leasing of the asset, as the cost of capital will be
low in the leasing of assets to the outsider.
 Lessor being the owner of the asset can claim various tax benefits such as depreciation,
investment allowances, interest on the amount borrowed on loan capital for the
purchase of the asset.
 The lessor gets quick returns in the form of lease rentals as compared to investment in
the projects, which have a longer gestation period.
 Leasing financing through third parties has helped manufactures to increase their sales.
The lessor is also in a comfortable position to borrow the funds to purchase and go for
the leasing them to the respective users.
2.2.8 Disadvantages of Leasing to the Lessor
 The lessor has to bear the risk of obsolescence especially in the present era or rapid
technology developments.
 More firm entering into the leasing finance options it is becoming tough time for the
lessor to demand the effective leaser rental income.
 Inflation factor does not influence the lease rental income, as it is decided prior
agreement.
Evaluation of leasing option:
Leasing is beneficial to the lessee and lessor in some aspects and disadvantageous to both the
persons to some extent. Therefore a leasing proposal has to be evaluated for the purpose of
decision making with respective to the both the persons i.e., lessor and lessee. For the lessor
the leasing project will be bring the benefit called as the lease rental income, which after
deduction of the tax available to him as the return on the services cost transferred to the lessee.
When the lessor transfers the asset to the lessee, the depreciation benefit is foregone by the
lessor, as the condition of charge of depreciation will arise only when used for the self operated
57
business. Hence lease option for the lessor has to be evaluated by using the amount of
depreciation benefit lost with leasing rental income.
Decision for the lessor, if the lease rental income after tax is greater than the depreciation
benefit tax shield, then leasing the asset is more profitable, and if the lease rental income
after tax is lesser than the depreciation benefit tax shield then using the asset for own
business is profitable.
Evaluation of leasing for lessee
Lessee is the user of the asset, who is having much advantage of leasing option such as the
protection of obsolescence risk, lack of investment for long term projects and so on. Hence a
lease option for the lessee has to be evaluated by considering the opportunity cost leasing i.e.,
cost of funds used for the purchase of asset, risk of obsolescence. Lessee will be paying a return
for acquiring the value of services from the lessor, which are reduced to the tax saving value
(also called as expenses tax shield). Expenses tax shield are to be compared with the
opportunity cost such as depreciation tax shield and interest tax shield.
Decision for the lessee, if the expenses tax shield on leasing is greater than the opportunity
cost tax shield of lease, then leasing is more profitable, and if the leasing expenses tax shield
is lesser than the opportunity cost tax shield purchasing the asset is more profitable.
58
2.3 DECISION ON LEASING LESSOR/LESSEE AND ILLUSTRATION
VARIABLE COST OF PRODUCTION
FIXED PROFITS SUBJECTED TO TAX
PRODUCTION PROFITS AFTER TAX

COST
TAXES
Tax shield for used for

leasing decision
Alternatively the same decision can be expressed as follows:
VARIABLE COST OF PRODUCTION
FIXED COST OF PRODUCTION
PROFITS FOR TAXES
Advantage cost
on leasing
option
Illustration 1: From the following information given to you calculate which of the options given
below are best suitable for the investment decisions for Delta Incorporation.
Option 1: Purchase the asset using own funds.
Option 2: Purchase the asset using borrowed funds at 10 % interest of loan borrowed.
Option 3: Lease the asset for five years by paying $25,000 per annum.
59
Further information:
1. Cost of the asset value is given as $100,000,
2. Method of depreciation Accelerate Cost Recovery System (ACRS),
3. Cost of capital of the firm is 9 %,
4. Tax rate applicable 35 %.
Sol: Method of evaluation: NET INCOME METHOD, which considers tax savings.
1. Calculation of net present value of depreciation tax shield:
Option 1: Buying the asset with own funds
1 2 3 4 5 6 7
Depreciation $20,000 $32,000 $19,200 $11,520 $11,520 $5,760
Tax shield $7,000 $11,200 $6,720 $4,032 $4,032 $2,016
PV at 9 % $5,892 $8,648 $4,761 $2,621 $2,404 $1,103
Total saving as per the depreciation tax shield $25,428
2. Calculation of net present value of interest tax shield
Years 1 2 3.0 4.0 5.0
Total $25,709 $25,709 $25,709 $25,709 $25,709
Loan interest $9,000 $7,496 $5,857 $4,070 $2,123
Loan
principle $16,709 $18,213 $19,852 $21,639 $23,586
Loan paid $16,709 $18,213 $19,852 $21,639 $23,586
Unpaid loan $83,291 $65,078 $45,225 $23,586 $0
Interest $9,000 $7,496 $5,857 $4,070 $2,123 $0
Tax shield $3,150 $2,624 $2,050 $1,425 $743 $0
Total Shield $3,150 $2,624 $2,050 $1,425 $743 $0
PV at 10% $2,651 $2,026 $1,452 $926 $443 $0
Total Benefits for the total shield $ 7498
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3. Calculation of net present value of total benefits with tax shield.
Decision 3: Buying the asset with borrowed
funds
Depreciatio
n $20,000 $32,000 $19,200 $11,520 $11,520 $5,760
Tax shield $7,000 $11,200 $6,720 $4,032 $4,032 $2,016
Interest $9,000 $7,496 $5,857 $4,070 $2,123 $0
Tax shield $3,150 $2,624 $2,050 $1,425 $743 $0
Total Shield $10,150 $13,824 $8,770 $5,457 $4,775 $2,016
PV at 10% $8,543 $10,674 $6,213 $3,546 $2,847 $1,103
Total Benefits for the total shield $ 32,927
4. Calculation of net present value of lease rent tax shield.

Decision 2: Leasing the asset with own funds
Years 0 1 2 3 4 5 6
Lease rent $25,000 $25,000 $25,000 $25,000 $25,000
Tax shield $8,750 $8,750 $8,750 $8,750 $8,750 $0
PV at 10 % $7,365 $6,757 $6,199 $5,687 $5,217 $0
Total saving as per the lease rent shield $31,224
Decision 1: Lease versus purchasing the asset
Decision 2: Lease versus purchasing the asset using borrowed funds
Method of evaluation: TOTAL EXPENDITURE METHOD, which considers total

amount spent of the each alternative/option.
61
Decision 1: leasing with buying decisions using own funds
Particulars 0 1 2 3 4 5 6 7
Lease rent $25,000 $25,000 $25,000 $25,000 $25,000 $0
Tax shield $8,750 $8,750 $8,750 $8,750 $8,750 $0
Net lease
rent $25,000 $16,250 $16,250 $16,250 $16,250 ($8,750) $0
Depreciatio
n $20,000 $32,000 $19,200 $11,520 $11,520 $5,760 $0
Tax shield* $7,000 $11,200 $6,720 $4,032 $4,032 $2,016
Total $25,000 $16,250 $23,250 $27,450 $22,970 ($4,718) $4,032 $2,016
PV at 10% $25,000 $14,908 $19,569 $21,196 $16,273 ($3,066) $2,404 $1,103
Total expenditure on leasing the asset $ 97,387 97387
Total expenditure on buying the asset $100,000
Decision 2: leasing with buying decision using borrowed funds

Lease rent $25,000 $25,000 $25,000 $25,000 $25,000 $0
Tax shield $8,750 $8,750 $8,750 $8,750 $8,750
Net lease rent $25,000 $16,250 $16,250 $16,250 $16,250 ($8,750)
Depreciation $20,000 $32,000 $19,200 $11,520 $11,520 $5,760
Tax shield* $7,000 $11,200 $6,720 $4,032 $4,032 $2,016
Interest $10,000 $8,429 $6,701 $4,800 $2,709 $0
Tax shield* $3,500 $2,950 $2,345 $1,680 $948 $0
Total $25,000 $16,250 $26,750 $30,400 $25,315 ($3,038) $4,980 $2,016
PV at 10% $25,000 $14,908 $22,515 $23,475 $17,934 ($1,974) $2,970 $1,103
Total expenditure on leasing the asset $105,930
* Depreciation tax shield and Interest tax shield are opportunity cost, hence assumed as
expended with leasing option.
Decision 1: Lease versus purchasing the asset using own funds Leasing is profitable
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Leasing Buying Leasing cost Buying
cost 49 % cost 51 % 51 % cost 49 %
Decision 2: Lease versus purchasing the asset using borrowed funds Buying is profitable
Illustration 2: From the following information given to you calculate the lease decision versus
buying decision advantage and which option is the best.
Cost of machinery $ 40,000
Useful service life of the asset 5 years
Method of depreciation ACRS
Tax rate applicable to the firm 40 %
Cost of capital of the project 8 %,
Interest rate applicable to the firm 6 %
Lease rent per annum is given as $11,000 for 5 years
Sol: Total expenditure method: leasing with buying decisions using own funds
Calculation of interest amount on the loan capital
Years 1 2 3.0 4.0 5.0
Total $12,523 $12,523 $12,523 $12,523 $12,523
Loan interest $3,000 $2,429 $1,823 $1,181 $500
Loan principle $9,523 $10,094 $10,700 $11,342 $12,022
Loan paid $9,523 $10,094 $10,700 $11,342 $12,022
Unpaid loan $40,477 $30,383 $19,683 $8,341 $0
Calculation of present value of total expenditure on leasing option:
Lease rent $11,000 $11,000 $11,000 $11,000 $11,000 $0
Tax shield $4,400 $4,400 $4,400 $4,400 $4,400
Net lease rent$11,000
rent$11,000 $6,600 $6,600 $6,600 $6,600 ($4,400)
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Depreciation $10,000 $16,000 $9,600 $5,760 $5,760 $2,880
Tax shield $4,000 $6,400 $3,840 $2,304 $2,304 $1,152
Interest $3,000 $2,429 $1,823 $1,181 $500 $0
Tax shield $1,200 $971 $729 $472 $200 $0
Total $11,000 $6,600 $11,800 $13,971 $11,169 ($1,624) $2,504 $1,152
PV at 10% $11,000 $6,111 $10,117 $11,091 $8,210 ($1,105) $1,578 $672
Therefore it can be concluded that leasing option will incur an investment of $ 47,674 while
buying option incurs $ 50,000. Leasing option is considered more beneficial to the firm.
Illustration 3:An
3:An investment proposal demands initial cost of $80,000. The asset is having the
useful service life of 5 years. Due to the acute shortage of the cash, firm is considering the
following two options:
Option 1: purchase the asset using 75 % loan, or
Option 2: Lease the asset by paying a sum of 20,000 for three years, which can be renewed
after that. The firm comes under 38 % tax limit, and carries a cost of capital as 12 %. Should
the firm go for lease option or purchase option. (Interest rate of the borrowed capital will be 7
%).
Sol:
Total expenditure method of evaluation of leasing project:
Calculation of interest for a period of three years*
Years 1 2 3.0
Total $23,282 $23,282 $23,282
Loan interest $4,200 $2,864 $1,435
Loan principle $19,082 $20,418 $21,847
Loan paid $19,082 $20,418 $21,847
Unpaid loan $40,918 $20,500 0
Calculation of total leasing expenditure in terms of present value:
Lease rent $20,000 $20,000 $20,000
Tax shield $8,000 $8,000 $8,000
64
Net lease rent $20,000 $12,000 $12,000 $12,000
Depreciation $12,000 $19,200 $11,520
Tax shield $4,800 $7,680
Interest $4,200 $2,745 $1,189
Tax shield $1,680 $1,098
Total $20,000 $12,000 $18,480 $20,778
PV at 10% $20,000 $10,714 $14,732 $14,789
Decision: As the leasing cost is much higher than the purchasing cost, the firm should not go
for leasing decision.
Illustration 4:
ABC Incorporation Plans to lease out an asset whose cost is $50,000 with 5 years life.
Asset carries 5-year depreciation on ACRS schedule. What is the lease break-even for the
asset, when it is leased for 5 years, 4 years, and 3years for $10,000; $12,000; and $15,000?
The cost of capital is 10 %. Tax rate applicable to the firm is 35%.
Sol: Lease break even for the lessor: Asset value/ PV annuity at 10 % for 5 years
$ 50,000/3.790
$13,192.61
Therefore lease rent after tax is arrived as $ 13,192.61 lease rent before tax is given by dividing
the value $ 13,192.61 by (1- tax rate). $ 13,192.61/0.65
$ 20,296.33
Lease break even for the lessee:

Depreciatio
Years n Tax shield Lease rent Tax shield Net lease Total
0 - - $10,000 - $10,000 $10,000
1 $10,000 - 12,000 - 12,000 $12,000
2 $16,000 $3,500 15,000 $3,500 $11,500 $15,000
3 $9,600 $5,600 15,000 $4,200 $10,800 $16,400
4 $5,760 $3,360 15,000 $5,250 $9,750 $13,110
65
5 $5,760 $2,016 - $5,250 ($5,250) ($3,234)
6 $2,880 $2,016 - $5,250 ($5,250) ($3,234)
7 - $1,008 - $0 $1,008
Calculation of IRR of the total expenditure for the lessee:
PV Factor
Years Total 10% PV of total PV Factor 11% PV of total
0 $10,000 1 $10,000 1 $10,000
1 $12,000 0.909 $10,908 0.901 $10,811
2 $15,000 0.826 $12,390 0.812 $12,174
3 $16,400 0.751 $12,316 0.731 $11,992
4 $13,110 0.683 $8,954 0.659 $8,636
5 ($3,234) 0.621 ($2,008) 0.593 ($1,919)
6 ($3,234) 0.564 ($1,824) 0.535 ($1,729)
7 $1,008 0.513 $517 0.482 $486
$51,253 $50,450
Calculation of IRR of the project:
PVCFAT rL - PVCO
(Trial and Error method) IRR = rL +--------------------------- r
PVCFAT
Where: IRR = internal rate of return
rL = Discounting factor at lower rate = 10 %
rH = Discounting factor at Higher rate = 11%
PVCFAT rL = Present value of cash flow after-tax at lower rate = $51,253
PVCFAT rL = Present value of cash flow after-tax at higher rate =$50,450
PVCO = Present value of cash out flows = $ 50,000
PVCFAT = PVCFAT rL– PVCFAT rH = $ 803
r = r L - rH = 1 %
$51,253 - $ 50,000
IRR = 10 % +--------------------------- X 1 %
$803
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IRR = 10 % + 1.56% =11.56%
Illustration 5: NSW Private Limited has the proposal of four-year financial lease. The firm
considering the following case flows for the leasing option:
Lease cash $ 23,000 20,000 25,000 15,000
flows
The above cash follows reflects the leasing cost with depreciation tax shield. If the firm
borrows at 10% and is under 38 % tax limit, find (1) Value of the lease; (2) Is leasing
profitable for the firm?
Sol: From the given problem information is says that cash flows include all the
consideration required for the lessee i.e., inclusive of net lease with depreciation hence the
value given will the total expenditure on leasing option,
Leasing evaluation of lessee

Years Total expenditure on PV factor at 10 PV of Total
leasing %
0 $23,000 1 $23,000
1 $20,000 0.909 $18,180
2 $25,000 0.826 $20,650
3 $15,000 0.751 $11,265
4 $73,095
Therefore the value of the leasing for the lessee will be $ 73,095. Hence the decision goes
with the value of the leasing, that is, if the purchasing cost of the asset is less than $ 73,095,
then buying is more profitable, and if the purchasing cost is more than $ 73,095 then leasing
is acceptable.
Illustration 6: SBR Company has a large tax-loss carry forward and does not expect to pay
taxes for another 5 years. The company is therefore proposing to lease $80,000 of new
machinery. The lease terms consist of five equal lease payments prepaid annually. The
lessor can write the machinery off over five years using the tax depreciation schedule. The
67
tax rate is 35 % and the rate of return expected is 10 %. The president of the company is
interested to know the minimum amount payable as the lease rental payment, acceptable to
the lessor. Can you help the President is finding the same? What will be effect on your
decision if the method of depreciation is straight-line method?
Sol: a) The president is interested to know the lowest value of the lease rent payable, which
will be acceptable by the lessor. Lessor will accept any amount above the lease break even
for him; if it is less than lease break even he will reject the lease agreement. Hence the
required amount of lease rent is arrived using lease break-even calculation for the lessor.
Lease break even for the lessor: Asset value/ PV annuity at 10 % for 5 years
$ 80,000/3.790
$21,108.18
Therefore lease rent after tax is arrived as $ 21,108.18 lease rent before tax is given by dividing
the value $ 21,108.18 by (1- tax rate).
$ 21,108.18/0.65
$ 32,474.12
b) The second part of the exercise deals with tax planning. The firm is stated to have a loss
brought forward from the past years. Therefore firm has to take a decision is such a way that
the amount of tax savings (either by leasing option or by purchasing option) should be least.
Because if shows higher tax savings the recovery of brought forward losses will take longer
period. Hence a decision of leasing versus buying should be accepted not the higher tax shield,
but on the lower tax shield.
Lease rent expenses = $ 32,474.12
Depreciation straight line method = $ 16,000
Tax savings will be equal to Lease rent expenses/Depreciation Tax rate
Lease rent tax shield = $ 32,474.12 (35 %) = $11,366
Depreciation tax shield = $ 16,000 (35%) = $ 5,600
Hence leasing option is more profitable as leasing will save tax $ 11,366 while buying
will go for 5,600 after capital expenditure of $ 80,000.
68
2.4 SUMMARY
Leasing is an arrangement that provides a firm with the use and control over the assets without
buying and owning the same. It is a form of hiring assets. With only condition is that the hiring
is for the longer period. Leasing is “the process of transferring the rights of using an asset form
the owner called as the lesser to the user of the asset called as lessee, through an agreement for
valuable consideration called as lease rent”. Leasing is classified into two major categories, (1)
Operating lease or Service lease, and (2) Financial lease or Capital lease. (1) Direct leasing, (2)
Leverage leasing and (3) Sale and lease
Leasing is beneficial to the lessee and lessor in some aspects and disadvantageous to both the
persons to some extent. Therefore a leasing proposal has to be evaluated for the purpose of
decision making with respective to the both the persons i.e., lessor and lessee. For the lessor
the leasing project will be bring the benefit called as the lease rental income, which after
deduction of the tax available to him as the return on the services cost transferred to the lessee.
When the lessor transfers the asset to the lessee, the depreciation benefit is foregone by the
lessor, as the condition of charge of depreciation will arise only when used for the self operated
business. Hence lease option for the lesser has to be evaluated by using the amount of
depreciation benefit lost with leasing rental income.
Check Your Progress Exercises

1. Define the Leasing? Briefly explain the types of leasing options available to the
business?
2. Evaluate the leasing option of a lessee?
3. Evaluate the leasing option for lessor?
4. State briefly the advantages and disadvantages of leasing finance?
5. Abu Incorporation Plans to lease out an asset whose cost is $30,000 with 5 years life.
Asset carries 5-year depreciation on ACRS schedule. What is the lease break-even for the
asset, when it is leased for 5 years, 4 years, and 3years for $7,000; $10,000; and $13,000?
The cost of capital is 9 %, and inflation rate is 0 %. Tax rate applicable to the firm is 35%.
6. NSW Private Limited has the proposal of four-year financial lease. The firm
considering the following case flow for the leasing option:
69
Lease cash $ 93,000 40,000 45,000 35,000
flows
The above cash follows reflects the leasing cost with depreciation tax shield. If the firm
borrows at 10% and is under 38 % tax limit, find (1) Value of the lease; (2) Is leasing
profitable for the firm?
7. SR Company has a large tax-loss carry forward and does not expect to pay taxes for
another 10 years. The company is therefore proposing to lease $100,000 of new machinery.
The lease terms consist of eight equal lease payments prepaid annually. The lessor can
write the machinery off over seven years using the tax depreciation schedule. The tax rate
is 35 % and the rate of return expected is 10 %. The president of the company is interested
to know the minimum amount payable as the lease rental payment, acceptable to the lessor.
Can you help the President is finding the same? What will be effect on your decision if the
method of depreciation is straight-line method?
8. Imagine you are planning to buy a computer for your self. It can either be bought for
$20,000 or lease it for six annual payments of $5,000 each. Tax rate is given as 30 %. And
the cost of capital is 12 %. Find: I) The NPV of the lease for your self? II) NPV of the
lease for the LESSOR? And III) what will be your decision at the end?
9. An investment of $250,000 towards the purchase of machinery can be used for 5 years
successfully generating sufficient revenue to the business. It can also be acquired for a
lease agreement from the vendor by paying $62,000 annually for 5 years. When the tax rate
applicable to the firm is 35%, and the required rate of return before inflation is 8 %, find the
best possible decision for the buying the asset o leasing with 2 % as inflation.
10. Find the internal rate of return for the lease project given below:
Lease benefit $ 25,000 $ 35,000 $ 40,000 $30,000
to lessor
Lease benefits $ 20,000 $ 25,000 $ 20,000 $18,000
to the lessee
Project value for the above information is given as $ 60,000. Assume that the values
given to you as after tax and include all the other computations.
11. Sigma Incorporation is planning to purchase new Machinery whose cost is $300,000. The
asset is having a useful service life of 5 years with low maintenance cost. Sigma is not in a
70
position to fund the entire investment for the machinery. Hence it is considering the
following two options for the purpose of running the business. Assist and advice the firm is
selecting the best alternative, so as to maximize the value of the firm. Tax rate applicable to
the firm is 38 %, and the cost of capital is 11 % for all its capital projects. Oran will be
following ACRS as method of depreciation.
Option 1: Purchase the asset by borrowing 50 % of the funds at 7 %, Interest rate.
Option 2: Go for the leasing the same machinery from Mr. Y by paying $70,000 as
annual lease rent for 5 years.
Given that:
Years 1 2 3 4 5 6 7
Depreciation rate 20 % 32 % 19.2 % 11.52 % 11.52 % 5.76 Nil
%
Discounting factor 0.9009 0.8116 0. 7312 0. 6587 0.5935 0.5346 0.4817
12. Oran International Limited is planning to purchase new Machinery whose cost is $400,000.
The asset is having a useful service life of 5 years with low maintenance cost. Oran is not
in a position to fund the entire investment for the machinery. Hence it is considering the
following two options for the purpose of running the business. Assist and advice the firm
is selecting the best alternative available so as to maximize the value creation concept of
the firm. Tax rate applicable to the firm is 35 %, and the cost of capital is 12 % for all its
capital projects. Oran will be following ACRS as method of depreciation, and
depreciation rate for 5 years are 20%, 32%, 19.2%, 11.52% 11.52% and 5.76%.
Option 1: Purchase the asset by borrowing 75 % of the funds at 8 %, Interest rate.

Option 2: Go for the leasing the same machinery from Mr. Y by paying $100,000 as
annual lease rent for 5 years.
Years 1 2 3 4 5 6 7
Discounting 0.892 0.797 0. 7118 0. 6355 0.5674 0.5066 0.4523
factor 9 2
71

4. See Section 2.2.7 & 2.2.8
5. Sol:
Calculation of value of lease: 5
years
Years Lease rent Tax shield Net lease PV factor Total
0 7,000 7,000 1 7000
1 7,000 2450 4,550 0.926 4213
2 7,000 2450 4,550 0.857 3901
3 7,000 2450 4,550 0.794 3612
4 7,000 2450 4,550 0.735 3344
5 2450 -2,450 0.681 -1667
Value of the lease (break-even) 20403
Calculation of value of lease: 4 years

PV
Years Lease rent Tax shield Net lease factor Total
0 10,000 10,000 1 10000
1 10,000 3500 6,500 0.926 6019
2 10,000 3500 6,500 0.857 5573
3 10,000 3500 6,500 0.794 5160
4 0 3500 -3,500 0.735 -2573
5 0 0 0.681 0
72
Calculation of value of lease: 3
years
Years Lease rent Tax shield Net lease PV factor Total
0 13,000 13,000 1 13000
1 13,000 4550 8,450 0.926 7824
2 13,000 4550 8,450 0.857 7245
3 0 4550 -4,550 0.794 -3612
4 0 0 0 0.735 0
5 0 0 0.681 0
6 Sol:
Calculation of value of
lease:
Years Lease rent expenses
0 NPV of lease rent
1 93,000 0.909 84537
2 45,000 0.826 37170
3 40,000 0.751 30040
4 35,000 0.683 23905
175652
7. Sol:
Calculation of lease break-even for
Lessee:
Leasehold property value $100,000
Interest rate 10%
Tax rate 35%
Table value at interest rate 6.145
Lease break-even equation Leasehold property / table value

$16,273.39
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lease break even will be $16,273.39
Lease rent annual at break-even Lease break even / tax rate
$46,495.41
8. Sol:
Cost of the asset value at the beginning of the year $20,000
Asset useful service life 6 years
Depreciation method ACRS
Lease rent for the asset for the life service $5,000
Cost of capital of the firm 0.12 12%
Option 1: Own funds
Option 2: Borrowed funds @7%
@7%
Tax rate applicable to the firm 30%
Decision 1: Buying the asset with own funds

Years 1 2 3 4 5 6 7
Depreciation $4,000 $6,400 $3,840 $2,304 $2,304 $1,152
Tax shield $1,200 $1,920 $1,152 $691 $691 $346
PV at 10 % $957 $1,367 $732 $392 $350 $156
Decision 2: Leasing the asset with own

funds
Lease rent $5,000 $5,000 $5,000 $5,000 $5,000
Tax shield $1,500 $1,500 $1,500 $1,500 $1,500 $0
PV at 10 % $1,196 $1,068 $953 $851 $760 $0
Decision 1 $3,954
Decision 2 $4,828
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9. Sol:
Method one: net income tax savings approach
Asset useful service life 5
Option 1: Own funds
@7%
Decision 1: Buying the asset with own funds

Years 1 2 3 4 5 6 7
Depreciation $50,000 $80,000 $48,000 $28,800 $28,800 $14,400
Tax shield $17,500 $28,000 $16,800 $10,080 $10,080 $5,040
PV at 10 % $14,463 $21,037 $11,475 $6,259 $5,690 $2,586
Decision 2: Leasing the asset with own

funds
Lease rent $62,000 $62,000 $62,000 $62,000 $62,000
Tax shield $21,700 $21,700 $21,700 $21,700 $21,700 $0
PV at 10 % $17,934 $16,304 $14,821 $13,474 $12,249 $0
Decision 1 $61,509
Decision 2 $74,782
75
10. Sol:
Calculation of internal rate of return of leasing proposal:
Lessor
Years Lease rent income
0 -60,000
1 25,000
2 35,000
3 40,000
4 30,000
IRR = 38%
Calculation of internal rate of return of leasing proposal:

Lessee
Years Lease rent expenses
0 -60,000
1 20,000
2 25,000
3 18,000
4 20,000
IRR = 15%
11. Sol:
Option 1:
Loan interest repayment calculation:
Years 1 2 3.0 4.0 5.0
Total $36,584 $36,584 $36,584 $36,584 $36,584
Loan interest $10,500 $8,674 $6,720 $4,630 $2,393
Loan principle $26,084 $27,909 $29,863 $31,954 $34,190
Loan paid $26,084 $27,909 $29,863 $31,954 $34,190
Unpaid loan $123,916 $96,007 $66,144 $34,190 $0
76
Option 1: Own funds
@7%
Decision 3: Buying the asset with borrowed funds

Depreciation $60,000 $96,000 $57,600 $34,560 $34,560 $17,280
Tax shield $22,800 $36,480 $21,888 $13,133 $13,133 $6,566
Interest $10,500 $8,674 $6,720 $4,630 $2,393 $0
Tax shield $3,990 $3,296 $2,554 $1,759 $909 $0
total Shield $26,790 $39,776 $24,442 $14,892 $14,042 $6,566
PV at 10% $21,743 $29,084 $16,101 $8,838 $7,508 $3,163
Total Benefits for the total shield 86436
Decision 4: leasing versus buying through

borrowed funds
Lease rent $70,000 $70,000 $70,000 $70,000 $70,000 $0
Tax shield $26,600 $26,600 $26,600 $26,600 $26,600
($26,60
Net lease rent $70,000 $43,400 $43,400 $43,400 $43,400 0)
Depreciation $60,000 $96,000 $57,600 $34,560 $34,560 $17,280
Tax shield $22,800 $36,480 $21,888 $13,133 $13,133 $6,566
Interest $10,500 $8,674 $6,720 $4,630 $2,393 $0
Tax shield $3,990 $3,296 $2,554 $1,759 $909 $0
($11,70
Total $70,000 $43,400 $70,190 $83,176 $67,842 8) $14,042 $6,566
PV at 10% $70,000 $39,099 $56,968 $60,818 $44,689 ($6,948)$7,508
($6,948)$7,508 $3,163
77
Decision 1 86436
Decision 2 $275,296
12. Sol:
Leasing solution: Buying vs. leasing decisions
Method one: net income tax savings approach
Option 1: own funds
Option 2: Borrowed funds @ 8%
Years 1 2 3.0 4.0 5.0

Total $50,091 $50,091 $50,091 $50,091 $50,091
Loan interest $16,000 $13,273 $10,327 $7,146 $3,710
Loan principle $34,091 $36,819 $39,764 $42,945 $46,381
Loan paid $34,091 $36,819 $39,764 $42,945 $46,381
Unpaid loan $165,909 $129,090 $89,326 $46,381 $0
Decision 3: Buying the asset with borrowed funds
78
Depreciation $80,000 $128,000 $76,800 $46,080 $46,080 $23,040
Tax shield $28,000 $44,800 $26,880 $16,128 $16,128 $8,064
Interest $16,000 $13,273 $10,327 $7,146 $3,710 $0
Tax shield $5,600 $4,645 $3,615 $2,501 $1,299 $0
total Shield $33,600 $49,445 $30,495 $18,629 $17,427 $8,064
PV at 10% $26,786 $35,194 $19,380 $10,571 $8,829 $3,648
Total Benefits for the total shield 104407
Decision 4: leasing versus buying through

borrowed funds
Lease rent $100,000 $100,000 $100,000 $100,000 $100,000 $0
Tax shield $35,000 $35,000 $35,000 $35,000 $35,000
Net lease rent $100,000 $65,000 $65,000 $65,000 $65,000 ($35,000)
Depreciation $80,000 $128,000 $76,800 $46,080 $46,080 $23,040
Tax shield $28,000 $44,800 $26,880 $16,128 $16,128 $8,064
Interest $16,000 $13,273 $10,327 $7,146 $3,710 $0
Tax shield $5,600 $4,645 $3,615 $2,501 $1,299 $0
Total $100,000 $65,000 $98,600 $114,445 $95,495 ($16,371) $17,427 $8,064
PV at 10% $100,000 $58,036 $78,603 $81,460 $60,688 ($9,289) $8,829 $3,648
UNIT 3: MANAGEMENT OF CASH
Content
3.0 Ames and Objective
3.1 Introduction
3.2 Cash Management Cycle
3.3 Cash Planning
3.4 Preparation of Cash Budget and Illustration
3.5 Determining the Optimum Cash Balance
3.6 Cash Management Models
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3.6.1 Baumol Model and Illustration
3.6.2 Miller-or Model and Illustration
3.7 Summary
3.8 Answer to Check Your Progress Exercises
After completing this unit one should be able to:

 explain the role of cash in current assets management
 calculate optimal cash balance
 apply the tools and techniques of cash management
 analyze and evaluate the results of cash management techniques.
3.1 INTRODUCTION
Cash is the medium of exchange that clients will accept in transactions related and affected in
business. Management of cash is of major importance in any business, because cash is the
only means of acquiring desired goods and services. A careful scrutiny of cash operations is
required because cash may be readily misappropriated. Cash is the important current asset used
widely in the operations of the business. Cash is the basic input needed to keep, so as
maintaining continuous operating condition in business. Every firm is expected to maintain
sufficient cash balance required for its operations. Any surplus cash held will result as idleness
of cash reducing the profitability of the firm, while cash shortage leads to the disruption of the
manufacturing process. Thus, a major function of finance manager is to maintain a sound cash
balance required for business operations.
Cash is the pure liquid asset widely used in the day-to-day operations of business. Cash
holding for the firm will serve three basic motives. They are, the first being transaction motive,
the second being precautionary motive and the third being the speculative motive. Transaction
motive has an objective of holding cash to meet the day-to-day requirements like making
payments to suppliers, purchase of materials, payment of wages and salaries, and other
operating expenses. Cash is also used in standing payments like taxes, dividends and other
payments. Precautionary motive of holding cash is to meet the unexpected business expenses.
80
Cash is held to meet contingencies in future like emergencies. Speculative motive serve the
objective of holding cash for investing in profit-making ventures. Such opportunities are
unusual within the business operations; hence they may throw more options outside the
business like, investment in the bank, purchase of shares and bonds with an intention to resale,
and purchase of government bills.
3.2 CASH MANAGEMENT CYCLE
Cash management is concerned with the managing of cash efficiently. Cash is the form of
money, which is involved, with all operations of business as inflows or outflows. Cash
management can basically categorized into (a) cash outflow like, purchases, payment to
expenses and services; (b) cash inflows like, sales, other revenues; and (c) cash balance held at
any point of time. A cash management cycle is used to explain the basic function of cash
management. It seeks to accomplish the objective of cost minimization by achieving liquidity
and profitability. Every business transaction resulting, as cash inflow will increase the cash
balance, while cash outflow transaction will decrease cash balance. Cash management cycle is
defined as “ the process of identifying various cash inflows and making them available to
business needs as cash outflows, maintaining the objective of liquidity and profitability”. The
following diagram explains the basic process of cash management cycle.
CASH MANAGEMENT CYCLE Fig.7.1
Increases
CASH
BUSINESS
TRANSACTION (S)
CASH
Decreases
CASH OUTFLOWS
81
Any firm can be successful with its cash management, when it is able to achieve the following
objectives:
1. Cash Planning: the process of estimating cash inflows and outflows to project cash
surplus or deficit for future planning period. A cash budget is used to serve this
objective.
2. Managing cash flows: The cash flows should be properly managed to avoid the variance
between planned event to actual event. Accelerating cash inflows and decelerating cash
outflows can achieve this.
3. Optimum Cash Balance: It is always essential to determine appropriate cash balance.
The cost of excess of cash holding and also the danger of cash deficiency should be
matched to determine the optimum level of cash balance.
4. Investing supplies/Borrowing deficit: The surplus cash balance over and above the
minimum balance should be always be invested in the profitable ventures, while the
deficit balance should be arranged from various financing sources.
3.3 CASH PLANNING
Cash planning is a technique to plan and control the use of cash. It helps a firm in its future
actions, by preparing estimated or projected cash statement for a planning period. Forecast
may be based on the present operations or on the anticipated future operations. Cash planning
may be done on daily, weekly, or monthly basis. The period and frequency of the cash
planning usually depend upon the size of the firm and philosophy of management. Cash
planning can be prepared based on the planning period. A cash planning prepared for shorter
period say, a year or less is called short-tem plan or cash budget. On the other hand, a cash
plan prepared for a period above one year is called long-term plan or cash forecasting.
Cash budget is the most significant device to plan for and control cash receipts and payment. A
cash budget is a summary statement of the given firm’s expected cash inflows and outflows
over the projected period. It gives information on the timing and magnitude of expected cash
flows and the end balances over the planning period. This information is vital for decision-
makers to determine future cash needs, and plan for the same accordingly. The time horizon of
a cash budget may differ from firm to firm, and industry-to-industry. Generally the cash
82
budget time period will be monthly (suitable to the seasonal variations). Estimation of cash
requirements and preparation of cash budget should satisfy the following objectives:
 Identify the quantity and timing of cash inflows and outflows accurately.
 Anticipation of cash deficits or cash surplus, and arrange various alternative course of
actions.
 Provision of basic guidelines for various operations, so as to adhere to organization
plans.
Every firm essentially should hold adequate cash balance, but avoid idle cash balances. The
firm has to assess its needs for cash in order to achieve its business objectives. Cash budget is
the statement showing the cash requirement and replenishment, which will be helpful
identifying excess holding or shortage of cash balance. Cash budget serves the following
purposes:
 To coordinate the timing of cash needs. It identifies the time intervals when there
might either be a shortage and also the volume of deficit balance.
 It pinpoints the periods during which the firm can have excess cash balance as a
surplus.
 It enables a firm to take advantages from the market conditions like, cash discounts
on accounts payables and receivables, pay obligations whenever they are due,
formulate efficient dividend policy and finance the capital requirements. It is also
helpful in quantifying seasonal requirements influencing the production scheduling,
fluctuations of interest and inflation effects in the market.
 It helps to arrange needed funds on the most favorable terms and prevents the
accumulation of excess funds.
3.4 PREPARATION OF CASH BUDGET AND ILLUSTRATION
Cash budget is prepared using the operating and financial cash flows. Cash flows generated
using the cash operations of the firm are known as operating cash flows, while the financial
cash flows are concerned with long-term opportunities. Events like sales, disposal of fixed
assets come under operating cash inflows, and activities resulting as purchase of raw materials,
payment of expenses, maintenance expenses, purchase of fixed assets are identifiable as
83
operating cash outflows. Borrowing of funds, sale of securities, receipt of interest or rent or
any other revenue comes under the financial cash inflows. Events like payment of income tax,
repayment of loan amount, repurchase of shares, payment of interest or dividends are
categorized under financial outflows.
The cash management strategies are intended to minimize the operating cash balance
requirements. This can be achieved by (i) stretching accounts payable without affecting the
credit status of the firm, (ii) employing efficient inventory management, and (iii) accelerating
collections of accounts receivables. Some of the specific techniques for accelerating collection
of receivables from customer are ensuring prompt payment from customers, and early
payment/conversion into cash. The techniques of delay in payments include avoidance of early
payment, centralized disbursement and float.

1. Explain cash management.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. What is cash planning?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
Illustration: From the information given below construct a cash budget for six months period
starting form July 20X1 till December.
MONTH AND YEAR PROJECTED SALES

April 20X1 $ 120,000
May 20X1 100,000
June 20X1 80,000
July 20X1 50,000
August 20X1 60,000
84
September 20X1 90,000
October 20X1 150,000
November 20X1 180,000
December 20X1 200,000
January 20X2 150,000
Additional information:
a) Assume that opening cash balance as $ 20,000 and same balance has to be maintained
through out the planning period.
b) 80 percent of sales are on credit basis. 50 percent of the accounts receivables are
collected in one month, 30 percent during the second month of sale and remaining
during the third month of sale.
c) Material cost accounts for 30 percent of sales. Suppliers allow 45 days credit, and
materials to be procured one month in advance for production purpose.
d) Payroll expenses amounts to 20 percent of sales and carry a lag-in-payment period of
one month.
e) Production overheads accounts for 10 percent of sales, and carry a lag-in-payment
period of 60 days.
f) Production should be completed at least 30 days before the date of sale.
g) All the payments and earnings accrue uniformly through out the year.
Sol: CASH BUDGET FOR THE GIVEN FIRM

For the period of 6 months starting from July 20X1
Cash receipts July August September October November December
Cash sales (1) $10,000 $12,000 $18,000 $30,000 $36,000 $40,000
Collections (2) 75,200 5,5200 48,800 58,400 91,200 122,400
Miscellaneous
Total receipts $85,200 $ 67,200 $ 66,800 $ 88,400 $ 127,200 $ 162,400
85
Cash payments
Payments to suppliers 16,500 22,500 36,000 49,500 57,000 52,500
Payroll 10,000 12,000 18,000 30,000 36,000 40,000
Overheads 8,000 5,000 6,000 9,000 15,000 18,000
Others

Total payments 34,500 39,500 60,000 88,500 108,000 110,500

Receipts less Payments 50,700 27,700 6,800 -100 19,200 51,900
Minimum balance 20,000 20,000 20,000 20,000 20,000 20,000
Ending balance 30,700 7,700 -13,200 -20,100 -800 31,900

Surplus/(deficit)
Decision Invest Invest Borrow Borrow Borrow Invest
Working notes:
1. Cash sales amounts to 20 percent of total sales
Month July August September October November December
Total Sales $50,000 $60,000 $90,000 $150,000 $180,000 $200,000
Cash sales $10000 $12000 $18000 $30000 $36000 $40000
2. Credit collections from accounts receivables:

Total Sales Credit collection Total
1 Month 2 Month 3 month
May 20X1* $ 48,000 $ 48,000
June 20X1* 40,000 28,800 68,800
July 20X1 32,000 24,000 19,200 75,200
August 20X1 20,000 19,200 16,000 55,200
September 20X1 24,000 12,000 12,800 48,800
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October 20X1 36,000 14,400 8,000 58,400
November 20X1 60,000 21,600 9,600 91,200
December 20X1 72,000 36,000 14,400 122,400
January 20X2* 80,000 43,200 24,000 147,200
* Events out side the planning period.
Credit collection made for the planning period:
80 % of total sales are credit, and it is given that 50 % of credit sales (that means 40 % of total
sales will be collected during the 1st month). Therefore the total sales collection will be as
follows:
Cash sales 20 % Given
First month collection 40 % 50 % of 80 %
Second month collection 24 % 30 % of 80 %.
Third month collection 16 % 20 % of 80 %
Total 100% -
Note: Total production cost is estimated as 60 percent of sales. Material cost to sales ratio is
given as 30 percent, payroll expenses given as 20 percent and production overhead expenses is
given as 10 percent of sales. Therefore, 50 percent of production cost accounted for material
cost, 30 percent for payroll expenses and remaining 20 percent for production overheads.
3. Material cost 30 percent of sales or 50 percent of production cost.
Month Sales Production cost Material cost Due month

April 20X1 * $120,000 $ 60,000 $ 24,000
May 20X1* 100,000 48,000 15,000
June 20X1* 80,000 30,000 18,000 $ 19,500
July 20X1 50,000 36,000 27,000 16,500
August 20X1 60,000 54,000 45,000 22,500
September 20X1 90,000 90,000 54,000 36,000
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October 20X1 150,000 108,000 60,000 49,500
November 20X1 180,000 120,000 45,000 57,000
December 20X1 200,000 90,000 - 52,500
January 20X2* 150,000 - - 22,500
Payments to the suppliers for materials:
May 20X1 June 20X1 July 20X1
TOTAL PURCHASES
TOTAL PURCHASES
$ 15,000
$ 18,000
$ 7,500 $ 7,500 $ 9,000 $ 9,000
$ 7,500
$ 7,500
First fifteen days purchases of $ 7,500 of month May are paid after 15 th of June 20X1, and
second fifteen days purchases of $ 7,500 of month May are paid during first fifteen days of
July. In the same way first fifteen days purchases of June 20X1 are paid during the second
fortnight of July 20X1. Therefore the payment rule for purchase can be derived as follows:
Month Material purchased Due for payment

May 1st fortnight $ 7,500 No
May 2nd fortnight $ 7,500 No
June 1st fortnight $ 9,000 No
June 2nd fortnight $ 9,000 $ 7,500
July 1st fortnight $ 13,500 $ 7,500
July 2nd fortnight $ 13,500 $ 9,000
August 1st fortnight $ 22.500 $ 9,000
August 2nd fortnight $ 22,500 $ 13,500
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September 1st fortnight $ 27,000 $ 13,500
September 2nd fortnight $ 27,000 $ 22.500
5. Payment due for payroll expenses:

6.
Month Sales Production cost Payroll expensesDue
expensesDue month
April 20X1 * $120,000 $ 60,000 $ 20,000
May 20X1* 100,000 48,000 16,000 $ 20,000
June 20X1* 80,000 30,000 10,000 16,000
July 20X1 50,000 36,000 12,000 10,000
August 20X1 60,000 54,000 18,000 12,000
September 20X1 90,000 90,000 30,000 18,000
October 20X1 150,000 108,000 36,000 30,000
November 20X1 180,000 120,000 40,000 36,000
December 20X1 200,000 90,000 30,000 40,000
January 20X2* 150,000 - 30,000
Payroll expenses
Payroll expenses
$ 16,000
$ 10,000
$ 16,000
$ 10,000
6. Payment of Production overheads:
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Month Sales Production cost Production
overheads Due month
April 20X1 * $120,000 $ 60,000 $10,000
May 20X1* 100,000 48,000 8,000
June 20X1* 80,000 30,000 5,000 $ 10,000
July 20X1 50,000 36,000 6,000 8,000
August 20X1 60,000 54,000 9,000 5,000
September 20X1 90,000 90,000 15,000 6,000
October 20X1 150,000 108,000 18,000 9,000
November 20X1 180,000 120,000 20,000 15,000
December 20X1 200,000 90,000 15,000 18,000
January 20X2* 150,000 - 0 20,000
Production overheads
$ 8,000
$ 8,000
Once the cash budget has been prepared and appropriate net cash flow established, one should
ensure that there does not exist a significant deviations between projected cash flows and actual
cash flows. Better cash management improving control over cash collection and disbursements
can achieve this. Cash management objective can be achieved by accelerating cash collection
and decelerating cash payments to the possible extent. Cash management should always aims
to achieve the following objectives:
 Liquidity:
Liquidity: Business units should satisfy the primary objective of cash availability for all
business needs.
 Safety:
Safety: Cash availability will always imposes risk of loss; therefore the second
objective of cash management is to avoid the risk of loss, or thefts.
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 Profitability:
Profitability: Secondary and final objective of cash management is earn a highest
possible return after satisfying the above two objectives.
Cash budget always should the projects end result as surplus cash balance or deficit cash balance.
Therefore, finance manager should carefully plan well in advance for arranging such balances
with actual business situations. A surplus cash balance induces cash idleness to the business
reducing the profitability; therefore surplus cash balances should be invested in the following
alternatives:
 Investment in the bank, as term deposits that earn higher return of interest.
 Investment in money market instruments that provide a higher return compared to
bank returns.
 Investment in capital market instruments like shares and bonds that provide
maximum returns.
In the same way a deficit cash balance leads to cash shortage and makes the business suffer
from cash crisis. This may result as disruption of business activities, and financial distress
among the stakeholders. It is necessary to avoid such financial problems, which can be done
through successful borrowing techniques. The following are few events advised to avoid such
chaotic conditions:
 Bank overdrafts: Making an arrangement with the bankers to have overdraft facility,
that is the most economical way of dealing with borrowing. Interest will be chargeable
on the outstanding amount at any time, and the bank may also require payment of an
overdraft at any time.
 Bank loans: Represent the formal agreement between the bank and the borrower, that
the bank will lend a specific sum for a specific period. Interest must be paid on the
whole of the sum for the duration of the loan.
 Disposal of investments: If the business unit has maintained any investments with the
surplus cash balances, can be used in financing the deficit balance by disposing them.
3.5 DETERMINING THE OPTIMUM CASH BALANCE
Liquidity position of any firm is maintained perfectly after obtaining optimum cash balance
(also called as operating cash balance). This is the balance that caters the needs of business
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perfectly attaining both the objectives of cash management. The test of liquidity is really the
availability of cash to meet the firm’s obligation when they become due. The optimum cash
balance is maintained for the transaction purpose and additional amount may be maintained as
a buffer or safety balance. Firm maintaining limited cash balance result as payment crisis, and
excess cash balance held will decline the profitability of the firm. Therefore, a tradeoff
between the profitability and liquidity has to achieve using the optimum cash balance
technique. This can be explained through the following diagram.
OPTIMUM CASH BALANCE Fig. 7.2
Total cost curve
Opportunity cost curve

Cost
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Transaction cost curve
Optimum cash balance
Cash Balance
From the above figure (Fig.7.2) it is clearly evidential that, increasing cash balance, reduces
transaction cost but increased the opportunity cost like interest charges, which may reduced the
profitability of the firm. That means the liquidity objective of the firm is achieved but
profitability declines. On contrary, limited cash balance held reduces the opportunity cost but
the transaction cost, like acquiring funds at the time of shortage, increases. That means,
profitability is achieved but not liquidity. Therefore, the intersection point of transaction curve
with opportunity cost curve, yields the desired optimum cash balance, where the firm attains
both the objectives.
3.6 CASH MANAGEMENT MODELS
A number of cash management models have been developed for managing cash balances. All
models assume that a business will have a certain amount of ready cash available, (in the
current account) for day-to-day operations. An additional amount is made available in the form
of bank deposits, marketable securities, as buffer cash balance.
3.6.1 Baumol Model and Illustration
Baumol model is similar to that of economic order quantity (EOQ model) used in the
inventory management. If a cash resources are steadily used up by a constant daily
demand for cash, the model suggests that the optimum regular cash injections say ‘a’ into
the business can be determined as follows:
A=
Where Ad = Annual demand for the cash

Ct = Cost per transaction (purchase or sale or both of securities)
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Ir = Interest rate for the said period
A = Optimum cash injection
Illustration: A firm has annual demand of cash equal to $ 240,000 per annum. Investment
earnings rate is given as 12 percent per annum and the cost per transaction of investment is $
100 per sale/purchase. Calculate the optimum cash balance of the firm?
Sol:
A=
Given Ad = $ 240,000
Ct = $ 100
Ir = 12 percent or 0.12
A=?
A=
A = $ 20,000
According to the Baumol model, low cash balance held without earning interest is
considered as best decision, at the time of increasing interest rates. The basic limitation of
this model is the unrealistic assumption of the constant cash demand. In practice the
demand for cash usually is fluctuating.
3.6.2 Miller-Orr Model and Illustration
Uncertainty of both cash receipts and cash payments are considered in Miller-Orr model. This
model is explained through the following diagram. The firms
MILLER-ORR CASH MANAGEMENT MODEL Fig 7.3
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UPPER LIMIT
CASH
BALANCE
LOWER LIMIT
TIME INTERVAL
Using the upper limit and lower limit consider all receipts and payments. As per this model,
the lower limit is to be specified and upper limit can be determined using the equation of spread
between the upper limit and lower limit. The spread can be determined using the following
equation.
¾ transaction cost variance of cash flow 1/3
Spread =3 ------------------------------------------------------------
Interest rate
Illustration: A firm sets its minimum cash balance as $ 5,000 and estimates the following:
Transaction cost per sale/purchase = $ 15
Standard deviation = $ 1,200 per day
Interest rate = 7.3 percent p.a. or 0.02 per day
Calculate the spread using Miller-Orr model?
Sol: ¾ transaction cost variance of cash flow 1/3
Spread =3 -----------------------------------------------------------
Interest rate
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¾ $ 15 {$ 1,200  $ 1,200} 1/3
Spread =3 ---------------------------------------------------
0.02
Therefore Spread = 3 {81014113000}1/3

= 3  4,327
= $ 12,981
3.7 SUMARY
Cash is the pure liquid asset every firm is expected to maintain for its day-to-day activities.
Cash holding for the firm will serve three basic motives and they are (a) transaction motive; (b)
precautionary motive, and (c) speculative motive. Transaction motive of holding of cash is
essential to meet day-to-day operational requirements. Precautionary motive of holding of cash
is to meet the requirements above the basic requirements, which are unexpected business
activities. Speculative motive of holding cash is to explore the opportunities of business or
opportunities outside the business.
Cash budget is prepared unsung the operating and financial cash flows. Cash flows generated
using the cash operations of the firms are knows as operating cash flows, the latter consists of
cash flows in the long-term opportunities.
Operating cash flows are: Inflows arise due to business receipts like, cash sales, collections
from accounts receivables, and disposal of fixed assets. Cash outflow are accounted as
business payments as, accounts payable, purchase of raw materials, wages and salaries, factory
expenses, administrative and selling expenses, maintenance expenses, and purchases of fixed
assets.
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Marketable securities are an outlet for surplus cash as liquid security/Assets. To be liquid a
security must have two basic characteristic that is, a ready market and safety of principal. The
selection criterion for marketable securities include the evaluation of financial risk, interest rate
risk, liquidity, taxability and yield among different financial assets. The prominent marketable
securities available for investment are: treasury bills, negotiable certificates of deposits,
commercial paper, bankers’ acceptance, inter-corporate deposits, inter bank call money.
1. What are the motives of holding cash?

2. Explain briefly the process of constructing cash budget?
3. What are the conditions to be followed for managing cash effectively and efficiently?
4. Explain briefly the Baumol cash management model?
5. How can a firm attain the appropriate level of optimum cash balance?
Exercises:
1. From the following information prepare a cash budget for four months period starting
from March.
Production Other
Month Sales Material cost Payroll overheads overheads
January $ 36,000 $ 12,500 $ 5,000 $ 3,000 $ 2,500
February 48,500 15,000 6,000 3,200 3,000
March 43,000 13,000 5,800 3,000 3,500
April 44,000 14,000 7,000 3,200 4,000
May 52,000 18,000 10,000 4,000 4,500
June 54,000 19,000 11,000 4,200 5,000
Assume the following information for constructing the cash budget:
a) Cash on hand on March 1st is $ 36,000.
b) 50 % of sales are on cash basis with 2 percent discount.
c) A loan amount for $ 10,000 was granted by bank receivable during the month of April.
d) A payment of $ 15,000 is to make during May for purchase of plant asset.
e) Accounts receivables are allowed a credit of one month.
f) Accounts payable do carry a credit of two months.
97
2. From the following forecasts of revenues and expenditure, you are required to prepare a
cash budget for three months starting from September. The cash balance on September 1 st
was $ 10,000.
Production Other
Month Sales Purchases Payroll overheads overheads
July $ 80,000 $ 40,000 $ 5,600 $ 3,900 $ 10,000
August 76,500 42,000 5,800 4,200 12,000
September 78,000 38,500 5,800 4,200 14,000
October 90,000 37,500 5,900 5,100 16,000
November 95,000 43,000 5,900 6,000 13,000
A sales commission of 4 % on sales, due in the month following the month in which the sales
dues are collected, is payable in addition to other overheads. Fixed assets worth of $ 65,000
will be purchased in September to be paid for the following month. $ 20,000 in respect of
interest on loan amount is due for payment during the month of October. The period of credit
collection from customers is two months and one month is the credit obtained from suppliers.
Wages are paid on fortnightly basis after completion of work.
3. Hail Incorporation has an annual cash demand of $ 1 million. Transaction cost is given
as $ 200 per purchase or sale of securities. Interest on borrowings is given as 12
percent. Determine constant cash injections, using Baumol model.
4. His Investments Incorporation has an annual cash demand of $ 408,000. Transaction
cost is given as $ 120 per purchase or sale of securities. Interest on borrowings is given
as 9 percent. Determine constant cash injections, using Baumol model.
5. Green House limited has a monthly cash demand of $ 560,000. Transaction cost is
given as $ 180 per purchase or sale of securities. Interest on borrowings is given as 12
percent per annum. Determine constant cash injections, using Baumol model.
6. FGH private limited has a daily cash demand of $ 1000. Transaction cost is given as $
80 per purchase or sale of securities. Interest on borrowings is given as 7.3 percent per
annum. Determine constant cash injections, using Baumol model.
7. Beta Limited sets its minimum cash balance as $ 1,000 and estimates the following:
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8. FEDEX limited sets its minimum cash balance as $ 1,250 and estimates the following:
Standard deviation = $ 200 per day
Interest rate = 12 percent p.a.
9. A firm sets its minimum cash balance as $ 5,000 and estimates the following:

10. A firm sets its minimum cash balance as $ 6,000 and estimates the following:
Standard deviation = $ 750per day

1. See Section 3.2
2. See Section 3.3

1. See Section 3.2
2. See Section 3.4
3. See Section 3.6
5. See Section 3.5
Exercises:
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1. Sol:
CASH BUDGET
Cash receipts March April May June
Cash sales $21,500 22000 $26,000 27000
Collections 24250 $21,500 22000 $26,000
Miscellaneous 10,000

Total receipts 45750 53500 48000 53000
Cash payments
Payments to suppliers $12,500 15,000 13,000 14,000
Payroll $5,800 $7,000 $10,000 $11,000
Overheads $3,000 $3,200 $4,000 $4,200
Others $3,500 $4,000 $4,500 $5,000

Total payments 24800 29200 31500 34200

Receipts less Payments 20950 24300 16500 18800
Opening balance 36,000 56,950 81,250 97,750
Ending balance 56,950 81,250 97,750 116,550

2. Sol:
CASH BUDGET
Cash receipts September October November
Cash sales $80,000 76,500 $78,000
Collections
Miscellaneous

100
Total receipts 80000 76500 78000
Cash payments
Payments to suppliers $42,000 38,500 37,500
Payroll $5,800 $5,900 $5,900
Overheads $4,200 $5,100 $6,000
Others $14,000 $16,000 $13,000
Interest and asset price 85,000
Total payments 66000 150500 62400

Receipts less Payments 14000 -74000 15600
Opening balance 10,000 24,000 -50,000
Ending balance 24,000 -50,000 -34,400

3. Sol:
A=
Given Ad = $ 1,000,000
Ct = $ 200
A=?
A=
A = $ 57,735
4. Sol:
A=
101
Given Ad = $ 408,000
Ct = $ 120
A=?
A=
A = $ 32,984
5. Sol.
A=
Given Ad = $ 560,000
Ct = $ 180
A=?
A=
A = $ 40,987
6. Sol:
A=
Given Ad = $ 1,000
Ct = $ 80
Ir = 0.0002 percent per day
A=?
A=
A = $ 28,284
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7. Sol
Sol: transaction cost variance of cash flow

¾
1/3
Spread =3 -----------------------------------------------------------
Interest rate

$ 15 {$ 1,200  $ 1,200}

¾
1/3
Spread =3 ---------------------------------------------------
0.02
= $ 2,060
8. Sol
Spread =3 -----------------------------------------------------------
Interest rate

Interest rate = 12 percent p.a. or 0.04 per day
$ 25 {$ 200  $ 200}

¾
1/3
Spread =3 ---------------------------------------------------
0.04
= $ 877
103
9. Sol
Sol: transaction cost variance of cash flow

¾
1/3
Spread =3 -----------------------------------------------------------
Interest rate

$ 20 {$ 800  $ 800}

¾
1/3
Spread =3 ---------------------------------------------------
0.027
= $ 2,125
10.
Spread =3 -----------------------------------------------------------
Interest rate

$ 32 {$ 750  $ 750}

¾
1/3
Spread =3 ---------------------------------------------------
0.022
= $ 2,550
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UNIT 4: RECEIVABLES AND INVENTORIES MANAGEMENT
Contents
4.1 Introduction to Receivables Management
4.2 Establishment of Credit Policy and Illustration
4.3 Implementing Credit Policy
4.4 Optimum Credit Policy
4.5 Factoring Receivables
4.6 Inventory Management
4.7 Objective of Inventory Management
4.8 Inventory Management Techniques
4.9 Determination of Economic Order Quantity
4.10 Reorder Point
4.11 Inventory Control
4.12 Summary
4.13 Answer to Check Your Progress Exercise
4.0 AIMS AND OBJECTIVES
After completion of this unit, one should be in a position to:

 explain the role of accounts receivables in current assets
 analyze discount policy and credit policy
 understand and apply tools of receivables management
 illustrate the advantages of factoring services
 demonstrate the significance of inventories
 explain the role of inventories in current assets
 understand and analyze the tools and techniques of inventory management.
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4.1 INTRODUCTION
Granting credit to the customers is the essential marketing principle, which expands the volume
of sales for every business unit. A firm granting credit to its customers does not receive cash
immediately for its sales, but creates receivables, that the firm expected to collect in the near
future. Receivable arising out of credit sales has the following three characteristics features: (1)
involvement of risk in collection; (2) collection at latter period do have lower economic value
and (3) problems of non-collection. Receivables constitute a substantial portion in the current
assets. Receivables usually block the funds employed. The time interval between the date of
sale and the date of collection has to be financed out of working capital. Such funds have to
arrange from banks or other financing sources, that consume additional interest expenses.
Thus, the receivables investment represents investment in credit sales that increase profitability
on one hand and additional investment cost (interest on additional borrowings both on
investment and extended period of repayment). Therefore, finance manager will be anxious to:
i) Establish a credit policy in relation to normal credit period and determine and fix
individually the credit limit depending on the credibility of the customers.
ii) Develop a system that will control the implementation of credit policy.
iii) Prescribe the reporting procedures, which will monitor the efficiency of the system.
Illustration 1: A firm has an investment in the credit sales as $ 100,000 and the average
collection period allowed to the customers as 15 days. Find the amount of investment gained
and lost when the return on investment in the business is at 7 percent and borrowings demand
an interest at the rate of 4 percent per annum. The firm has a proposal to expand its sales by
extending the credit days from 15 days to 30 days. Does the proposal worth accepting when
increase in sales is expected as 5 percent. Ignore all other expenses as constant.
Sol:
Existing situation: Average collection period = 15 days

Average investment in receivables = $ 100,000
Total credit sales =?
106
Total credit sales = (Average investment X 360 days) / average collection period.
Therefore total credit sales = ($ 100,000 X 360 days) / 15 days

Total credit sales = $ 2,400,000
Profitability with the existing situation:

Return on investment (sales) = $ 2,400,000 X 7 % = $ 168,000
Less: Interest expenses on investment
Average receivables X 4 % 4,000
Net returns = $ 164,000
Revision in the credit period:

Average collection period = 30 days
Total credit sales = $ 2,400,000 + 5 % on $ 2,400,000
= $ 2,520,000
Average investment in receivables = ?
Average receivables = (total credit sales X Average collection period) / 360 days
Average receivables = ($ 2,520,000 X 30 days) / 360 days
Average receivables = $ 210,000

Profitability with the existing situation:
Return on investment (sales) = $ 2,520,000 X 7 % = $ 176,400
Less: Interest expenses on investment
Average receivables X 4 % 8,400
Net returns = $ 168,000
Therefore, increase in the credit period has increased the net returns from $ 164,000 to $
168,000. The new proposal is worth accepting.
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4.2 ESTABLISHMENT OF CREDIT POLICY AND ILLUSTRATION
Any firm’s investment in accounts receivables depends on (a) the volume of credit sales, (b)
risk involved in collection; and (c) collection period. Investment in receivables is expressed in
terms of costs. The volume of credit sales is a function of firm’s total sales and the percentage
of credit sales to total sales. Total sales depend on the market size, firm’s market share,
product’s quality, intensity of competition, and economic conditions prevailing in the market
environment. Finance manager usually have limited or no control over these variables.
Finance manager can affect the volume of credit sales and collection period and consequently,
investment in accounts receivables. This is possible through establishment of credit policy,
retaining the terms of credit under the control of the business. The terms of credit policy is
used to refer to the combination of three decision variables. They are:
1. Credit standards: This criterion will decide the type of customer to whom credit can
be allowed with the credit limit. Allowing credit to more slow-repaying customer will
increase investment in receivables and vice-versa. Increase in investment may result in
increase in risk of default (non-collection of debt).
2. Credit terms: It specifies duration of credit (in time) and terms of payments
(discounts) by the customer. Investment in accounts receivables will be high if
customers are allowed extended credit period in making payments, and decreases with
reduction in credit period. Alternatively offering a discount on early payments by the
customer will reduce the investments as well as the credit period. This is also referred
as accelerating collection policy.
3. Collection efforts: Collection efforts will increase the expenses on investment by
payment of charges of collection incase of collection done by outsiders, and payroll
expenses if done by internal staff. Collection charges will depend on the collection
period. Lower the collection period lower will the collection charges and vice-versa.
Any credit policy before implementation has to be evaluated. An evaluation procedure

includes three stages. The first stage,
stage, of evaluation is the process of identifying incremental
revenue a firm may receive with extending the credit. Increased sales multiplied by the
108
profitability rate will give this value. Empirically,
Empirically, this can be calculated as ∆ sales X net
income ratio. The second stage, is the analysis of additional credit grant to the customers with
risk of default. That means extension of credit to the existing customers may increase the bad
debt expenses. Therefore incremental revenue with sales should also be analyzed with
increment in expenditure as bad debts expenses. Such additional expenses should be deducted
from the net returns calculated in stage one. Empirically, incremental expenses as bad debts can
be calculated as ∆ sales X bad debts ratio (percentage of bad debts). The third stage, increased
sales will increase in investment in the accounts receivables, thereby increase the interest
expenses on the borrowings. Incremental interest expenses should also be deducted from the
incremental revenue calculated from stage one. If the net revenue is positive then the credit
policy established would increase the wealth of the shareholders, and if the return is negative,
the shareholders wealth will be decreased. Positive returns will always qualify for acceptance
decision while the negative returns will be rejected.

1. How do you establish credit policy?
……………………………………………………………………………………………………
……………………………………………………………………………………………………
……………………………………………………………………………………………
Illustration 2: A firm currently has annual sales of $ 5 millions will average collection period of 30
days allowed to customers. Firm plans to relax its credit policy as follows:
Credit policy % Change in sales % Change in bad Increase in credit
debts cost period
A $ 100,000 1.2 % 15 days
B $ 200,000 1.5 % 30 days
C $ 500,000 1.8 % 45 days
D $ 1,000,000 2.0 % 60 days
109
Profitability rate of the firm is given as 10 percent and firm can borrow at 6 percent (interest
cost). Which credit policy is advisable to the firm, including the existing policy? Ignore tax
affect and assume a year of 360 days.
Sol:
Assessment of existing policy:
Volume of credit sales $5,000,000
Return on investment $ 5,000,000 X 10 % $500,000
Less : Incremental expenses
1) Bad debts *1 $0
2) Interest on additional investment *2 $2,500
Net return on investment $497,500
Average collection period is given as 30 days
Accounts receivables = Credit sales / Average collection period $41,666.67
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate.
Assessment of Credit policy A:

1) Bad debts *1 ($1,200)
2) Interest on additional investment *2 ($13,250)
Net return on investment ($4,450)
Accounts receivables = Credit sales / Average collection period $637,500
*2 interest on additional investment = Increased investment on receivables X interest rate
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Assessment of Credit policy B:
Incremental sales $200,000
Incremental return $ 200,000 X 10 % $20,000
1) Bad debts *1 ($3,000)
Assessment of Credit policy C:

1) Bad debts *1 ($9,000)
Accounts receivables = Credit sales / Average collection period $1,145,833
Assessment of credit policy D:

Incremental sales $1,000,000
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1) Bad debts *1 $(20,000)
2) Interest on additional investment *2 $(65,000)
From the above solution it is clear that the credit policy D is more profitable when compared to
all other policies, as it is giving a positive returns of $ 15,000 while all other policies are giving
negative policies. Therefore the firm should go for the credit policy D for acceptance.
4.3 IMPLEMENTING CREDIT POLICY
Implementation of credit policy involves assessing credit worthiness of customers, controlling

credit limits, prompting action on the over dues and defaulters. Therefore, credit policy can be
implemented if the following events are satisfied:
1. Assessment of credit standards: Every customer should be carefully assessed before a
credit terms are extended. Information from various sources regarding credit
worthiness should be collected and analyzed. Some of the major sources are trade
references, bank references, credit agencies, credit associations and reports from sales
personnel. Assessment of credit standards in other words is called as pre-credit analysis
of customers.
2. Controlling credit limits is the second major component of implementing credit policy.
Once an extension of credit is granted, a close credit monitoring system has to be
adopted. Credit monitoring includes age of receivables, constructing of ratios,
preventing of credit limit extension, promptly invoicing clients. This is also referred as
post credit analysis.
3. Action in collection of over dues and defaulters. Longer the period of collection, higher
the probability of default. A follow-up system has to developed and implemented in
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order to reduce the risk of default. Such procedures includes, sending reminder letters,
or phone calls, withholding additional supplies, debt collection agencies support in
collection, and finally instigating legal action.
4.4 OPTIMUM CREDIT POLICY
Investment in credit sales will accumulate costs in the form of bad debts losses, collection
charges, and interest on additional borrowings. An increase in investment in the accounts
receivables increases such costs. A reduction in the investment in accounts receivables reduces
such costs but also decreases profitability of firms as decrease in receivables means decrease in
sales. An optimum credit policy is one that maximizes value of the firm, by minimizing the
associated costs of credit sales and providing a incremental revenue to the business.
Optimum credit policy is a trade-off between the increased profitability and increased cost can
be arrived with an efficient credit policy. This can be explained with the following diagram.
From the figure below, it is clear that the firms credit policy has to be determined at point ‘x’.
Costs and Benefits
This the point at which the trade-off occurs, where total of opportunity costs of lost
contribution and credit administration cost and bad debts losses are minimum.
OPTIMUM CREDIT POLICY Fig. 8.1
Total cost curve
Profitability options
Liquidity options
Optimum Credit policy
Credit policy
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Optimum credit policy is the point where operating profits are maximum and firms total cost on
investment in receivables in minimum. The point of intersection of profitability slope and
liquidity slope is the optimum point as the incremental return is equal to incremental costs of
funds employed. Thus, the point ‘x’ is considered as optimum credit policy. Once the firm
moves away from optimum point towards the Y-axis, credit policy has to be hardened by
reducing credit terms. If the intersection point moves away from Y-axis and it has to be
softened. A hard credit policy means reduction of credit terms and soft credit policy means
extension of additional credit terms.
4.5 FACTORING RECEIVABLES
Credit management is a specialized activity, and involves a lot of time and efforts to the
company. Collection of receivables poses a problem particularly from banks, financing
receivables for a limited period and the seller of goods and services has the bear the risk of
default by client. As an alternative, a firm assigns the task of collection to specialist
organizations called factoring organizations. Factoring is of both financial as well as
management support to a client. It is the process of selling receivables (especially aged debts)
to the firms specialized in collection and administering. Therefore a firm sells it debts to the
collecting firm will have cash received as advance and the risk involved in collections are
transferred to specialized clients.
The basic functions of a factor include finding the customer, and collects sales proceeds and
remit the same to the client. Other secondary functions of factor includes:
 Sales ledger administration: Full credit services are provided by factor to client, like
advising about credit extension or reduction, maintenance of accounts receivables,
information related to market trends, competitors, and so on.
 Credit collection and protection: a factor performs all the actions related to the
collection of debts. In additions too the collection, factor also provides protection from
debts like partial or full protection from bad debts.
 Financial assistance: A factor has provides facilities like advancing the debts to the
clients. Thus factor provides various services like managing debts and financing them
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for a return called as factor service commission with or without reserve commission to
cover bad debts losses.
The factoring facilities can be broadly classified into two groups. They are (1) full service non-
recourse factoring and (2) full service recourse factoring. Full service non-recourse factoring is
the method under which, book debts are purchased by the factor, assuming 100 percent credit
risk. The full amounts of invoices have to be paid to client in the event of debt becoming bad.
Under full service recourse factoring, client is not protected against the risk of bad debts.
Factor does not provide any indemnity against book debts on which a customer subsequently
defaults. The client will have to refund the money in case of non-collection of book debts.

1. Explain the implementation of credit policy.
……………………………………………………………………………………………………
……………………………………………………………………………………………………
……………………………………………………………………………………………
2. What is optimum credit policy.
……………………………………………………………………………………………………
……………………………………………………………………………………………………
……………………………………………………………………………………………
Illustration 3: A firm has annual sales of $ 20 millions. 80 percent of sales are on 60-day
credit. Average collection period is given as 75 days. Based on the past performance bad debts
costs are estimated as 1 percent on credit sales. The firm has credit collection cost of $ 75,000
per annum. A factor offers 1.75 % service charges for collection of receivables. Factor also
provides finance facility of 80 percent of amount sold to him within 10 days of sale. Interest
cost on borrowings is given to you as 6 %. Should the firm go for factoring service?
Sol:
Existing credit collection (without factoring)
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Bad debts expenses @ 1 % on credit sales
1 % of ($20,000,000 X 80%) $ 160,000
Collection charges per annum (given) 75,000
Interest on receivables investment
Receivables X interest cost
[16000,000 X 75 days) / 360 days] X 6 % 200,000
Total expenses $ 435,000
Factoring Services as an alternative of own collection policy:
Factor commission
[$16,000,000 X 1.75%] $ 280,000
Bad debts expenses 160,000
Interest expenses (same as above) 200,000
Less: savings on factoring service
Collection charges (not required) (75,000)
Interest saved on cash advance received from
Factor after 10 days of sale
[$16000,000 X 65days) / 360 days] X 6 % (173,333)
Net expenses after benefits $ 391,667
It can be concluded that the total expenses with factoring services is lower than the expenses
with own collection policy, therefore it advisable to the firm to go for factor service for
collection of receivables.
4.6 INVENTORY MANGAGEMENT
Inventories constitute the most significant part of current assets. Because of the larger size of
investments in current assets, considerable funds are committed on inventories. It is essential
for every firm to minimize such investments by avoiding unnecessary storing costs,
obsolescence costs, and purchasing costs. Business units that are unable to control inventories
investment, end-up with decrease in profitability in the long run. The primary objective of
inventory management is to ensure sufficient levels of inventories to maintain an acceptable
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level of availability on demand, and minimizing the associated holding and administrative
costs.
Inventories for a manufacturing firm include raw materials, work-in-progress and finished
goods. Raw materials are the basic inputs that are converted into finished goods through
conversion process (manufacturing process). Raw materials inventories include materials
purchased and stored for future production needs. Work-in-progress inventories are semi-
completed goods. These goods represent partly completion of conversion process and partly
incompletion of conversion process. Hence these goods are neither raw materials nor finished
goods. Finished goods inventories are completed goods in all aspects of manufacturing process
and are ready for sale. Inventories also include supplies on hand, which are consumed for
internal demand. But supplies on hand for internal consumption are insignificant in both value
of inventories and volume occupied by them.
4.7 OBJECTIVES OF INVENTORIES MANAGEMENT
Every business unit is required to maintain certain level of inventories for efficient and smooth
production and sales operations. Maintaining large size of inventories increases investment in
current assets, and also associated costs with maintenance of inventories like storing cost,
administrative cost, obsolescence cost and wastage. Maintaining higher volume of inventories
will facilitate successful production cycle, with un-interrupted production procession. But
higher inventories volume result in increasing indirect production costs like, storing costs,
security costs, administration expenses, and losses from obsolescence. On contrary, lower
volumes of inventories may result as decrease in indirect expenses on one hand and increases
production costs on the other as idle machine hours, idle labor hours and so on. Therefore
firms’ should try to achieve the dual objective of inventories management of continuous un-
interrupted production and minimum investment in inventories. In other words, an efficient
inventory management should always aim for the following objectives:
 Ensure a continuous supply of materials to facilitate un-interrupted production.
 Maintain sufficient quantities of inventories in period of short supply and un-
anticipated price changes.
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 Maintain sufficient volume of finished goods inventories for smooth sales
operations, and efficient customer services.
 Minimize the carrying cost of inventories.
 Control investments in inventories and maintain optimum level.
4.8 INVENTORY MANAGEMENT TECHNIQUES
In managing inventories, the firms’ objective should be in consonance with the wealth
maximization principle. One can achieve this, by determining the optimum level of inventory.
Efficiently controlled inventories makes the firm flexible, and inefficiently controlled
inventories results in unbalanced inventories and inflexibility in production and operational
activities. A successful inventory management should always aim for two basic conditions.
The first being the identification of quantity to be ordered, minimizing the investments in
inventories. The second one is the using pattern of inventory, which determines the timing
interval for the replenishment of inventories. The first one is called economic order quantity
and the second one is re-order point.
Economic order quantity is the inventory replenishment cycle and the major decision area
processed in the inventories management. A firm buying raw materials has to decide two basic
criteria influenced by purchasing decisions. They are (1) carrying costs of inventory and (2)
ordering cost of inventories. Determination of optimum inventories level or quantity of
inventory to be injected depends on the trade-off between inventory carrying cost and inventory
ordering costs. Economic order quantity is that level of inventory, which minimizes the total
ordering costs, and also carrying costs.
Ordering cost of inventory is also called as purchasing costs of inventory. Costs that are
associated with purchasing activities are called as ordering costs. Usually costs like material
requisition, receiving, inspecting and pre-storing arrangements are part of ordering costs.
Ordering costs increases with increase in the number of purchases and decreases on decrease in
the number of purchases.
Carrying costs are cost of storing the raw materials and finished goods in the stores. The costs
incurred for maintaining a given level of inventory are called carrying costs or storing costs.
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Carrying costs includes storing expenses, insurance, taxes, deterioration and obsolescence of
materials. Storage expenses also include expenses on warehousing, handling and clerical staff
maintenance expenses. Behavior of carrying costs is in directly proportional to the inventory
volume. Increase in the volume of inventories increases carrying costs and vice-versa.
Inventory carrying cost is always expected to maintain on the assumption of average volume,
as the events under the two extreme points will give biased results. Inventory volume under at
the time of beginning of the year (BOY) will be maximum in volume thereby the inventory
ratio will lower, while the inventory volume during the end of year (EOY) will be low reducing
the inventory ratio. Therefore the average inventory principle should be used in arriving the
Quantity of inventory
carrying costs, which minimizes the variances of excess/deficit volumes of inventory over a
period of time. The same is explained below with the following figure.
AVERAGE CARRYING COST OF INVENTORY Fig. 8.2
Over estimation of inventory
Average inventory (BOY+EOY)/2
Under Estimation of Inventory
BOY EOY
Time interval (year/Months/Weeks/days)
The optimum size of inventory is commonly referred as economic order quantity. It is that size
of inventory where inventory carrying cost will be equal to the inventory ordering costs.
Before attaining this trade-off, inventory-carrying cost will be more than ordering costs, and
after this, carrying cost will be less than the ordering costs. This can be explained with the
following figure more clearly.
OPTIMUM INVENTORY COST Fig 8.3
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Costs and Benefits
Total cost curve
Inventory ordering cost curve
Inventory carrying cost curve
Economic order quantity
Quantity
4.9 DETERMINATION OF ECONOMIC ORDER QUANTITY
Economic order quantity can be determined using three different approaches. Graphical
method is the first method, trial and error method is the second and order formula approach is
the third method. Graphical method is explained in the above paragraph. Trial and error
method is the analytical approach adopted to determine economic order quantity of the given
firm. This can be explained in detail using the following illustration:
Illustration 5: A firm provides the following information related to its inventories operations.
Determine the economic order quantity using trial and error method.
Annual consumption of raw materials 10,000 units

Ordering cost per order placed $ 200
Inventory carrying cost per unit per annum 4 percent
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Cost per unit $ 100.
Sol:
Estimation of economic order quantity (trial and error method)
Particulars
Total quantity per
annum 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Cost per unit
purchased $100 $100 $100 $100 $100 $100 $100
total purchasing
cost (a) $1,000,000$1,000,000
$1,000,000$1,000,000$1,000,000
$1,000,000$1,000,000
$1,000,000 $1,000,000 $1,000,000 $1,000,000
Number of orders 1 2 4 5 8 10 12
Ordering cost per
order $200 $200 $200 $200 $200 $200 $200
Total ordering
cost (b) $200 $400 $800 $1,000 $1,600 $2,000 $2,400
Quantity
purchased per
order 10000 5000 2500 2000 1250 1000 833
Average inventory 5000 2500 1250 1000 625 500 417
Inventory carrying
cost per unit $4 $4 $4 $4 $4 $4 $4
Total inventory
carrying cost [c] $20,000 $10,000 $5,000 $4,000 $2,500 $2,000 $1,667

Total cost (a) +
(b) + [c] $1,020,200 $1,010,400 $1,005,800 $1,005,000 $1,004,100 $1,004,000 $1,004,067
Economic
ordering quantity $1,004,000
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(a) Total purchasing cost of inventory = quantity purchased X Unit cost price
(b) Total ordering cost of inventory = Number of orders X ordering cost
(c) Total inventory carrying cost = Average inventory X unit carrying cost per annum.
Order formula Approach: Trial and error approach is time consuming and tedious approach of
determining economic order quantity. Order formula approach is the simple method used in
determining the economic order quantity. Under this method, economic ordering quantity is
determined using the following formula:
EOQ =
where AC = Annual consumption of quantity

O = Ordering cost per single order placed
I = annual carrying cost per single unit of inventory
EOQ = Economic ordering quantity
Using the information from the illustration 5, EOQ can be determined as follows:
Given AC = 10,000 units
O = $ 200 per order placed
I = $ 4 per unit
EOQ =
EOQ =
EOQ = 1,000 units per order.
Usually suppliers encourage placing larger orders by offering discount. Firms will save big
margins on the purchase prices on accepting discount offers. Basic equation of economic
ordering quantity will not resolve this issue. Therefore the discount offer is to analyze
separately. Under this option, benefits on decrease in price should compare with incremental
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costs of inventory. If the net benefit is positive discount offer will be profitable, if it is negative
discount offer will be not worth accepting.
4.10 REORDER POINT
Economic order quantity solves the problem of how much inventory level has to be maintained,
but when to order can be determined effectively by reorder point. The reorder point is that
inventory level at which an order should be placed to replenish the inventory. To determine the
reorder point under certainty one should know (a) lead time, (b) average usage of inventory and
(c) economic order quantity or quantity replenished. Lead-time is the normal time taken to
replenish inventory after placing an order of the same inventory. Under certainty assumption,
lead-time will not fluctuate. Average usage of inventory is the quantity consumed by the
production process. Therefore reorder point can be calculated using the following formula:
Reorder point = Lead-time X Average usage on inventory (units)
Determination of reorder point under uncertainty assumptions differs with the certainty model
slightly. Uncertainty is the condition where, lead-time may fluctuate, or average inventory
consumption may vary or both. Reorder point under the uncertainty can be determined as
follows:
Reorder point = {Lead-time X Average usage}+ {safety stock}
Illustration 6: From the following information given below calculate the inventory reorder point
both under the certainty assumption and under uncertainty assumptions.
Given Economic order quantity 2,000 unity

Lead-time 1 week
Average consumption 400 units per week
Uncertainty condition
Lead-time 1 to 1½
1½ week
Average consumption 400 to 500 units
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Sol: Under Certainty assumption
Reorder point = Lead-time X Average usage on inventory (units)
Reorder point = 1 week X 400 units per week
Reorder point = 400 units
Under Certainty assumption (lead-time)

Reorder point = Lead-time X Average usage + safety stock
Reorder point = 1 week X 400 units per week + ½ week stock

Reorder point = 400 units + 200 units
Under Certainty assumption (average consumption)

Reorder point = Lead-time X Average usage + safety stock
Reorder point = 1 week X 500 units per week +½
+½ week stock
Reorder point = 500 units + 250 units

QUANTITY ORDERED
Under Certainty assumption (both)

Reorder point = Lead-time X Average usage +½
+½ week stock
Reorder point = 1 week X 400 units per week + 250 units
Graphically reorder point can be explained as follows:
5 WEEKS
INVENTORY
Inventory
replenishment
REORDER POINT
(1 week)
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USAGE OF INVENTORY FOR THE YEAR

Reorder point with certainty option may vary slightly. The basic variation starts with defining
uncertainty, as a result arising due to inconsistency in lead-time and consumption of materials
in production. The following diagram explains the same. Uncertainty will assume some
amount of stock a fixed or unused called as buffer stock or safety stock kept in reserve to meet
the contingency needs.
Reorder Point With

A Safety Stock
Inventory level
Reorder
point, R
Safety stock
0
LT LT
Time
© 2000 by Prentice-Hall Inc
Russell/Taylor Oper Mgt 3/e Ch 12 - 24
4.11 INVENTORY CONTROL
Inventory management should also aim for control over inventories. Usually a firm has to
maintain multiple types of inventories. Control over operations of such inventories will be
quite difficult. Therefore a firm should be selective in its approach in inventories controlling
system. This selective approach is also called as ABC analysis that tends to measure
significance of each item of inventories in terms of its value. Inventories with high vale (in
terms of investment) are called as ‘A’ class items and are expected to keep under tight control.
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Inventories with low value of investments are expected to have limited or no control called as
‘C’ class items. Finally, inventories with moderate investment are called as ‘B’ class items are
kept under moderate control measures.
ABC analysis concentrates on important items and is also know as control by importance and
exception [CIF]. As the items, are classified in the importance of their relative value, this
approach is also called as proportional value analysis [PVA]. The following steps are
involved in implementing ABC analysis:
 Classify the items of inventories; determine the expected usage in units and the price
per unit for each item.
 Determine the total value of each item by multiplying the expected units by the unit
price.
 Rank the items in accordance with the total value starting from the items with highest
total values.
 Compute the ratio (percentage) of number of units of each item to total units of all items
and the ratio of total value of each item to total value of all items.
 Combine items on the basis of their relative value to form ABC categories.
Illustration 6: From the following information determine the inventory control measure using
ABC analysis.
Items of 1 2 3 4 5 6 7
inventory
Units 10,000 5,000 16,000 14,000 30,000 15,000 10,000
Unit price $ 30 $ 50 $5 $4 $2 $1 $0.50
Sol:
Construction of ABC Analysis of control measure
Item Number Units % Of total Cumulative Unit price Total cost % of Total cost Cumulating
1 10,000 0.10 0.10 $30 $300,000 0.3916 0.3916
2 5,000 0.05 0.15 $50 $250,000 0.3264 0.7180
3 16,000 0.16 0.31 $5 $80,000 0.1044 0.8225
4 14,000 0.14 0.45 $4 $56,000 0.0731 0.8956
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5 30,000 0.30 0.75 $2 $60,000 0.0783 0.9739
6 15,000 0.15 0.90 $1 $15,000 0.0196 0.9935
7 10,000 0.10 1.00 $0.50 $5,000 0.0065 1.0000

Total 100,000 1.00 1.00 None $766,000 1.0000 1.0000
Classification Quantity % of total total cost %

"A" class items
1 10,000 10 $300,000 39
2 15,000 15 $250,000 32
Total 25,000 25 550,000 71
"B" class
3 16,000 16 $80,000 11
4 14,000 14 $56,000 7
Total 30,000 30 136,000 18
"C" class
5 30,000 30 $60,000 8
6 15,000 15 $15,000 2
7 10,000 10 $5,000 1
Total 55,000 55 80,000 11

1. Explain inventory management and its objective.
……………………………………………………………………………………………………
……………………………………………………………………………………………………
……………………………………………………………………………………………
2. Discus the different inventory management technique.
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……………………………………………………………………………………………………
……………………………………………………………………………………………………
……………………………………………………………………………………………
4.12 SUMMARY
An account receivable is created when a buyer is granted a certain length of time to delay
payment. This in simple terms called as the open account credit. The only evidence supporting
the debt is the sales invoice which accompanies the merchandise or service and which the buyer
signs to indicate the receipt. Allowing a customer to delay payments represents an extremely
important decision for the seller. In the event of failure from the part of customer to repay, or
failure from the part of the seller to collect the due will result in the form of loss of income.
Credit policy is established to determine which customer qualifies for the credit and under with
terms. The following are basic reasons, which help the firm as guidelines in credit policy:
Credit period, Discount, Discount period, Credit limit.
Credit information sources: Credit managers have access to customer information from several
important sources. First, most communities maintain credit associations. By becoming a
member of an association, the manager can attend meetings and meet other people with similar
interests and problems. Exchanging information among members is common and a valuable
information resource.
Efficiency in financial operations is based on the management of inventories effectively.

Efficiency in the inventory management means reduction of investment in the inventory
without affecting the productivity of the firm. Rotation of inventory quickly by avoiding the
stock-outs might result decrease in the production idle cost and increase the profit margins.
Objectives of inventory management are:

1. Minimization of investment in the inventories
2. Meeting of demand on time to satisfy sales with units produced

1. Explain briefly the credit management policy applicable to accounts receivables?
2. Define optimum credit policy? Explain how a firm attains it?
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3. Illustrate briefly the functions performed by the factor in collection of credit?
4. Define the role and significance of inventory management in business?
5. What do you know about economic order quantity? Haw is it computed?
6. Explain the concept of reorder point? How is it determined under certainty?
7. Why is inventory control is significant for business success? Illustrate your answer
using ABC analysis?
Exercises:
1. A firm desires to earn 10 percent required rate of return on its investments. Its current
credit terms are net 10. The total volume of sales of the firm are 12 millions per
annum. The firm collection period is 60 days. If the firm offers 2/10, net 30, 60 percent
of the customers will take the discount and the collection period will be reduced to 40
days. Should the credit terms be changed?
2. DC Incorporation has current sales of $ 3 million. To push the sales, the company is
considering a more liberal policy. Existing collection period of the firm is 30 days.
Each unit is sold at the price of $ 10. Average cost per unit at current level is $ 8 and
variable cost per unit is $ 6. Interest on additional borrowings will be 10 percent. The
proposes to implement one of the following policies:
Credit policy Revised collection period Incremental sales
A 45 days $ 500,000
B 60 days $ 1,000,000
C 75 days $ 2,000,000
Should the firm DC Inc. should go for new policies when the required rate of return is
12 percent.
3. ABC Private Limited has the current collection period of 60 days, and average
investment in receivables as $ 600,000. Calculate the amount of credit sales and
receivables turnover ratio?
4. Profit High Limited has an amount of $ 12 million credit sales. The current bad debts
cost are estimated as 1.5 percent and collection charges of $ 100,000 per annum. A
factor offers the following two proposals as an alternative of collection, advice which
proposal is suitable for Profit High Limited?
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Proposal A: 1.8 percent commission payable to full service recourse factoring.
Proposal B: 2.5 percent commission payable to full service non-recourse factoring.
5. A manufacturer has expected annual usage of product “560” of 50,000 units. The cost
of processing an order of purchases is $ 20, and carrying cost per unit for a year is 50
cents. Lead-time on an order is 5 days and it is a practice to keep stock usage in reserve
for 2 days. Calculate (a) economic order quantity (b) reorder point.
6. A firm has $ 4 per year carrying cost on each unit of inventory and annual usage of
50,000 units. Ordering cost is $ 100 per order. Calculate economic ordering quantity,
total cost of inventory, annual ordering cost and annual carrying cost? If the quantity is
offered at a discount of 0.25 cents on purchases above 10,000 units, will you accept the
offer price?
7. A firm has estimated annual demand of 2,500 units with $ 400 as ordering cost and $ 50
per unit as carrying cost. Safety stock is kept at 20 percent of economic ordering
quantity. Lead-time is 10 days. Determine (a) economic order quantity (b) safety stock
and (c) reorder point?
8. Price High Limited requires materials of 3,000 units of product “X”. Each unit is
priced $ 20, and ordering cost per order placed will $ 30. If the annual carrying cost per
unit is 2.5 percent per annum, calculate the economic order quantity? If the suppliers
offer the following discounts, what will be your decision?
Quantity purchased Discount rate

001 – 500 units none
500 – 1,000 units 0.5 %
1,000 – 2,000 units 1.0 %
2,000 – 3,000 units 2.0 %
3,000 and above 2.5 %
9. A firm is considering a selective inventory control measure for controlling inventories.

The following date is given to you:
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Item Code Units Unit price
1 6,000 $ 4.00
2 61,200 $0.05
3 16,800 $ 2.10
4 3,000 $ 6.00
5 55,800 $0.20
6 22,680 $ 0.50
7 26,640 $ 0.65
8 14,760 $0.40
9 20,520 $ 0.40
10 90,000 $ 0.10
11 29,940 $.030
12 24,640 $ 0.50
Categorize the above items into ABC analysis groups?
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10. Stock well limited is considering implementing ABC inventory control system for its
inventories. Assist the firm in constructing the ABC analysis graph.
Units Unit price
7,000 $ 10.00
8,000 $9.00
10,000 $ 2.00
6,000 $ 8.00
8,000 $1.00
2,000 $ 60
5,000 $ 0.40
4,000 $40.00

1. See Section 4.2

1. See Section 4.3
2. See Section 4.4

1. See Section 4.6
2. See Section 4.8

1. See Section 4.2 and 4.3
2. See Section 4.4
3. See Section 4.5
4. See Section 4.6 & 4.7
5. See Section 4.8
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6. See Section 4.10
7. See Section 4.11
Workout Solutions
1.
Sol: required rate of return = 10 %
Current credit terms = net 10
Volume of credit sales = 12 millions
Collection period = 60 days
Existing return is equal to $ 2 millions X 10 % = $ 1.2 millions
New credit terms=
g) 2/10 and net 30 with 60 % of the customers taking the advantage
h) Increase in investment cost = $ 12 million X 60 % X 2 % = $ 144,000
i) Decrease in interest (borrowing rate)= $ 12 million X 60% X 98% X 2 %= $
14,400
j) Decision existing policy is best.
2. Sol:
Assessment of existing policy:
Return on investment $3,000,000 X 10 % $300,000
1) Bad debts *1 $0
Assessment of Credit policy A:
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1) Bad debts *1
Assessment of Credit policy B:

Incremental return $ 200,000 X 10 % $20,000
1) Bad debts *1 $3,000
Assessment of Credit policy C:

Incremental sales $2,000,000
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1) Bad debts *1
3. Sol:
Current collection peiod = 60days
Average investment in receivables = 600,000
Credit sales = ?
Credit sales = (average investment X 360)/ 60 days
= $ 600,000 X 6 = 3,600,000
Receivables turn over = 360 days / 60 days
= 6 times
4. Sol:
Proposal A
Bad debts expenses @ 1.5 % on credit sales
1.5 % of ($12,000,000) $ 180,000
Collection charges per annum (given) 100,000
Interest on receivables investment
Factoring Services as an alternative of own collection policy:

Factor commission
[$12,000,000 X 2.5%] $ 300,000
Interest expenses (same as above) 200,000
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It can be concluded that the total expenses with factoring services of proposal A is lower than
proposal B. therefore it advisable to the firm to go for factor service of proposal A for
collection of receivables.
5. Sol:
Annual consumption 50,000
Ordering cost per order placed 20
Inventory carrying cost per unit 50%
Cost per unit 1
Estimation of economic order quantity (trial and error method)

Particulars
Total quantity per annum 50,000 50,000 50,000 50,000 50,000 50,000 50,000
Cost per unit purchased $1 $1 $1 $1 $1 $1 $1
total purchasing cost (a) $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000
Number of orders 1 2 4 5 8 10 12
Ordering cost per order $20 $20 $20 $20 $20 $20 $20
Total ordering cost (b) $20 $40 $80 $100 $160 $200 $240
Quantity purchased per order 50000 25000 12500 10000 6250 5000 4167
Average inventory 25000 12500 6250 5000 3125 2500 2083
Inventory carrying cost per unit $0.5 $0.5 $0.5 $0.5 $0.5 $0.5 $0.5
Total inventory carrying cost [c] $12,500 $6,250 $3,125 $2,500 $1,563 $1,250 $1,042

total cost (a) + (b) + [c] $62,520 $56,290 $53,205 $52,600 $51,723 $51,450 $51,282
Economic ordering quantity $51,450
6. Sol:
I = $ 4 per unit
136
EOQ =
EOQ =
EOQ = 1,581 units per order.
7. Sol:
I = $ 50 per unit
EOQ =
EOQ =
EOQ = 200 units per order.
8. Sol:
Quantity purchased Discount rate
001 – 500 units none
500 – 1,000 units 0.5 %
1,000 – 2,000 units 1.0 %
2,000 – 3,000 units 2.0 %
3,000 and above 2.5 %
I = $ 0.5 per unit
EOQ =
137
EOQ =
EOQ = 600 units per order.
9. Sol:
Classification Quantity % of total Total cost %
"A" class items
3 16,800 5 $35,280 23
1 6,000 2 $24,000 15
4 3,000 23 $18,000 12
Total 25,800 30 77,280 50
"B" class
7 26,640 7 $17,316 11
Total 26,640 7 17,316 11

"C" class
2 61,200 16 $3,060 2
5 55,800 15 $11,160 7
6 22,680 6 $11,340 7
8 14,760 4 $5,904 4
9 20,520 6 $8,208 5
10 90,000 24 $9,000 6
11 29,940 8 $898 1
12 24,640 7 $12,320 8
Total 319,540 86 31,464 40
Units % of total Cumulative Unit price total cost % of Total cost Cumulation
6,000 0.02 0.02 $4.00 $24,000 0.15 0.15
61,200 0.16 0.18 $0.05 $3,060 0.02 0.17
16,800 0.05 0.23 $2.10 $35,280 0.23 0.40
3,000 0.01 0.23 $6.00 $18,000 0.12 0.51
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55,800 0.15 0.38 $0.20 $11,160 0.07 0.58
22,680 0.06 0.44 $0.50 $11,340 0.07 0.66
26,640 0.07 0.52 $0.65 $17,316 0.11 0.77
14,760 0.04 0.56 $0.40 $5,904 0.04 0.81
20,520 0.06 0.61 $0.40 $8,208 0.05 0.86
90,000 0.24 0.85 $0.10 $9,000 0.06 0.92
29,940 0.08 0.93 $0.03 $898 0.01 0.92
24,640 0.07 1.00 $0.50 $12,320 0.08 1.00
1.00
10. Sol:
Construction of ABC Analysis of control measure
Item Number Units % Of totalCumulative
totalCumulativeUnit
Unit priceTotal
priceTotal cost%
cost% Of Total costCumulating
costCumulating
1 7,000 0.14 0.14 $10.00 $70,000 0.1400 0.1400
2 8,000 0.16 0.30 $9.00 $72,000 0.1440 0.2840
3 10,0000.20
10,0000.20 0.50 $2.00 $20,000 0.0400 0.3240
4 6,000 0.12 0.62 $8.00 $48,000 0.0960 0.4200
5 8,000 0.16 0.78 $1.00 $8,000 0.0160 0.4360
6 2,000 0.04 0.82 $60 $120,000 0.2400 0.6760
7 5,000 0.10 0.92 $0.40 $2,000 0.0040 0.6800
8 4,000 0.08 1.00 $40.00 $160,000 0.32 1.0000
Total 50,0001.00
50,0001.00 1.00 None $500,000 1.0000 1.0000
Classification Quantity % Of total Total cost %

"A" class items
8 4,000 8 $160,000 32
6 2,000 4 $120,000 24
Total 6,000 12 280,000 56
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"B" class
1 7,000 14 $70,000 14
2 8,000 16 $72,000 14
total 15,000 30 142,000 28
"C" class
3 10,000 20 $20,000 4
4 6,000 12 $48,000 10
5 8,000 16 $8,000 1.6
7 5,000 10 $2,000 0.4
total 29,000 58 78,000 16
UNIT 5: INTERNATIONAL FINANCIAL MANAGEMENT
Content
5.1 Introduction
5.2 Transaction Costs
5.3 Cross Rates
5.4 Triangular Arbitrage
5.5 Direct Terms Vs. Indirect Terms
5.6 Exchange Rate Notation
5.7 Changes in Currency Values and Exchange Rate Qutes
5.8 Sigels Paradox
5.9 Key Topics in Global Financial Management
5.10 Currency Markets
5.11 Forward Exchange and Hedging
5.12 Forward Premiums and Discounts Again
5.13 Rules of Thumb
5.14 Forward Contracts and Transaction Exposure
5.15 Hedging Philosophy
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5.16 Foreign Exchange Futures Contracts
5.17 Summary
5.0 AIMS AND OBJECTVES
After completing this unit, you should be able to:

 know what transaction costs are
 explain direct terms vs. indirect terms
 explain key topics in global financial management
 understand the rules of thumb in international financial management
5.1 INTRODUCTION
Exchange rate: Exchange rate is the price of one currency in terms of another currency.
Direct (or Normal) quote: quote in domestic currency (e.g., a US bank gives a direct quote for
the British pound, denoted as £, as US$/one pound or US$/£, whereas a British bank gives a
direct quote for the US dollar as £/US$.)
Indirect (or Reciprocal) quote: the inverse of the direct quote.

US (or American) Terms: direct quote used in doing business in the US (e.g., US$/£).
Euro: a new currency, introduced on January 4, 1999, issued by the EU. It will come into
common use in about three years.
Spot (exchange) rate: bank rate (guaranteed) for up to 48 hours.
Forward rate: contractually agreed to rate for a future exchange.
Bid rate: buy rate
Offer rate: sell rate
Spread = bid rate - offer rate
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Cross rate - exchange rate computed from two other rates.
For example assume that, the US exchange rates for Belgium and the UK are as follows:
US $ equiv.
(US Terms)
Currency per US $
(European Terms)
Belgium (Spot) 0.0321 ($/BF) 31.1150 (BF/$)
Britain (Spot) 1.5901 ($/£) 0.6289 (£/$)
Suppose you subscribe to a journal produced in the UK and the bill for a given year is 50 £.
The proper payment, if they will accept a personal check, is $81, determined as follows:
From the table, the rate is 1.5901 US$/£. Thus, the exact payment in US$ is
(1.5901 US$/£) x (50 £) = 79.505 US$.
One should include an extra amount, say $1.50, to cover inconvenience and any transactions
costs that the publisher might encounter.
5.2 TRANSACTIONS COSTS
The spread (= bid rate - offer rate) is the profit to the currency dealer and is a transaction cost to
the other party. For example, suppose you must pay for the British journal in British pounds.
For example, one can assume the rate to sell as 1.5904 US$/£. Thus, it will cost you (1.5904
US$/£) x (50 £) = 79.52 US$ to acquire the 50 £.
Note that there is not a great deal of difference here. However, if we were dealing in millions of
dollars or millions of pounds, then the difference would be quite large. Furthermore, common
sense suggests that if the publisher will accept a personal check, which is very convenient for
you and quite inconvenient for the publisher, then you should add $1.50 (or so) to correct for
exchange rate changes, transactions costs, and convenience. Therefore, if you were paying in
US$, you would remit $81. (Most international businesses maintain offices in many countries
exactly to make transactions convenient for the buyer. For example, Oxford University Press,
Cambridge University Press, and Springer-Verlag (of Germany) all have offices in New York,
and Kluwer Academic Press (of the Netherlands) has an office in Boston.)
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5.3 CROSS RATES
Under the presumption of no transactions costs and efficient markets, we can calculate the
exchange rate between any two currencies. For example, it is provided that American-terms
rates for the Swiss Franc (SwF) and the German Deutsche mark (DM), which yields the
exchange rate for the SwF in terms of the DM, as follows:
.840790 (SwF/DM) = 1.2685 (SwF/US$)

1.5087 (DM/US$)
Cross rates can be calculated due to a very simple form of efficiency in the currency market,
known as Triangular Arbitrage.
5.4 TRIANGULAR ARBITRAGE
Suppose you can get exchange rates that are not in balance. For example, suppose one can
exchange dollars for Belgian francs at a rate of XBF/$
XBF/$ and Belgian francs for French francs at
the rate of XFF/BF
XFF/BF.. Let X$/FF
X$/FF be the exchange rate between US$ and FF. If the product
(XBF/$
(XBF/$)(X
)(XFF/BF
FF/BF)) is greater than X$/FF
X$/FF (ignoring transactions costs), then you would make the
swap and “best the market.” The net effect of your activity would be to alter the market rates
because you would influence supply and demand. The final effect, in a free (currency)
exchange market, is to bring all of the exchange rates into balance. Since there are three sides to
this trade, it is called triangle arbitrage.
Graphically, triangle arbitrage is as follows:
US Currency Belgian Currency T (XBF/$
(XBF/$)) T
French Currency (XFF/$
(XFF/$)) T versus (XBF/$
(XBF/$)) T (XFF/BF
(XFF/BF))
If the currency market is efficient, then (XFF/$
(XFF/$)) T = (XBF/$
(XBF/$)) T (XFF/BF
(XFF/BF),
),
Whereupon, removing T, one has XFF/$
XFF/$ = (XBF/$
(XBF/$)(X
)(XFF/BF
FF/BF).
). Rearranging yields XFF/BF =
XFF/$ finally,
XBF/$.
BF/$.
Thus, this form of efficiency is what allows the computation of cross-rates. Note that this form
of currency market efficiency is time-independent, and pertains only to spot rates.
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5.5 DIRECT TERMS VS. INDIRECT TERMS
Recall the definitions given above:

Direct (or Normal) quote: quote in domestic currency (e.g., a US bank gives a direct quote for
the British pound, denoted as £, as US$/one pound or US$/£.) Indirect (or Reciprocal) quote:
the inverse of the direct quote.
5.6 EXCHANGE RATE NOTATION
The text denotes exchange rates with an ‘X’ and a subscript representing the units of the quote.
E.g., X£/$
X£/$ is the British pound price of a US dollar (measured in British pounds per US dollar),
and X$/£
X$/£ is the US dollar price of a British pound (measured in US dollars per British pound).
The text also uses ‘C’ to represent a generic currency, and a ‘b’ to represent the base currency.
Furthermore, the text uses a superscript to denote time. For example, the spot (i.e., the time 0)
exchange rates for British pounds and US dollars will be denoted X$/£ 0 and X£/$ 0.
5.7 CHANGES IN CURRENCY VALUES AND EXCHANGE RATE QUOTES
Exchange rates are simply prices (of currencies in terms of other currencies), and like all prices,
they respond to changes in supply and demand. As the text notes, if the demand for British
pounds increases and the demand for dollars stays fixed, then X$/£
X$/£ will rise and X£/$
X£/$ will fall.
The parallel with a commodity is complete. For example, if the demand for loaves of bread
increases while the supply stays fixed, then the price of a loaf of bread will increase, i.e.,
P$/loaf will rise. Clearly, the US dollar price of the British pound has fallen rather steadily.
There are some interesting, and historically important, segments to the graph. The dip and rise
around 1930 reflects the differential effects of the Great Depression. The steep drop in the late-
1930s reflects the early years of World War II (which the US did not enter until 1941). The flat
segments reflect the rigidity introduced by the Bretton Woods agreement (designed to stabilize
the major currencies after WWII). The general decline beginning in the late-1960s reflects the
end of fixed exchange rates and the post-WWII transition of economic power from Great
Britain to the US. This last decline results from an increasing demand for US$ and a decreasing
demand for British pounds that resulted as the US$ replaced the British pound as the principal
international currency. Note that the transition of economic (and military) power from Great
144
Britain to the US was nearly complete by 1945 (i.e., the end of WWII). However, the rigidity of
exchange rates introduced via the Bretton Woods Agreement (see O’Brien, pages 32-33) masks
the transition of economic power. Put differently, the British pound was seriously over valued
(relative to the US$). This is why the US dropped the fixed exchange rate system in favor of
floating (i.e., market determined) exchange rates.
5.8 SIEGEL’S PARADOX
As always, there is no paradox, just some funny algebra. Siegel’s “Paradox” refers to the
following fact: in general, if a currency C has appreciated (depreciated) against a base currency
by k%, then the base currency b will not have depreciated (appreciated) against C by k%. This
is simply the way percentages work.
The text uses the following example. Suppose the initial (i.e., time-0) exchange rate of US
dollars for British pounds is X$/£ 0 = 2.00 and the final (i.e., time-1) exchange rate is X$/£ 1 =
1.80.
Then the percentage change is % .X$/£
.X$/£ = (X$/£
(X$/£ 1 - X$/£0)
X$/£0)
X$/£ 0 = X$/£
X$/£ 1
X$/£0 -1 = 1.80 -2.00
2.00= 1.80
2.00 - 1 = -.10 = -10%
Now consider the same basic calculation for X£/$
X£/$.. By definition,
X£/$0 = 1
X$/£0 and X£/$
X£/$
1=1
X$/£1,
so that
X£/$0 = 1
2.00= .50 and X£/$
X£/$
1=1
1.80= .55.
.55. Therefore,
% .X£/$
.X£/$ = (X£/$1
(X£/$1 - X£/$0)
X£/$0)
X£/$0=
£/$0= .55 - .50
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.50= .11> 11%
Thus, where the British pound has depreciated 10% against the US$, the US$ has appreciated
by more than 11% against the British pound. There is no paradox here. “Common sense”
suggests that we will have %. X$/£
X$/£ = -%. X£/$
X£/$.. Suppose this is true. Then we have % .X$/£
.X$/£ =
X$/£1
X$/£0-
$/£0- 1 = -(X£/$1
-(X£/$1X
X£/$0-
£/$0- 1)= % .X£/$.
.X£/$.
By definition,
X$/£1 = 1X£/$1
1X£/$1 and X$/£0
X$/£0 = 1X£/$0
1X£/$0
So that the equality % .X$/£
.X$/£ = X$/£1
X$/£1X
X$/£0-
$/£0- 1 = -(X£/$1
-(X£/$1X
X£/$0-
£/$0- 1)= % .X£/$
.X£/$
becomes % .X$/£
.X$/£ = X$/£1
X$/£1X
X$/£0 - 1
= -1X£/$1
-1X£/$1 1X£/$0
1X£/$0-1...
-1... . . ..ÿÿ ÿ ÿ ÿ
= - X£/$0
X£/$0X
X£/$1 +1.
+1.
Rearranging the components of the end-most terms yield
X$/£1X
$/£1X$/£0+
$/£0+ X£/$0
X£/$0X
X£/$1=
£/$1= 2.
Rearranging again yields
(X$/£1)
(X$/£1) 2 + (X$/£0)
(X$/£0) 2X$/£0 X£/$1 = 2,
so that (X$/£1
(X$/£1 )2 + (X$/£0
(X$/£0 )2 = 2X$/£0
2X$/£0 X£/$1 ,
(X$/£1)
(X$/£1) 2 - 2X$/£0
2X$/£0 X£/$1 +(X$/£0)
+(X$/£0) 2 = 0,
(X$/£1
(X$/£1 - X$/£0)
X$/£0) 2 = 0,
which implies X$/£1 = X$/£0
X$/£0 .
Therefore, the only time that the “common sense” view that %.X$/£
%.X$/£ = -%.X£/$
-%.X£/$ holds is when
%.X$/£
%.X$/£ = -%.X£/$
-%.X£/$ = 0.
As noted, there is no paradox. What is at issue is the weakness of common sense as it pertains
to the behavior of percentages.
5.9 KEY TOPICS IN GLOBAL FINANCIAL MANAGEMENT
Global financial managers must deal with three basic issues, as follows:
I. Corporate Financing
• In which countries and currencies should a firm find financing?
• Is there an international financial package that minimizes financing costs?
146
II. Measurement and Management of Exposure and Risk
• What is the company’s currency exposure?
• What are the problems associated with measurement and management of
exposure and risk?
III. Capital Budgeting Decisions in a Global Environment
• What are the relevant cash flows?
• What are the proper accept/reject criteria?
These questions are addressed in the remaining parts of the text. The rest of Part I provide a
brief history of, and some background to, the evolution and structure of the contemporary
international financial system.
5.10 CURRENCY MARKETS
The Eurocurrency markets and foreign exchange markets provide clearance and settlement
mechanisms for inter-bank transfers. Graphically, part of the system is as follows:
CURRENCY MARKETS
(Source: K. C. Butler, Multinational Finance, Cincinnati, OH: South-Western College
Publishing, p. 57.)
US customers
US credit market
UK customers
UK credit market
Eurodollars Euro pounds
Euro yen
Japanese credit mark
Japanese customer
Eurocurrencies
The Eurocurrency market transfers purchasing power over time (by bringing together
borrowers and savers).
147
The foreign exchange markets transfers purchasing power over currencies, i.e., from one
currency to another.
Spot market -- trades made for immediate (i.e., 24 hour) delivery.
Forward market -- trades made for future delivery according to an agreed upon delivery date,
exchange rate, and amount.
5.11 FORWARD EXCHANGE AND HEDGING
A money market hedge is an arrangement to exchange currencies, the purpose of which is to

reduce or remove exposure risk. The currency market determines exchange rates for various
times to delivery. The rates determined for delivery are called spot rates; the rates for longer
times to delivery are called forward rates.
Notation: FC/$
FC/$ = forward rate of currency C in $ = spot rate, at time t, of currency C in $
Terminology contract amount = the money value of the contract (in the denominator currency)
contract size = the money value of the contract (in the numerator currency) E.g., a contract for
the amount $1,000,000 at the forward rate FDM/$
FDM/$ = 1.5 is a contract of size DM 1,500,000
More Notation C# = forward contract size $GL
$GL = gain (measured in $) on long forward position
on currency C Accounting Identity $GL
$GL = C#( X$/C 1 - F$/C
F$/C ) where time 1 is the time of the
forward contract.
5.12 FORWARD PREMIUMS AND DISCOUNTS AGAIN
We need to be careful with both the terminology and the timing on the spot rate. In particular,
we must keep careful track of which currency is in the numerator currency and which is in the
denominator currency. And note that premiums and discounts, unlike gains and losses (as
discussed above), are determined by the difference between a forward rate and the present spot
rate.
Recall that the spread is the difference between the forward and spot rates. If the spread is
positive (negative), i.e., if the forward rate is higher (lower) than the spot rate, then the
denominator currency is said to be at a premium (discount) with respect to the numerator
currency.
148
For example, suppose the difference between the 90-day forward rate and (the present) spot
rate for the Canadian dollar and the US dollar is F$/C - X$/C
X$/C 0 = .7599(US$/Can$)
- .7609(US$/Can$) = -.0010 < 0.
Thus, the Canadian dollar (i.e., the denominator currency) is at a discount against the US$ (i.e.,
the numerator currency).
RULES OF THUMB:
Always use direct quotes; then ‘buy low and sell high’ makes sense. Always think of the
currency in the denominator as the currency of reference (i.e., the currency being bought and
sold).
The calculation above is a direct quote calculation for a Canadian. The direct quote calculation
for an American is FC/$ - XC/$
XC/$ 0 = 1.7599 (Can$ / US$)- 1.7609 (Can$ / US$) =
1.3160(Can$/US$) - 1.3142(Can$/US$) = 0.0018 > 0
Consistent with the earlier calculation, this calculation shows the US$ at a premium against the
Can$.
5.14 FORWARD CONTRACTS AND TRANSACTION EXPOSURE
Consider a simple transaction whereby your firm, which functions in US$, will receive DM
3,000,000 in 3 months (90 days). You, the manager, are uncertain about the spot exchange rate
that will hold 90 days hence. However, you are certain about the 90 days forward exchange
rate. Thus, you can hedge the uncertainty by purchasing today a dollar-denominated forward
contract at the standing forward rate. Following the example in the text, suppose the 90-day
forward rate is 1.50 (DM/$). At that rate, the DM 3,000,000 you will receive in 90 days will be,
without risk, equal to $ 2,000,000.
Alternatively, you can do the accounting in cash settlement terms. Of course, given the forward
contract, the cash settlement terms show the DM 3,000,000 as $2,000,000 with certainty. It is
the ‘with certainty’ that is of immediate relevance here. Finally, this can be reversed. If you are
an American manager who must deliver DM 3,000,000 ninety days hence, you can purchase a
forward contract at today’s forward rate, say 1.5 DM/$, which will commit you to deliver
$2,000,000 ninety days hence.
149
Again, all this is done to remove risk. There is an interesting side point here—who’s risk are
we removing? Even if the firm is not exposed, and therefore requires no hedging, the manager
of a division may find hedging in his/her own best interest. Suppose you are the manager of the
export division of a (two division) firm. Suppose the export division buys jewelry in US and
sells it in France, and suppose that the import division buys high fashion clothing in France and
sells it in the US. Suppose also that contracts are settled in six months. Suppose your export
division sells FF 1,000,000 worth of jewelry and the import division purchases FF 1,000,000
worth of clothing. The net of this contract, with respect to transaction exposure, is zero.
Therefore, the firm has no need for a hedge. You, however, may find a hedge a great idea and
for either of two reasons. First, by hedging the transaction exposure of your division you are
reducing the variability of divisional performance. If you are the division manager, then this is
the source your reward and you may be very interested in hedging. Second, your management
performance is usually judged on the basis of accounting performance (as opposed to cash flow
performance), so you may be interested in hedging your accounting (i.e., translation) exposure
to risk. By reducing the translation exposure you can reduce the variability in your
performance.
Now, view all this from the perspective of shareholders. If the managers are running around
hedging divisional risk when there was no firm risk, then shareholder’s costs are rising for no
good reason. The solution to all this is to align the incentives of managers and shareholders.
The interesting open issue is this--does such an alignment exist for a given firm? The hedged
value of the contract is F$/DM
F$/DMT
T and the speculative value is X$/DM 1 T. Then the two line
intersect at X$/DM 1 = F$/DM.
F$/DM. Clearly, if X$/DM 1 > F$/DM,
F$/DM, speculation would have been
superior to hedging; and if X$/DM 1 < F$/DM,
F$/DM, then hedging would have been superior to
speculation. The amount of the gain/loss from speculation is straightforward. All we require is
a probability distribution on the spot exchange rate, and we can compute the expected gain/loss
on speculation. Indeed, assuming informational efficiency in the currency markets, we know
the mean of the distribution, i.e., we know E[X$/DM
E[X$/DM 1 ]= F$/DM
F$/DM . If we have a normal
distribution with E [X$/DM1]
[X$/DM1]=
= F$/DM,
F$/DM, then we have the following:
Spot exchange rate Dollar value of the contract F$/DM
F$/DM
F$/DMTX
$/DMTX$/DM
$/DM1TX1
1TX1$/DM
$/DM
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Now consider the linearity comment. The text notes that if the obligation is denominated in
DM, then we need to use exchange rates where the direct quote is in DM, i.e., where DMs are
in the denominator. If we do not, then the graph is non-linear. This is easy to see. Suppose we
have a contract for DMT and we represent the situation in terms of forward and spot exchange
rates in terms of DM per $. Then the hedged value of the contract is 1 F$/DM
F$/DM T and the
speculative value is 1X$/DM1
1X$/DM1T.
T.
5.15 HEDGING PHILOSOPHY
The text makes two important points here:

(1) “Philosophically, the use of forward exchange contracts for hedging should be to
eliminate uncertainty.”
(2) (2) Thus, the opportunity cost of hedging with the forward exchange contract “really
should not matter to the hedger.”
The text then makes an odd point:

“Thus, you may choose not to eliminate your exposure with a forward contract position if you
have a strong belief that the future spot rate will be favorable to your natural position.”
What is odd here is the term “strong belief.” Taken literally, this means that if you have a very
high probability that the future spot rate will be greater than the forward rate, and then you
should not hedge. This can be taken literally only if we mean that the probability that the future
spot rate will be greater than the forward rate (by a sufficiently large amount) is itself greater
than the critical value of the relevant probability, then you should not hedge. Correctly stated,
we have the following translation of the text: if your probabilities over future spot rates and
your utilities (i.e., risk attitudes) over payoffs are such that the expected utility of not hedging is
greater than the expected utility of hedging, then you should not hedge.
The key point is this--hedging removes risk; i.e., it is a form of insurance. [Note-Strictly
speaking, uncertainty is reduced by gathering information, risk is reduced by buying
insurance.] Note that a forward rate hedge is an insurance contract.
5.16 FOREIGN EXCHANGE FUTURES CONTRACTS
151
The key points are as follows:
Spot exchange rate Dollar value of the contract
FDM/$TX
DM/$TXDM/$
DM/$1F
1FDM/$
DM/$X
XDM/$1T/
DM/$1T/
(1) Foreign exchange futures contracts are very similar to forward exchange contracts; and
(2) They are not the same thing.
Differences: where traded timing settlement futures contracts open market settled daily cash-
settled; on standardized dates forward contracts inter-bank currency market settled on specified
dates not necessarily cash-settled; on standardized dates.
5.17 SUMMARY
This unit should focus into the issues that are required to finance manager in the
international arena. The basic problems, which are encountered in the international
finance, are the export risk and transactional exposure risk. International finance deals
with issues like, international banking, international capital markets, and export risk, and
exposure risk. International banks acts as financial intermediaries across national
boundaries, and provide a range of banking services to international trading activities.
International banking consists of :
a. Traditional foreign banking – involving transactions in the domestic currency with non-
resident business organizations.
b. Euro currency banking – involving transactions in currencies other than domestic
currency.
The volume of international banking transactions has increased enormously in recent

decades mainly centered at New York, London and Tokyo. The following are reasons,
which can be attributed to the growth of international banking.
1. Growth of international trade and overseas investment increasing the demand for
international funds.
152
2. Abolition of exchange controls encouraging the globalization of international financial
markets where by national financial markets became integrated into a single
international market.
3. Deregulation of capital markets permitting securities like debt instruments which
company’s issue internationally traded debt instruments such as euro-bonds and euro
commercial papers.
4. Development of multi-national companies, including the major banks themselves,
operating in a range of countries.
International Money and Capital Markets

The primary function of banks is to act as financial intermediaries tat is to provide a link
between net savers and net borrowers. In international banking the same function is fulfilled
but across national boundaries. In addition international banks provide a range of banking
services for their customers engaged in international business activities like: Financing foreign
trade, Financing capital investments, Providing local banking services in a range of countries,
Trading in foreign exchange markets, Providing advice and information.
Foreign trade risk can be classified into two categories and they are:
1. Export risk; and the other
2. Foreign exchange transaction exposure.
Export credit risk

The following are possible risk factors applicable to the foreign trade: Illiquidity, Bankruptcy
or failure of the bank in the remittance chain, poorly specified remittance channel,
Inconvertibility of customer’s currency, and lack of access to the currency in which payment is
due. This can be caused by deliberate exchange controls or unplanned foreign exchange
requirements in the customer’s central banks Political risks – like change of regime, civil war
or blockade to the country concerned.
Exporters can protect themselves against the above risks as follows:

 Use banks in both countries to act as the collecting channel for the remittance and to
control the shipping documents so that they are only released against payment or
acceptance of negotiable instruments.
 Commit the customer’s bank through an irrevocable letter of credit.
153
 Obtain support form the third parties like get a guarantee of payment from a local bank,
get a letter from the local finance ministry or central bank confirming availability of
foreign currency.
 Take out export credit cover.
 Use an intermediary like confirming, export finance, factoring or forfeiting house to
handle the problem on their behalf.
Foreign exchange transactions exposure

Transaction exposure leads to uncertainty as to future domestic currency cash flows
arising from sales, purchases, and so on. The impact of this uncertainty can be minimizes
by the following means: Hedging the currency forward or future contract, Hedging
money market, Leading and lagging, Settlement in domestic currency, Matching.
154

Financial Management 3RD Degree Acctn

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UNIT 1: FINANCIAL PLANNING AND CAPITAL STRUCTURE

1.0 AMES AND OBJECTIVES

After completion of this unit, on should be in a position to:

MODEL FINANCIAL PLANNING

1.3 TERMS OF FUNDING

1.4 SOURCES OF FUNDS

Check Your Progress Exercise 1

1.5 FORECASTING MODELS

1.5.1 Income Statement

FOR THE YEAR ENDED DECEMBER 31 20x1

1.5.2 Balance Sheet

As on date December 31 20X1

Income statement Ratios

Revised income statement and balance sheet with increased sales as 25 %.

1.5.3 Proforma Cash Flow Statement

A simple financial forecasting model is illustrated below:

ILLUSTRATION 2: Financial forecasting model is illustrated below to make the business

Tax rate 40%

1.6 COST OF CAPTAL

1.6.1 Significance of Cost of Capital

Market value of the Common share

1.6.2 Determination of Cost of Capital

Check Your Progress Exercise 2

1. Explain the significant of cost of capital.

1.6.3 Computation of Specific Costs of Capital

1.6.3.1 Dividend Price Approach

Where Po = Price of the Equity/Common share

1.6.3.2 Dividend Price Plus Growth Approach

Where P0 = Price of common shares

1.6.3.3 Earnings Price Approach

where E = Earnings per share

1.6.3.4 Realized Yield Approach

1.7 COST OF PREFERENCE

(i) Cost of Irredeemable preference shares (Kp):

(ii) Cost of Redeemable preference shares (Kp):

Where Kp = Cost of preference share

1.8 COST OF DEBT CAPITAL

Cost of Irredeemable Debt (Kd):

Int (1-t) + [(RV-SV)/n]

Where Kd = Cost of debt

Ke = 0.12 + 0.06 = 0.18 or 18 %

When the preference share is redeemable, then Kp will be:

Where Kp = Cost of preference share

Where Kp = Cost of preference share

Where Kd= Cost of debt

(ii) With 10 % discount

Where Kd= Cost of debt

1.9 COMPUTATION OF SIMPLE AVERAGE COST OF CAPITAL

Weighted average cost of capital (WACC) is calculated as follows:

Ko = (We Ke + Wp Kp + Wd Kd)/ (We + Wp + Wd)

Ko = (30 % + 8 % + 14 %)/ (5)

Ko = (52 %)/ (5)

Ko = (We Ke + Wp Kp + Wd Kd)/ (We + Wp + Wd)

Ko = (30 % + 24 % + 14 %)/ (5)

Ko = (68 %)/ (5)

Particulars Book Values in $ Market values in $ Specific costs

Ko = (13.5 % + 7.9 % + 5.8 %)/3

(iii) Calculation of cost of capital using market weights:

Preferred share 150,000 7.9 % 0.200 1.58 %

Percentage change in profits

Decision rule: Operating leverage may be favorable or unfavorable. A favorable leverage

Operating leverage = 1.33 times.

Operating leverage = 2.66 times.