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Financial management An overview Financial management is that management activity which is concerned with the planning and controlling of the firms financial resources. It is concerned mainly with procuring funds in the most economical and prudent manner, deploying these funds in most profitable way in a given risk situation, planning future operations ad controlling current and future performances and developments through different tools. It an approach by which depending on importance, resources can be allocated to various projects. For efficient operations of a business, there is necessity for obtaining and effectively utilizing funds. These jobs are done by Financial Management. Basically, therefore, finance management centres around fund raising for business in the most economical way and investing these funds in optimum way so that maximum return can be obtained for the shareholders. Since all business decisions have financial implications, financial management is interlined with all other functions of the business. FUNCTIONS OF FINANCE


Investment Decision : Investment decisions or capital budgeting involves the decision of allocation of capital or commitment of duns to long term assets which would yield benefits in future. One significant aspect of this is the task of measuring prospective profitability of new investment. Future benefits are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, capital budgeting decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgeting also involves decision of recommitting funds when an asset become less productive or non-profitable. Another major aspect of investment decision is the measurement of a standard or hurdle rat against which the expected return of new investment can be compared There is a broad agreement that the correct standard to use for this purpose is the required rate of return or the opportunity cost of capital. However, one confronts many problems in computing the cost of capital in practice.


Financing Decision : The finance manger must decide when, where and how to acquire funds to meet the firms investment needs. The central issue before him is to determine the proportion of equity and debt. The mix of debt and equity is known as the firms capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his firm, the firms capital structure is considered to be optimum when the market value of shares is maximized. The use of debt affects the return and risk of shareholders; it may increase the return on equity funds but it always increases risk.

A proper balance will have to be struck between return and risk. When the shareholders return is maximized with minimum risk, the market value per share will be maximized and the firms capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he must raise the appropriate amount through best available sources. In practice, a firms considers many other factors such as control, flexibility, loan covenants, legal aspects, etc. in deciding its capital structure.


Dividend Decision : This is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. Like the debt policy, the dividend policy should be determined in terms of its impact on shareholders value. The optimum dividend policy is one which maximizes the market value of the firms shares. Thus, if the shareholders are interested in the firms dividend policy, the financial manager must determine the optimum dividend payout ratio. The dividend payout ratio is equal to the percentage of dividends distributed to earnings available to shareholders. The financial manager should also consider the question of dividend stability, bonus shares and cash dividend in practice. Most profitable companies pay cash dividends regularly. Periodically additional shares, called bonus shares are also issued to the existing shareholders in addition to the cash dividend.


Liquidity Decision :

Current assets management which affects a firms liquidity is yet another important Current assets should be managed

finance function, in addition to the management of long-term assets. assets affects firms profitability, liquidity and risk.

efficiently for safeguarding the firms against the dangers of illiquidity and insolvency. Investment in current

A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability as idle current assets would not earn anything. Thus a proper trade-off must be achieved between profitability and liquidity. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound techniques of managing current assts and make sure that funds would be made available when needed. JOB OF FINANCIAL MANAGER Financial Manager is a person who is responsible in a significant way to carry out the finance functions. He is one of the dynamic members of a top management team, and his role day-to-day is becoming more pervasive, intensive and significant in solving the complex management problems. His main functions include : a. b. c. d. Raising of funds Allocation of funds Profit planning Understanding Capital Markets

CHANGING ROLE OF FINANCE MANAGER The critical problem being faced by the companies today is obtaining finance for expansion. Initially the capital markets were primitive. The transfer of funds from individual savers to businesses were quite difficult few years ago. With changes in regulation of Stock Exchanges, the environment in the capital is better now than earlier and is progressing towards a near perfection stage slowly. In earlier years, Finance managers in India used to practice in an environment where sellers market prevailed. Near monopoly was the state of affairs in the Indian business. Sources of finance used to come mostly from Bank/Financial Institutions. The emphasis on Debt/Equity took a back sear. The satisfaction of shareholders were not the concern of the promoters wince most companies were closely help (family businesses). Because of the opening up of the economy, competition increased and sellers market has been converted into a buyers market. The emphasis on decision making by the Finance manager has changed in recent years. Firstly, there has been increasing belief that sound investment decision require accurate measurements of cost of capital. Accordingly, ways of quantifying the cost of capital now play a key role in finance. Secondly, capital has been in short supply, making one reconsider ways of raising funds. Thirdly there has been continued merger activity leading to renewed interest in takeovers.

Financial Manager The financial manager raises capital from the capital markets. He or she should therefore know-how the capital markets function to allocate capital to the competing firms and how security prices are determined in the capital markets. Chief Financial Officer A number of companies in India either have a finance director or a vice-president of finance as the Chief Financial Officer (CFO). Most companies have only one CFO. But a large company may have both a treasurer and a controller, who may or may not operate under the CFO. Treasurer and Controller The treasurers function is to raise and manage company funds while the controller oversees whether funds are correctly applied. Functions of Treasurer: 1. 2. 3. 4. 5. Provision of finance Investor relations Short-term financing Banking and custody Credit and collections

Functions of Controller. 1. 2. Planning and control. Reporting and interpreting

3. 4. 5. 6.

Tax administration Government reporting Protection of assets. Economic appraisal

Agency Problem and Agency Costs : Shareholders and managers have the principal- agent relationship. In practice, there may arise a conflict between the interests of shareholders and managers. This is referred to the agency problem and the associated costs are called agency costs. Offering ownership rights (in the form of stock options) to managers can mitigate agency costs. FINANCIAL GOAL PROFIT VERSUS WEALTH The firms investment and financing decisions are unavoidable and continuous. In order to make them rationally, the firm must have a goal. It is generally agreed in theory that the financial goal of the firm should be the maximization of owners equity economic welfare. Owners economic welfare could be maximized by maximizing the shareholders wealth as reflected in the market value of share. PROFIT MAXIMISATION Profit maximization means maximizing the rupee income of firms. The profit maximization objective has, however, been criticized in recent years. It is argued that profit maximization assumes perfect competition and in the face of imperfect modern markets, it cannot be a legitimate objective of the firm. It is also argued that profit maximization, as a business obejc6ive developed in the 19th century when characteristic feature of business structure were self financing, private property and single entrepreneurship. The only aim of the single owner then was to enhance his individual wealth and personal power which could easily be satisfied by the profit maximization objective. The modern business environment is characterized by limited liability and a divorce between ownership and management. The business firm today is financed by shareholders and lenders but it is controlled and directed by professional management. The other interested parties are customers, employees, government and society. In practice, the objectives of the different stakeholders of a firm differ and may conflict with each other. The manager of a firm has the difficult task of reconciling and balancing these conflicting objectives. In the new business environment, profit maximization is regards as unrealistic, difficult, inappropriate and immoral. It is also feared that profit maximization attitude may tend to produce goods and service that are wasteful and unnecessary from the societys point of view. Also it might lead to inequality of income and wealth. It is for this reason that governments tend to intervene in business. Apart form the above objections, profit maximization fails to serve as an operational criterion for maximization the owners economic welfare. It fails to prove an operational feasibility for ranking alternative courses of action in terms of their economic efficiency. It suffers from the following limitations :

a. b. c.

It is vague It ignores timing of returns It ignores risk

Definition of Profit: The precise meaning of profit maximization objective is unclear. The definition of the term profit is ambiguous. Does it mean short or-long term profit? Does it refer to profit before or after tax? Total profits or profit per share? Does it mean total operating profit or profit accruing to shareholders? Time Value of Money : The profit maximization objective does not made a distinction between returns received in different time periods. It give no consideration to the time value of money and it values benefits received today and benefits received after a period to be the same. Uncertainty of returns : The stream of benefits may possess different degree of uncertainty. Two firms may have same total expected earning, but if the earnings of one firm fluctuate considerably as compared to the other, it will be more risky. Possibly, owners of the firm would prefer smaller but surer profits to a potentially larger but less certain stream of benefits. In trying to maximize the profits the following should be remembered :


Profit after Taxes :

Maximizing profits after tax will not maximization the economic welfare of the owners. It is not possible for a firm to increase profits after taxes by selling additional equity shares and investing the proceeds in low-yielding assets such as government bonds. Profits after tax will go up but earnings per share would go down.


Earnings per share :

If we adopt maximizing EPS as the financial objective of a firm, this will also not ensure maximization of owners economic welfare. It also suffers from flaws mentioned above i.e., it ignores timing and risk of the expected benefits. Wealth Maximization : The use of the objective of wealth maximization has been advocated as an appropriate and operationally feasible criterion to choose among the alternative financial actions. It provides an unambiguous measure of what financial management should seek to maximize in investment and financing decisions. Wealth maximization means maximizing the net present value (or wealth) of a course of action. The net present value of a course of actions is the difference between the present value of tits benefits and the initial outlay. A financial decision which has a positive net present value creates wealth and therefore is desirable. A financial action resulting in negative net present value should be rejected. Between a number of desirable mutually projects we have to choose those combinations of projects which give the highest positive NPV. SCOPE OF FINANCIAL MANAGEMENT

Traditional Approach (i) (ii) (iii) Arrangement of funds from financial institutions. Arrangement of funds through financial instruments, viz, shares, bonds, etc. Looking after the legal and accounting relationship between a corporation and its sources of funds.

Criticism on Traditional Approach: (i) (ii) (iii) (iv) (v) Outsider-looking in approach Ignored routine problems. Ignored non-corporate enterprises Ignored working capital financing No emphasis on allocation of funds.

Modern Approach According to modern concept, financial management is concerned with both acquisition of funds as well as their allocation. The modern approach is an analytical way of looking at the financial problems of a firm. The main contents of the new approach are as follows: (i) (ii) (iii) What is the total volume of funds an enterprise should commit? What specific assets should an enterprise acquire? How should the funds required be financed?

The above questions relate to four broad decision areas of financial management, viz., funds requirement decisions, financing decision, investment decision and dividend decision. Subsidiary functions of Finance Manager: (i) (ii) (iii) (iv) (v) (vi) To ensure supply of funds to all parts of the organization. Evaluation of financial performance. To negotiate with bankers. Financial institutions and other suppliers of credit. To keep track of stock exchange quotations and behavior of stock market prices. Financial Control Keeping the records of all assets:

Liquidity Profitability: The finance manager is always faced with the dilemma of liquidity vs profitability. He has to strike a balance between the two. a) b) c) The firm has adequate cash to pay for its bills. The firm has sufficient cash to make unexpected large purchases and above all. The firm has cash reserve to meet emergencies, at all times.

Profitability goal, on the other hand, requires that the funds of the firm are so used so as to yield the highest return. Liquidity and profitability are very closely related. When one increases the other decreases. There is also direct relationship between higher risk and higher return. Higher risk on the one hand endangers the liquidity of the firm. Higher return on the other hand increases its profitability. Forecasting of cash flows and managing the flow of internal funds are the functions which lead to liquidity. Cost control and forecasting future profits are the functions of finance manager which lead to profitability. An efficient finance manager fixes that level of operations where both return and risk are optimized. Such a level is termed as risk-return trade-off and every financial decision involves this trade-off. At this level the market value of the company's shares would be the maximum. Methods of Financial Management: The term 'financial method' or 'financial tool' refers to any logical method or technique to be employed for the purpose of accomplishing the following two goals. 1. 2. Measuring the effectiveness of firm's actions and decisions. Measuring the validity of the decisions regarding accepting of rejecting future projects.

Financial tools or methods: 1. 2. 3. Cost of Capital helps the financial manager in deciding about the sources from which the funds are to be raised. Financial Leverage or Trading on Equity is another tool which helps the financial manager in increasing the return to equity shareholders. Capital Budgeting Appraisal Methods such as, pay-back period average rate of return, internal rate of return, net present value, profitability index, etc., help the financial manager in selecting the best among alternative capital investment proposals. 4. 5. 6. ABC analysis, Cash Management Models, Aging Schedule of Inventories, Debtors' Turn-over Ratio, etc., help the financial manager in effective management of current assets. Ratio analysis is another method for evaluating different aspects of the firm. Different ratios serve different purposes. Funds flow analysis and Cash flow analysis techniques help the financial manager is determining whether the funds have been procured from the best available source and they have been utilized in the best possible way.


Individual investors generally prefer possession of a given amount of cash now, rather than the same amount at some future time. This time preference for money may arise because of : (a) uncertainty of cash flows, (b) subjective preference for consumption, and

(c) availability of investment opportunities. The last reason is the most sensible justification for the time valueof money. Risk Premium Interest rate demanded, over and above the risk-free rate as compensation for time, to account for the uncertainty of cash flows. Interest Rate or Time Preference Rate Rate which gives money its value, and facilitates the comparison of cash flows occurring at different time periods. Required Interest Rate A risk-premium rate is added to the risk- free time preference rate to derive required interest rate from risky investments.


Return on a Security consists of two parts, the dividend and capital gain. Expected Rate of Return on a Security is the sum of the products of possible rates of return and their probabilities. The expected rate of return is an average rate of return. This average rate may deviate from the possible outcomes (rates of return). Dispersion When the expected rate of return (also called average rate of return) deviate from the possible outcomes (rates of return), this is referred to as dispersion. Variance and Standard Deviation Dispersion can be measured by variance and standard deviation of returns of a security. Variance ( s2) or standard deviation ( ) is a measure of the risk of returns on a security. Historically investors have earned different rates of returns. The average return on shares has been more than the average returns on government bonds and treasury bills. Also, the variance or standard deviation of returns on shares has been more. Shares are more risky than the government bonds. Treasury Bills Government issued bonds with guarantees which offers risk free rate, as they do not have risk of default. Risk Premium The difference between the (long-term) average share return and (long-term) return on government bonds or treasury bills is the risk premium. Risk Preferences of Investors : Investors have different risk preferences. Investors may be risk averse, risk seeker or risk neutral. Most of them are, however, risk averse. Normal Distribution is a smoothed, symmetric curve. It best describes the mean-variance (or standard deviation). We generally assume that returns on shares are normally distributed. Portfolios Generally, investors in practice hold multiple securities. Combinations of multiple securities are called portfolios.

Expected Return on a Portfolio is the sum of the returns on individual securities multiplied by their respective weights (proportionate investment). That is, it is a weighted average rate of return.


Discount Rate being the rate of return that investors expect from securities of comparable risk. Bonds or Debentures are debt instruments or securities. In case of a bond/debenture the stream of cash flows consists of annual interest payments and repayment of principal. These flows are fixed and known. The Value of the Bond can be found by capitalising cash flows at a rate of return, which reflects their risk. The market interest rate or yield is used as the discount rate in case of bonds (or debentures). Yield to Maturity A bonds yield to maturity or internal rate of return can be found by equating the present value of the bonds cash outflows with its price Zero-Interest Bonds (called zero-coupon bonds in USA) do not have explicit rate of interest. They are issued for a discounted price; their issue price is much less than the face value. Therefore, they are also called deep-discount bonds. The basic discounting principles apply in determining the value or yield of these bonds. Preference shares have a preference over ordinary shareholders with regard to dividends. The preference dividend is specified and known. Similarly, in the case of redeemable preference share the redemption or maturity value is also known. Preference share value can be determined in the same way as the bond value. Here the discount rate will be the rate expected by the preference shareholders given their risk. This risk is more than the risk of bondholders and less than the equity shareholders. Value of the Share (General) Cash flows of an ordinary (or equity) share consist of the stream of dividends and terminal price of the share. Unlike the case of a bond, cash flows of a share are not known. Thus, the risk of holding a share is higher than the risk of a bond. Consequently, equity capitalisation rate will be higher than that of a bond. OPTIONS Option is a contract that gives the holder a right, without any obligation, to buy or sell an underlying asset at a given exercise (or strike) price on or before a specified expiration period. The underlying asset (i.e., asset on which right is written) could be a share or any other asset. Call Option is a right to buy an asset. A buyer of a call option on a share will exercise his right when the actual share price at expiration (St) is higher than the exercise price (E), otherwise, he will forgo his right. Put Option is a right to sell an asset. The buyer of a put option will exercise his right if the exercise price is higher than the share price; he will not exercise his option if the share price is equal to or greater than the exercise price. American Option can be exercised at expiration or any time before expiration while European options can be exercised only at expiration.

In/Out/At the Money Call option Exercise if St > E Do not exercise if St < E Do not exercise if St = E in-the-money out-of-the-money at-the-money Put option Exercise if E > St Do not exercise if E < St Do not exercise if St = E

Value of a Share Option There are five factors that affect the value of a share option: (1) the share price, (2) the exercise price, (3) the volatility (standard deviation) of the share return, (4) the risk-free rate of interest, and (5) the options time to expiration. Value of a Call At expiration the maximum value of a call option is: Value of call option at expiration = Max [(St E), 0] Call Options Value will increase with increase in the share price, the rate of interest, volatility and time to expiration. It will decline with increase in the exercise price. Value of Put Option at expiration is: Value of put option at expiration = Max [(E St), 0] price, and the rate of interest. Put Options Value will

increase with increase in the exercise price, volatility and time to expiration. It will decrease with increase in the share



Capital Budgeting: Principles and techniques, Nature of capital budgeting, Identifying relevant cash flows, Evaluation Techniques, Payback, Accounting rate of return, Net Present Value, Internal Rate of Return, Profitability Index, Comparison of DCF techniques, Project selection under capital rationing, Inflation and capital budgeting. CAPITAL BUDGETING DECISIONS The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be defined as the firms decision to invest its current funds most efficiently in long term assets in anticipation of an expected flow of benefits over a series of years. The following are the features of investment decisions: a. b. c. the exchange of current funds for futue benefits The funds are invested in long-term assets The future benefits will occur to the firm over a series of years.

Importance of Investment Decisions : a. b. c. d. e. They influence the firms growth in the long run They affect the risk of the firm They involve commitment of large amount of funds They are irreversible, or reversible at substantial loss Hey are among the most difficult to decisions to make

Types of investment decisions : There are many ways to classify investments. One classification is as follows : a. b. c. Expansion of existing business Expansion of new business Replacement and modernization

The firms investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firms expenditures and benefits, and therefore, they should also be evaluated as investment decisions.

Yet another useful way to classify investments is as follows: a. Mutually exclusive investments


b. c.

Independent investments Contingent investments

Mutually exclusive investments: Mutually exclusive investments serve the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded. A company, may, for example, either use a more labour-intensive, semi-automatic machinery or employ amore capital intensive, highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance of the highly automatic machine. Independent investments: Independent investments serve different purposes and do not compete with each other. For example, a heavy engineering company may consider expansion of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture a new product light commercial vehicles. Depending on the profitability and available of funds, the company can undertake both investments. Important Aspects of Capital Budgeting Process are : Identification of investment ideas is the most critical aspect of the investment process, and should be guided by the overall strategic considerations of a firm. It needs appropriate managerial focus. Each potential idea should be developed into a project. Development A company should have systems for estimating cash flows of projects. A multi-disciplinary team of managers should be assigned the task of developing cash flow estimates. Evaluation Once cash flows have been estimated, projects should be evaluated to determine their profitability. Evaluation criteria chosen should correctly rank the projects. Authorisation Once the projects have been selected they should be monitored and controlled to ensure that they are properly implemented and estimates are realised. Proper authority should exist for capital spending. The top management may supervise critical projects involving large sums of money. The capital spending authority may be delegated subject to adequate control and accountability. Control A company should have a sound capital budgeting and reporting system for this purpose. Based on the comparison of actual and expected performance, projects should be reappraised and remedial action should be taken. Companies are increasingly using DCF techniques, but payback remains universally popular for its simplicity and focus on recovery of funds and liquidity. In practice, judgement and qualitative factors also play an important role in investment analysis. A number of companies pay more attention to strategy in the overall selection of projects. Strategic Investments Decisions are large-scale expansion or diversification projects, and they involve either by their nature or by managerial actions valuable options. Such options include right to expand, right to abandon, right to delay, right to build new businesses, or right to disinvest or harvest.


Real Options create managerial flexibility and commitment. In principle, they can be valued in the same way as financial options are valued. But in practice, it is difficult to get all input parameters for valuing real options. Since large numbers of real assets are not traded in the market, it is quite difficult therefore to get information on the value of the underlying assets and the volatility. Since real options are valuable, managers must identify them, value them, monitor them and exercise them when it is optimal to do so. Managers generally strive to create flexibility and commitment by building real options into investment projects. INVESMENT EVLAUATION CRITERIA Three steps are involved in the evaluation of an investment : a. b. c. Estimation of cash flows Estimation of required rate of return (the opportunity cost of capital) Application of a decision rule for making the choice.

Investment Decision Rule It should maximise the shareholders wealth. It should consider all cash flows to determine the true profitability of the project. It should provide for an objective and unambiguous way of separating good projects from bad projects. It should help ranking of projects according to their true profitability. It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. It should help to choose among mutually exclusive projects that project which maximises the shareholders wealth. It should be a criterion which is applicable to any conceivable investment project independent of others.

Evaluation Criteria: A number of investment criteria (or capital budgeting techniques) are in use in practice. They may be grouped in the following two categories : a. Non-discounted Cash Flow Techniques / Traditional Methods i. ii. iii. b. Payback period (PB) Discounted Payback period Accounting Rate of return (ARR)

Discounted Cash Flow Technique i. ii. Net Prsent value (NPV) Internal Rate of return (IRR)



Profitability index (PI)

NET PRESENT VALUE METHOD The net present value method is the classic economic method of evaluating the investment proposals. It is a DCF technique that explicitly recognizes the time value of money. It correctly postulates that cash flows arising at different time periods differ and are comparable only when their equivalents present values are found out. NPV is the difference between PV of cash flows and the PV of cash outflows is equal to NPV; the firms opportunity cost of capital being the discount rate. Important points to be noted with respect to NPV Cash flows of the investment project should be forecasted based on realistic assumptions. Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the projects opportunity cost of capital. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. The project should be accepted if NPV is positive (i.e., NPV > 0). Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The formula for the net present value can be written as follows: Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The formula for the net present value can be written as follows :

C C3 C2 Cx 1 co NPV = + + + ..... + 2 3 n ( 1+ k) ( 1+ k) (1+ k ) (1 + k ) n et NPV = co 2 t =1 ( 1 + k )

Internal Rate of Return (IRR) is that discount rate at which the projects net present value is zero. Under the IRR rule, the project will be accepted when its internal rate of return is higher than the opportunity cost of capital (IRR > k). IRR methods account for the time value of money and are generally consistent with the wealth maximization objective. NPV and IRR NPV and IRR give same accept-reject results in case of conventional independent projects. Under a number of situations, the IRR rule can give a misleading signal for mutually exclusive projects. The IRR rule also yields multiple rates of return for non-conventional projects and fails to work under varying cost of capital conditions. Since the IRR violates the value additivity principle; since it may fail to maximise wealth under certain conditions; and since it is cumbersome, the use of the NPV rule is recommended.


Profitability index (PI) is the ratio of the present value of cash inflows to initial cash outlay. It is a variation of the NPV rule. PI specifies that the project should be accepted when it has a profitability index greater than one (PI > 1.0) since this implies a positive NPV. NPV and PI A conflict of ranking can arise between the NPV and PI rules in case of mutually exclusive projects. Under such a situation, the NPV rule should be preferred since it is consistent with the wealth maximisation principle. Payback is the number of years required to recoup the initial cash outlay of an investment project. The project would be accepted if its payback is less than the standard payback. The greatest limitations of this method are that it does not consider the time value of money, and does not consider cash flows after the payback period. Discounted Payback considers the time value of money, but like the simple payback it also ignores cash flows after the payback period. Under the conditions of constant cash flows and a long life of the project, the reciprocal of payback can be a good approximation of the projects rate of return. Accounting Rate of Return is found out by dividing the average profit after-tax by the average amount of investment. A project is accepted if its ARR is greater than a cut off rate (arbitrarily selected). This method is based on accounting flows rather than cash flows; therefore, it does not account for the time value of money. Like PB, it is also not consistent with the objective of the shareholders wealth maximisation. Following provides a summary of the features of various investment criteria. I. Discounted Cash Flow Methods 1. Net present value (NPV): The difference between PV of cash flows and PV of cash outflows is equal to NPV; the firms opportunity cost of capital being the discount rate.

C C3 C2 Cx 1 co NPV = + + + ..... + 2 3 n ( 1+ k) ( 1+ k) (1+ k ) (1 + k ) n et NPV = co 2 t =1 ( 1 + k )

Acceptance rule :

Accept if NPV > 0 (i.e., NPV is positive) Reject if NPV < 0 (i.e., NPV is negative) Project may be accepted if NPV = 0

Merits : Considers all cash flows. True measure of profitability. Based on the concept of the time . .

Satisfies the value-additivity principle (i.e., NPVs of two or more projects can be added).


Consistent with the share-holders wealth maximization (SWM) principle.

Demerits : Requires estimates of cash flows which is a tedious task Requires computation of the opportunity cost of capital which poses practical difficulties. Sensitive to discount rates. value of money

2. Internal rate of return (IRR): The discount rate which equates the present value of an investments cash inflows and outflows is its internal rate of return.

C C3 C2 Cn 1 + = co + + ............ + n (1+ r ) (1+ r) 2 (1+ r ) 3 (1 + r ) n Ct NPV = co t t =1 ( 1 + r )

Acceptance rule :


Accept if IRR > k Reject if IRR < k Project may be accepted if IRR = k

Considers all cash flows.. True measure of profitability. Based on the concept of the time Generally, consistent with wealth

Demerits Requires estimates of cash flows which is a tedious task Does not hold the value-additivity principle (i.e., IRRs of two or more projects do not add) At times fails to indicate correct choice between value of money. mutually exclusive projects. At times yields multiple rates.maximisation principle. Relatively difficult to compute.

3. Profitability index (PI): The ratio of the present value of the cash flows to the initial outlay is profitability index or benefit-cost ratio:


PI =

PV of Annual cash flows Initial Investment ct

PI =
Acceptance rule : Merits Considers all cash flows. Recognises the time value of Relative measure of profitability. Accept if PI > 1.0 Reject if PI < 1.0 Project may be accepted if PI = 1.0

t =1

( 1 + h)

Generally consistent with the wealth maximisation principle.

Demerits Requires estimates of the cash flows which is a tedious task. At times fails to indicate correct choice between money. Mutually exclusive projects.

II. Non-Discounted Cash Flow Criteria 4. Payback (PB): The number of years required to recover the initial outlay of the investment is called payback.

PB =
Acceptance rule Merits Demerits Easy to understand and compute Emphasises liquidity. Easy and crude way to cope with risk. . Uses cash flows information. Accept if PB < standard payback Reject if PB > standard payback

Initial Investment Co = Annual cash flow C

Ignores the time value of money. and inexpensive to use Ignores cash flows occurring after the payback period. Not a measure of profitability No objective way to determine the standard payback.


No relation with the wealth maximization principle The number of years required in recovering the cash outlay on the present value basis is the

5. Discount payback: payback method.

discounted payable period. Except using discounted cash flows in calculating payback, this method has all the demerits of

6. Accounting rate of return (ARR): An average rate of return found by dividing the average net operating profit [EBIT (1 T )] by the average investment Acceptance rule : Merits Uses accounting data with which Easy to understand and calculate. Gives more weightage to future Accept if ARR > minimum rate Reject if ARR < minimum rate

Demerits Ignores the time value of money executives are familiar Does not use cash flows. No objective way to determine the receipts. minimum acceptable rate of return.

Net present value (NPV) method is the most superior investment criterion as it is always consistent with the wealth maximisation principle. CONCEPTS RELATED TO CAPITAL BUDGETING Profits vs. Cash Flows Cash flows are different from profits. Profit is not necessarily a cash flow; it is the difference between revenue earned and expenses incurred rather than cash received and cash paid. Also, in the calculation of profits, an arbitrary distinction between revenue expenditure and capital expenditure is made. Incremental Cash Flows Cash flows should be estimated on incremental basis. Incremental cash flows are found out by comparing alternative investment projects. The comparison may simply be between cash flows with and without the investment proposal under consideration when real alternatives do not exist. The term incremental cash flows should be interpreted carefully. The concept should be extended to include the opportunity cost of the existing facilities used by the proposal. Sunk costs and allocated overheads are irrelevant in computing cash flows. Similarly, a new project may cannibalise sales of the existing products. The projects cash flows should be adjusted for the reduction in cash flows on account of the cannibalisation.


Components of Cash Flows Three components of cash flows can be identified: (1) initial investment, (2) annual cash flows, and (3) terminal cash flows. Initial Investment Initial investment will comprise the original cost (including freight and installation charges) of the project, plus any increase in working capital. In the case of replacement decision, the after-tax salvage value of the old asset should also be adjusted to compute the initial investment. Net Cash Flow Annual net cash flow is the difference between cash inflows and cash outflows including taxes. Tax computations are based on accounting profits. Care should be taken in properly adjusting depreciation while computing net cash flows. Change in Net Cash Flow from Operations Depreciation is a non-cash item, but it affects cash flows through tax shield. Free Cash Flows In practice, changes in working capital itemsdebtors (receivable), creditors (payable) and stock (inventory)affect cash flows. Also, the firm may be required to incur capital expenditure during the operation of the investment project. Therefore, the following formula should be used to compute the investments net cash flows or free cash flows: Terminal Cash Flows are those, which occur in the projects last year in addition to annual cash flows. They would consist of the after-tax salvage value of the project and working capital released (if any). In case of replacement decision, the foregone salvage value of old asset should also be taken into account. Terminal Value of a New Product may depend on the cash flows, which could be generated much beyond the assumed analysis or horizon period. The firm may make a reasonable assumption regarding the cash flow growth rate after the horizon period. Inflation and NPV The NPV rule gives correct answer to choose an investment under inflation if it is treated consistently in cash flows and discount rate. The discount rate is a market-determined rate and therefore, includes the expected inflation rate. It is thus generally stated in nominal terms. The cash flows should also be stated in nominal terms to obtain an unbiased NPV. Alternatively, the real cash flows can be discounted at the real discount rate to calculate unbiased NPV. The following equation gives the relationship between nominal and real cost of capital: Nominal discount rate = (1+real discount rate) (1+inflation rate) -1

Real Discount rate=

1+Nominall discount rate 1 1+inflow rate


CAPITAL RATIONING : Capital Rationing occurs because of either the external or internal constrain on the supply of funds. In capital rationing situations, the firm cannot accept all profitable projects. Therefore, the firm will aim at maximising NPV subject to the funds constraint. In simple one-period capital rationing situations, the profitability index (PI) rule can be used. PI rule breaks in the case of multi-period funds constraints and project indivisibility.


Cost of Capital to a firm is the minimum return, which the suppliers of capital require. In other words, it is a price of obtaining capital; it is a compensation for time and risk. decision-making. It is used: The cost of capital concept is of vital significance in the financial

(a) as a discount, or cut-off, rate for evaluating investment projects, (b) for designing the firms debt-equity mix and (c) for appraising the top managements financial performance. Firms obtain capital for financing investments in the form of equity or debt or both. Also, in practice, they maintain a Cost of

target debt-equity mix. Therefore, the firms cost of capital means the weighted average cost of debt and equity. capital; it is a compensation for time and risk. Definition

Capital to a firm is the minimum return, which the suppliers of capital require. In other words, it is a price of obtaining

Cost of capital is defined as the minimum rate of return which a company has to earn on the total capital employed in order to increase or maintain the market price of its shares. Cost of Debt includes all interest-bearing borrowings. Its cost is the yield (return), which lenders expect from their investment. In most cases, return is equal to annual contractual rate of interest (also called coupon rate). Interest charges are tax deductible. Therefore, cost of debt to the firm should be calculated after adjusting for interest tax exemption.: kd (after tax) = I ( 1- t) where kd I s before-tax cost of debt and t is the corporate tax rate. Definitions : Cost of debt is defined as the rate at which the company pays interest to its long term creditors with a further adjustment for the tax liability of the company. Cost of debt is defined as that discount rate which equates the present value of the future promised interest and principal repayment with the net proceeds of the issue. Formulae : In case of long term loans : kd (after tax) = I I 1-t)

In case of irredeemable debentures / bonds : a. when issued at par : kd (afer tax) when issued at premium or discount : kd (afer tax) = I NP (1 - t) = I (1 - t)


In case of redeemable debentures / bonds : I ( 1-t ) + F - NP n kd (after tax) = F + NP 2 In case the floatation costs (the difference between face value and net proceeds is to be amortized evenly over the life of debentures / bonds : I ( 1-t ) + F - NP (1 t) n kd (after tax) = F + NP 2 Cost of Preference : It is the rate at which the company declares preference dividend for its shareholders. Definition : It is defined as that discount rate which equates the present value of the future promised dividend and

principal repayment with the net proceeds of the issue. Formulae : In case of irredeemable preference shares :

a. when issued at par : kp (afer tax) b. = Dp F when issued at premium or discount : = Dp NP In case of redeemable preference shares : Dp + kd (after tax) = 2 Cost of Equity Equity has no explicit cost, as payment of dividends is not obligatory. However, it involves an opportunity cost. which the company must pay to attract capital from shareholders. gain: The F - NP n F + NP kd (afer tax)

opportunity cost of equity is the rate of return required by shareholders on securities of comparable risk. Thus, it is a price, In practice, shareholders expect to receive dividends and capital gains. Therefore, the cost of equity can be thought to include expected dividend yield and percentage capital


Definition :

Cost of equity capital is defined as the minimum rate of return which a company has to earn on the equity

capital employed in order to increase or maintain the market price of its shares. The company can expect to increase the MPS for its shares or at least maintain a constant MPS only when the expectations of the equity shareholders are satisfied. Hence cost of equity is always equated with the expectations of the equity shareholders. Approaches for calculation of cost of equity capital : Different approaches have been given for the calculation of cost of equity. They are as follows : a. Dividend Capitalization Approach : ke = D1 Po where D1 is the expected dividend per share and P0 is the market price today. b. Dividend Capitalization plus growth Approach : ke = D1 + Po where D1 is the expected dividend per share, P0 is the market price today and g is the expected dividend growth (capital gain). c. Capital Asset Pricing Model CAPM : ke = rf + b j ( rm - rf ) where rf is the risk-free rate equal to current yield on the Treasury bills or government bonds; (rm rf) is the market g

risk premium measured as average of historical returns of a long series; and bj is the beta of the firm j. Cost of Retained Earnings : of equity. In case of retained earnings the company will not have to incur floatation costs and underwriting costs. kr = D1 Po Weighted Average Cost of Capital Three steps are involved in calculating the firms weighted average cost of capital (WACC). First, the component costs of debt and equity are calculated. Second, weights to the each component of capital are assigned according to the target capital structure. Third, the product of component costs and weights is summed up to determine WACC. The weighted average cost of new capital is the weighted marginal cost of capital (WMCC). + g When a company issues new share capital, it has to offer shares at a price, which is

much less than the prevailing market price. Therefore, the cost of retained earnings will be less than the cost of new issue


Divisional or Projects Cost of Capital A firm may have several divisions or product lines with different risks. Therefore, the firms WACC cannot be used to evaluate divisions or projects. The following procedure can be used to estimate the divisional or the projects cost of capital: Identify comparable or pure-play firms and determine their equity beta based on the market data Find the average equity beta, and unlever it as follows: Determine the divisions target capital structure, and relever the beta This is division or projects levered or equity beta. Use CAPM to calculate the cost of equity. Calculate the after-tax cost of debt for the division or project. Use the target capital structure to calculate the division or projects WACC.



FINANCIAL AND OPERATING LEVERAGE Capital Structure The debt-equity mix of a firm is called its capital structure. The capital structure decision is a significant financial decision since it affects the shareholders return and risk, and consequently, the market value of shares. Financial Structure The term financial structure, on the other hand, is used in a broader sense, and it includes equity and all liabilities of the firm. Financial Leverage or Trading on Equity The use of the fixed-charges capital like debt with equity capital in the capital structure is described as financial leverage or trading on equity. The main reason for using financial leverage is to increase the shareholders return. Consider an example. Suppose you have an opportunity of earning 20 per cent on an investment of Rs 100 for one year. If you invest your own money, your return will be 20 per cent. On the other hand, you can borrow, say, Rs 50 at 10 per cent rate of interest from your friend and put your own money worth Rs 50. You shall get total earnings of Rs 20, out of which you will have to pay Rs 5 as interest to your friend. You shall be left with Rs 15 on your investment of Rs 50,which gives you a return of 30 per cent. You have earned more at the cost of your friend. Financial leverage, on the one hand, increases shareholders return and on the other, it also increases their risk. For a given level of EBIT, EPS varies more with more debt. Consider a simple example. Let us assume that a firms expected EBIT is Rs 120 with a standard deviation of Rs 63. This implies that earnings could vary between Rs 57 to Rs 183 on an average. Suppose that the firm has some debt on which it pays Rs 40 as interest. Now the shareholders expected earnings will be: Rs 120 Rs 40 = Rs 80 (ignoring taxes) and standard deviation will remain unchanged. Shareholders earnings will, on an average, fluctuate within a range of Rs 17 and Rs 143. If EBIT is less than Rs 40, the earnings of shareholders will be negative. In the extreme situation if the firm is unable to pay interest and principal, its solvency is threatened. In the insolvency, shareholders are the worst sufferers. Thus, we find that financial leverage is a double-edged sword. It increases return as well as risk. A trade-off of between return and risk will have to be struck to determine the appropriate amount of debt. Earnings Per Share (EPS) A firm determines the advantage of financial leverage by calculating its impact on earnings per share (EPS) or return on equity (ROE). For a 100 per cent equity-financed company, EPS is calculated as follows: EPS =


and for a company which employs both debt and equity EPS is given by the following formula:


( EBIT Int) ( 1 T)

where EBIT is earnings before interest and taxes, INT is interest charge which is given by the product of interest rate (i) and the amount of debt (D), T is corporate tax rate and N is number of shares. If the firms overall profitability is more than interest rate, EPS increases with debt. With increasing EBIT, EPSincreases faster with more debt.


Degree of Financial Leverage (DFL) The percentage change in EPS occurring due to a given percentage change in EBIT is referred to as the degree of financial leverage Degree of Operating Leverage (DOL) EBIT depends on sales. A change in sales will affect EBIT. The variability in EBIT due to a change in sales is affected by the composition of fixed and variable costs. You may recall that the percentage change in EBIT occurring due to a given percentage change in sales is referred to as the degree of operating leverage (DOL):


% change in EBIT EBIT / EBIT = % change in sales Sales / Sales

For alter due formula world be:

Degree of Combined Leverage (DCL) DOL and DFL can be combined to see the effect of total leverage on EPS.

CAPITAL STRUCTURE Meaning of Capital structure

Contribution Fixed cost = 1+ EBIT EBIT

Capital structure refers to the 'the make up of a firm's capitalization. In other words, it represents the mix of different sources of long term funds (such as equity shares, preference shares, long term loans, retained earning etc.) in the total capitalisation of the company. Capital structure and financial structure The term capital structure differs from financial structure. Financial structure refers to the way the firm's assets are financed. In other words it includes both, long term as well as short term sources of funds Capital structure is the permanents financing of the company represented primarily by long term debt and share holders funds but excluding all short term credit. Thus a company's capital structure is only a part of its financial structure. Patterns of capital structure In case of new company the capital structure may be of any of the following four patterns : (i) (ii) (iii) (iv) Capital structure with equity shares only. Capital structure with both equity and preference shares. Capital structure with equity shares and debentures. Capital structure with equity shares, preference shares and debentures.

The choice of an appropriate capital structure depends on a number of factors such as the nature of the company's business, regularity of earnings, conditions of the money market attitude of the investor, etc. We will like to emphasize only one point here. It is regarding the basic difference between debt and equity. Debt is a liability on which interest has to be paid irrespective of the company's profits. While equality consists of shareholders or owners funds on which payment of


dividend depends upon the company's profits. A high proportion of the debt content in the capital structure increases the risk and may lead to financial insolvency of the company in adverse time. However, raising funds through debt is cheaper as compared to raising funds through shares. Factors affecting capital structure : Forms of assets held by a company i.e., investment in current assets and fixed assets. Available growth opportunities Debt and non-debt tax shields Financial flexibility and operating strategy Loan covenants i.e. restrictions included in long term loan agreements, which curtail firms freedom in deciding on the capital structure. Financial slack which includes unused debt capacity, excess liquid assets, unutilized lines of credit and access to various untapped sources of funds. Early repayments - i.e. flexibility will be introduced if the company has the discretion of early repayment of its debts. Limits of financial flexibility Degree of control required in managing the affairs of the business. POINT OF INDIFFERENCE (FINANCIAL BREAK EVEN POINT) It refers to that EBIT level at which EPS remains the same irrespective of the debt equity mix. In other words, at this point rate of return on capital employed is equal to the rate of interest on debt. This is also known as break even level of EBIT for alternative financial plans. (X-I1) (1-T) PD ---------------------- = S1 Where X = Point of Indifference or Break even EBIT level. I1 = Interest under alternative 1. I2 = interest under alternative 2. T PD= = Tax Rate Preference Dividend. capital) under alternative 1. S2 = Number of equity shares (or amount of equity share capital) under alternative 2. The level of operating profit (EBIT) beyond which the debt alternative is beneficaial because of its favourable effect on earning per share (EPS) or uncommitted earnings per share (UEPS). In other words, it is profitable to raise debt for strengthening EPS or UEPS if there is likelihood that future operating profits are going to be higher than level of EBIT as determined. (X-12) ( 1 T) PD ---------------------------S2

S1 = Number of equity shares (or amount of equity share


Optimum capital Structure. A firm should try to maintain an optimum capital structure with a view to maintain financial stability. The optimum capital structure is obtained when the market value per equity share is the maximum. In case a company borrows and this borrowing helps in increasing the value of the company's shares in the stock exchange, it can be said that the borrowing has helped the company in moving towards its optimum capital structure. In case, the borrowing results in fall in market value of the company's equity shares, it can be said that the fall in market value of the company's equity shares, it can be said that the borrowing has moved the company away from its optimum capital structure. The objective of the term should therefore be to select a financing or debt equity mix which will lead to maximum value of the firm. Optimum leverage can be defined as that mix of bed and equity which will maximise the market value of a company.


Capital Structure Decision of the firm can be characterised as a choice of that combination of debt and equity, which maximises the market value of the firm. Capital Structure Theories : General Assumptions : a. There are only two sources of funds used by a firm : i. ii. b. c. Perpetual riskless debt , Ordinary shares

The are no corporate taxes. This assumption is removed later. The firms total financing remains constant. The firm can change its degree of leverage (capital structure )either by selling share and use the proceeds to retire debentures or by raising more debt ad reduce the equity capital.

NET INCOME APPROACH According to the Net Income Approach suggested by Durand, the capital structure decision is relevant to the valuation of the firm. In other words a change in the capita structure / financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. If, therefore, the degree of financial leverage as measured by the ratio of debt to equity is increased, the weighted average cost of capital will decline, while the value of the firm as well the market price of ordinary shares will increase. Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a decline both in the value of the firm as well as the market price of equity shares. The NI approach to valuation is based on three assumptions : a. b. c. There are no taxes Cost of debt is less than cost of equity Use of debt does not change risk-perception of investors.

The implications of the three assumptions underlying the NI approach is that as the degree of leverage increases, the proportion of an inexpensive source of funds, i.e., debt in the capital structure increases.


As a result the weighted average cost of capital tends to decline, leading to an increase in the total value of the firm. Thus with the cost of debt and cost of equity being constant, the increased se of debt (increase in leverage) will magnify the shareholders earnings and thereby, the market value of the ordinary shares. The financial leverage is, according to NI approach, an important variable in the capital structure decision of a firm. With a judicious mixture of debt ad equity, a firm can evolve an optimum capital structure which will be the one at which value of firm is the highest and the overall cost of capital the lowest. At that structure the market price per share will be maximum. If the firm uses no debt or if the financial leverage is zero, the overall cost of capital will be equal to the cost of equity. The weighted average cost of capital will decline an will approach the cost of debt as he degree of leverage reaches one.

ke ko kd

Degree of financial leverage ( B/ V) NET OPERATING INCOME (NOI) APPRAOCH : Another theory of capital structure, suggested by Durand, is the net operating income (NOI) approach. This approach is opposite to the net income approach. The essence of this appraoh is that the leverage / capital structure decision of the firm is irrelevant. Any change in leverage will not lead to any change in the total value of the firm and the market price of shares, as the overall cost of capital is independent of the degree of financial leverage. The NOI approach is based on the following assumptions : Overall cost of capital / Capitalisation Rate (ko) is constant : NOI approach to valuation argues that the overall capitalization rate of the firm remains constant for all degrees of leverage. The value of the firm, given the level of EBIT, is determined as follows : V = EBIT ko In other words, the market evaluates the firm as a whole. The split of the capitalization between debt and equity is, therefore, not significant.


Residual Value of Equity : The value of equity is a residual value which is determined by deducting the total value of debt (B) from the total value of the firm (V). Symbolically, The total market value of equity capital (S) = V - B Changes in cost of Equity Capital : The cost of equity (ke) increases with the degree of leverage. The increase in the proportion of debt in the capital structure relatively to equity shares would lead to an increase in he financial risk to the ordinary shareholders. To compensate for the increased ris, the shareholders would expect a higher rate of return on their investments. The increase in the equity capitalization rate would match the debt-equity ratio. The ke would be ko + (ko - kd) B / S Cost of Debt : The cost of debt (kd) has two parts :


Explicit part, represented by the rate of interest. Irrespective of the degree of leverage, the firm is assumed to be able to borrow at a given rate of interest. This implies that the increasing proportion of debt in the financial structure does not affect the risk perception of the lenders and they do not penalize the company by charging higher rates of interest.


Implicit part, or hidden cost. Increase in the degree of financial risk or the proportion of debt to equty in the capital structure increases the cost of equity capital. This increase in ke, being attributed to he increase in debt, is the implicit part of kd.

Thus, the advantage associated with the use of debt, supposed to be a cheaper source of funds in terms of the explicit cost, is exactly neutralized by the implicit cost represented by increase in ke. As a result the real cost of debt and the real cost of equity, according to the NOI approach, are the same and equal ko. Optimum Capital Structure : The total value of the firm is unaffected by its capital structure. No matter what the degree of financial leverage is, the total value of the firm will remain constant. The market price of shares will also not change with the change in the debt-equity ratio. There is nothing such as an optimum capital structure. approach. ke Cost of capital ko kd Any capital structure is optimum, according to the NOI


Degree of financial leverage ( B/ V) MODIGLIANI-MILLER (MM) APPROACH : The Modigliani-Miller thesis relating to the relationship between the capital structure, cost of capital and valuation is similar to the net operating income (NOI) approach. The NOI approach, as explained above lacks operational justification. The NOI approach, in other words does not provide operational justification for the irrelevance of the capital structure. Basic propositions : Thee are three basic propositions of the MM approach, namely, a. b. c. ko and value of the firm are independent of the capital structure. degrees of leverage. ke increases in a manner to offset exactly the use of a less expensive source of funds represented by debt i.e., as DFL increases, ke increases and vice versa. The cut off rate for investment purposes is completely independent of the way in which an investment is financed. ko and value of the firm are constant for all

Degree of financial leverage ( B/ V) Assumptions : The assumption that the weighted average cost of capital is constant irrespective of the type of capital structure is based on te following : 1. Perfect capital markets : The implications of a perfect capital market is that : 2. 3. 4. Securities are infinitely divisible Investors are free to buy / sell securities Investors can borrow without restrictions on the same terms and conditions as firms can There are no transactions costs Information is perfect i.e., each investor has the same information which is readily available to him without cost Investors are rational and behave accordingly All investors expect the company to make the same level of EBIT. Dividend payout ratio is 100% There are not taxes


MM on the other hand provides operational justification for the irrelevance of the capital structure decision with respect to the value of the firm which is called the arbitrage process. the market price of a security in different markets. MM illustrate the arbitrage process with reference to valuation in terms of two firms which are exactly similar in all respects except leverage such that one has debt in its capital structure while the other does not. TOTAL VALUE OF THE FIRM L AND U Firms L EBIT Rs. 1,00,000 LESS : Interest 50,000 Earnings available for equity holders 50,000 Equity capitalization ate (ke) 0.16 Total market value of equity (S) 3,12,500 Total market value of debt (B) 5,00,000 Total market value of firm (V) 8,12,500 The term arbitrage refers to an act of buying an asset / security in one market (at lower prices) and selling it in another (at a higher price). As a result, equilibrium is restored in

U Rs. 1,00,000 1,00,000 0.125 8,00,000 8,00,000

The total market value of a firm which employs debt in its capital structure (L) is more than that of the unlevered firm (U). According to the MM hypothesis, this situation cannot continue as the arbitrage process, based on the substitutability of personal leverage for corporate leverage, will operate and the values of the two firms will be brought to an identifiable level. ARBITRAGE PROCESS : The application of the arbitrage process is explained as follows : Suppose an investor, Mr. X holds 10% of the outstanding shares of the levered firm (L). His holdings amount to Rs. 31,250 (i.e. 10% of Rs. 3,12,500) and his share in the earnings that belong to the equity shareholders would be Rs. 5,000 or 10% of Rs. 50,000. He will sell his holdings in firm L and invest in the unlevered firm (U). Since the firm U has n debt in its capital structure,

the financial risk to Mr. X would be less than in firm L. To reach the level of financial risk of firm L, he will borrow additional funds equal to his proportionate share in the levered firms debt on his personal account. That is, he will substitute personal leverage (or home made leverage) for corporate leverage. capital structure e of the unlevered firm by borrowing on his personal account. Mr. X in our example will borrow Rs. 50,000 at 10% rate of interest. His proportionate holding (10%) in the unlevered firm will amount to Rs. 80,-000 on which he will receive dividend income of Rs. 10,000. Out of the income of R)s. 10,000 from the unlevered firm (U0 Mr. X will pay Rs. 5,000 as interest on his personal borrowings. He will be left with Rs. 5,000 i.e., same amount nt as he was getting from the levered firm (L). But, his investment outlay in U firm is less (Rs. 30,000) as compared with that in the L firm (Rs. 31,250). At the same time his risk is identifiable in both the situations. Thus it is clear, that Mr. x will be better off by selling his securities in the levered firm and buying the shares of the unlevered firm. With identical risk characteristic of the two firms he gets the same income with lower investment outlay in the unlevered firm. He would obviously prefer switching from the levered to the unlevered firm. Another way of saying it is that instead of the firm using debt, Mr. X will borrow money. The effect, in essence, of this is that he is able to introduce leverage in the


Traditional Appraoch : The crux of the traditional view relating to leverage and valuation is that though judicious use of debt-equity propositions, a firm can increase its total value and thereby reduce its overall cost of capital. The rationale behind this view is that debt is a relatively cheaper source of funds as compared to ordinary shares. Wit a change in the leverage, i.e, using more debt in the place of equity, a relatively cheaper source of funds replaces a source of funds which involves a relatively higher cost. This obviously causes a decline in the overall cost of capital. If the debt-equity is raised further, the firm would become financially more risky o the investor who would penalize the firm by demanding a higher rate of dividend. But the increase in ke may not be so high as to neutralize the benefit of suing cheaper debt. In order worlds, the advantages arising out of the use of debt is so large, that even after allowing for a higher ke, the benefits of the use of cheaper source of funds are still available. If, however, the amount of debt is increased further, two things are likely to happen : a. Owing to increased financial risk, ke will record a substantial rise and b. The firm would become very risky to the creditors who would like to be compensated by higher return such that kd will rise. Thus the use of debt beyond a point will there fore, has the effect of raising the ko and reducing the value of the firm. is an optimal capital structure. Thus up to a point use of debt will favourably affect the value of a firm. Beyond that point, use of debt will adversely affect it. At that level of debt-equity ratio, the capital structure


DIVIDEND POLICY, ASPECTS OF DIVIDEND POLICY, PRACTICAL CONSIDERATION, FORMS OF DIVIDEND POLICY, PRACTICAL CONSIDERATIONS, FORMS OF DIVIDENDS, SHARE SPLITS Dividends refer to the portion of a firms net earnings which are paid out to the share holders dividends are distributed out of the profits the alternative to the payment of dividends is the retention of the earnings DIVIDEND POLICY There are conflicting opinions regarding the impact of dividends on the valuation of the firm. According to one school of thought, dividends are irrelevant so that the amount od dividends paid has no effect on the valuation of a firm. On the other hand, certain theories consider the dividend decision as relevant to the value of the firm measured in terms in the market price of the shares. Relevance of Dividends : Some Theories : There are some theories that consider dividend decision to be an active variable in determining the value of a firm. The dividend decision is, therefore, relevant. The two theories representing this notion are : a. b. Walters Model and Gordons Model

Walters Model : Walters model supports the doctrine that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are, according to Walter, interlinked. affects the value of an enterprise. The key argument in support of the relevance proposition of Walters model is the relationship between the return on a firms investment or its internal rate of return (r ) and the cost of capital or the required rate of return (k). The firm would have an optimum divided policy which will be determined by the relationship of r and k. in other words, if the return on investments exceeds the cost of capital, the firm should retain the earnings, whereas it should distribute the earnings to the shareholders in case the required rate of return exceeds the expected return on the firms investments. The rationale is that if r > k, the firm is able to earn more than what the shareholders could be re-investing, if the earnings are paid out to them. The implication of r < k that the shareholders can earn a higher return by investing elsewhere. Walters model, thus, relates the distribution of dividends (retention of earnings) to available investment opportunities. If a firm has adequate profitable investment opportunities, it will be able to earn more than what the investors expect so that r > k. such firms may be called growth firms. For growth firms, the optimum dividend policy would be given by a D/P ratio of zero. That is to say, the firm should plough back the entire earnings within the firm. The market value of the shares will be maximized as a result. In contrast, if a firm does not have profitable investment opportunities (when r < k), the shareholders will be better off if earnings are paid out to them so as to enable them to earn a higher return by using the funds elsewhere. In such a case, the market price of shares will be maximized by the distribution of the entire earnings as dividends. A D/P ratio of 100 would give an optimum dividend policy. The choice of an appropriate dividend policy


Finally when r = ke, (normal firms), it is a matter of indifference whether earnings are retained or distributed. This so because for all D/P ratios (ranging between zero and 100) the market price of shares will remain constant. For such firms, there is no optimum dividend policy (D/P ratio). Assumptions The critical assumptions of Walters Model are : a. b. c. All financing is done through retained earnings; external sources of funds like debt or new equity capital are not used. With additional investments undertaken, the firms business risk does not change. It implies that r and k are constant. There is no change in the key variables namely, beginning earnings per share E and dividend per share D. The values of D and E may be changed in the model to determine results, but, any given value of E and E are assumed to remain constant in the determining a given value. d. The firm has perpetual (or very long) life.

Walter has evolved a mathematical formula to arrive at the appropriate dividend decision. His formula is based on a share valuation model which states : P = D ke g where P = Price of equity shares D = Initial dividend ke = Cost of equity capital g = expected growth rate of earnings Limitations The Walters model, one of the earliest theoretical models, explains the relationship between dividend policy and the value of the firm under certain simplified assumptions. Some of the assumptions do not stand critical evaluation. In the first place, the Walters model assumes that the firms cost of investments are financed exclusively by retained earnings; no external financing is used. The model would be only applicable to all equity firms. Secondly, the model assumes that r is constant. This is not a realistic assumptions because when increased investments are made by the firm, r also changes. Finally, as regards the assumption of constant ke, the risk complexion of he firm has a direct bearing on it. By assuming ke, to be constant, Walters model ignores the effect of risk on the value of the firm. Gordons Model : Another theory which contends that dividends are relevant is the Gordons model. This model, which says that dividend policy of a firm affects its value is based on the following assumptions : 1. The firm is an all equity firm. No external financing is used and the investment programmes are financed exclusively by retained earnings.


r and ke are constant.



The firm has a perpetual life. The retention ratio, once decided upon, is constant. Thus the growth rate (g = br) is also constant. ke > br


It can be seen from the assumptions of Gordon Model that they are similar to those of Walters mode. As a result, Gordons model like Walters model contends that dividend policy of a firm is relevant and that investors put a positive premium on current dividends /income. But Gordon goes one step further and argues that dividend policy affects the value of shares even in a situation in which the return on investment of a firm is equal to the required / capitalization rate (i.e., r = ke) while Walters model is of the view that the view that investors are indifferent between dividends and retention. The crux of Gordons argument is a two-fold assumption : a. b. Investors are risk averse and They put a premium on a certain return and discount/penalize uncertain returns.

The investors are rational. Accordingly, they want to avoid risk. The term risk refers t the possibility of not getting a return on investment. The payment of current dividends ipso factor completely removes any chance of risk. If however, the firm retains the earnings (i.e. current dividends are withheld), the investors can expect to get a dividend in future. The future dividend is uncertain, both with respect to the amount as well as the timing. The rational investors can reasonably be expected to prefer current dividend. In other words, they would discount future dividends, i.e., Bird-in-the-hands Argument Investors are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices. MM Model According to MM, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. They argue that the value of the firm depends on firm earnings which results from its investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance. Information Content In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear cut means of making a statement that speaks louder than a thousand words. Market Imperfections Tax DifferentialLow Payout Clientele, Flotation Cost, Transaction and Agency Cost, Information Asymmetry, Diversification, UncertaintyHigh Payout Clientele, Desire for Steady Income, and No or Low Tax on Dividends: Stable Dividend Policy Companies like to follow a stable dividend policy since investors generally prefer such a policy for the reason of certainty. A stable dividend policy does not mean constant dividend per share. It means reasonably predictable dividend policy. Companies determine dividend per share or dividend rate keeping in mind their long-term payout ratio. Firms Ability to Pay Dividend depends on its funds requirements for growth, shareholders desire and liquidity. A growth firm should set its dividend rate at a low level (because of its high needs for funds) and move towards its target slowly. Practical consideration


Financial Need of company, Shareholders Expectations, Closely/Widely Held Company, Constraints on Paying Dividends, Legal Restrictions, Liquidity, Borrowing Capacity, Access to the Capital Market, Restrictions in Loan Agreements.


UNIT 4 WORKING CAPITAL MANAGEMENT Principles of working capital: Concepts need; Determinants, issues and estimation of working capital, The management of current assets is similar to that of fixed asses in the sense that in both cases a firm analyses their effects o its return and risk. However it is to be remembered that a greater degree of flexibility is enjoyed in managing current assets. CONCEPTS OF WORKING CAPITAL There are two concepts of working capital gross and net. Gross working capital refers to the firms investment in current assets. Current assets are the assets which can be converted into cash within an accounting year and include cash, short term securities, debtors (accounts receivables), Bills receivables and stock (investment). Net working capital refers to the excess of current assets over current liabilities or in other words is the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment with an accounting year and include creditors (accounts payable), bills payable and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative net working occurs when current liabilities are in excess of current assets. OPERATING AND CASH CONVERSION CYCLE Operating cycle The need for working capital to run the day-to-day business activities cannot be overemphasized. We can hardly find a business firm which does not require any amount of working capital. working capital. Firms aim at maximizing the wealth of equity shareholders. In its endevour to do so, a firm should earn sufficient return from its operations. Earnings a steady amount of profit requires successful sales activity. The firm has to invest enough funds in current assets fro generating sales. Current assets are needed because sales do not convert into cash instantaneously. There is always a gap or an operating cycle involved in the conversion of sales into cash. Operating cycles is the time duration required to convert sales after the conversion of resources into inventories, into cash. The operation cycle of a manufacturing firm involves three phases : a. b. c. Acquisition of resources such as raw material, labour power, fuel, etc. Manufacture of the product which includes conversion of raw material into work-in-progress and work-inprogress into finished stock. Sale of the product either for cash or on credit. Credit sales create account receivable for collection. Indeed firms, differ in their requirements of the

Determination of Operating Cycle The length of an operating cycle of a manufacturing firm is the sum of :


a. b.

Inventory conversion period and Debtors conversion period.

The inventory conversion period is the total time needed for producing and selling a product. Typically it would include : i. ii. iii. Raw material conversion period WIP conversion period Finished goods conversion period The total of the

The debtors conversion period is the time required to collect outstanding amount from the customers. inventory conversion period and debtors conversion period is referred to as gross conversion period.

In practice, a firm may acquire resources (such as raw materials) on credit and temporarily postpone payment of certain expenses. Payables, which the firm can defer, are spontaneous sources of capital to finance investment in current assts. The creditors (payables) deferral period is the length of time the firm is able to defer payments on various resource purchases. The difference between (gross) operating cycle and payables deferral period is net operating cycle. If depreciation is excluded from expenses in the computation of operating cycles, the net operating cycle can be taken as the cash operating cycle. PERMANENT AND VARIABLE WORKING CAPITAL Need for operating cycle arises because of the operating cycle. The operating cycle is a continuous process ad therefore, the need for current assets is felt constantly. But the magnitude of current assets need is not always the same; it increases and decreases over time. However, there is always a minimum level of current assets which is continuously required by a firm to carry on its business operations. Permanent or fixed working capital is the minimum level of current assets. It is permanent in the same way as the firms fixed assets. Depending upon the changes in production and sales, the need for working capital, over and above permanent working capital, will fluctuate. For example, extra inventory of finished goods will have to be maintained to support the peak periods of sale, and investment in debtors (receivable) may also increase during such period. On the other hand, investment in raw materials, work-in-progress and finished goods will fail if the market is slack. Fluctuating or variable working capital is the extra working capital needed to support the changing production and sales activities of the firm. Both kinds of working capital permanent and fluctuating (temporary) are necessary to facilitate production and sale through the operating cycle. But the firm to meet liquidity requirements that will last only temporarily crease the temporary working capital. Permanent working capital is stale over time, while temporary working capital is fluctuating sometimes increasing and sometimes decreasing. However, the permanent working capital line need not be horizontal if the firms requirement for permanent capitol is increasing or decreasing over a period. Balanced working capital The firm should maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from the firms point of view.


Dangers of excessive working capital are as follows : It results in unnecessary accumulation of inventories. Thus chances of inventory mishandling, waste, theft and losses increase. It is an indication of defective credit policy and slack collection period. Consequently, higher incidence of bad debts results, which adversely affects profits. Excessive working capital makes management complacent which is reflected in managerial inefficiency. Tendencies of accumulating inventories tend to make speculative profits grow. This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to make speculative profits. Dangers of inadequate working capital : It stagnates growth. It becomes difficult for the firm to undertake profitable projects for non-availability of working capital funds. It becomes difficult to implement operating plans and achieve the firms profit target. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. Fixed assets are not efficiently utilized due to lack of working capital funds. Thus the profitability deteriorates. Paucity of working capital funds render the firm unable to avail attractive credit opportunities, etc. The firm loses its reputation when it is not in a position to honour its short term obligations. As a result the firm faces tight credit terms. DETERMINATNS OF WORKING CAPITAL There are no set of rules or formula to determine working capital requirements of a firm. A large number of factors influence working capital needs of a firm. They are as follows: 1. Nature of business : Working capital requirements of a firm are basically influenced by the nature of business.. Trading and financial firms have a very small investment in fixed assts, but require a large sum of money to be invested in working capital. Retail stores, for example, must carry large stock of a variety of goods to satisfy varied and continuous demand of their customers. Some manufacturing businesses such as tobacco manufacturers and construction firms, also have to invest substantially in working capital and a nominal amount in fixed assets. In contrast public utilizes may have limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they may have only cash sales and supply services, not products. Thus no funds are tied up in debtors and stock. 2. Market and Demand conditions : The working capital needs of a firm are related to its sales. However, it is difficult to precisely determine the relationship between volume of sales and working capital needs. In practice current assets will have to be employed before growth takes place. It is, therefore, necessary to make advance planning of working capital for a growing firm on a continuous basis. Growing firms may need to invest funds in fixed assets in order to sustain growing production and sales. This will, in turn, increase investment in current assets to support increased scale of operations. Sales depend on demand conditions. Large firms experience seasonal and cyclical fluctuations in the demand for their products and services. These business fluctuations affect the working capital requirements, especially the temporary working capital requirements.



Technology and Manufacturing Policy :

The manufacturing cycle (or the inventory conversion cycle)

comprises of the purchase and use of raw materials and the production of finished goods. Longer the manufacturing cycle, larger will the firms working capital requirements. An extended manufacturing time span means a larger tie up of funds in inventories. A strategy of level or steady production may be maintained in order to resolve the working capital problems arising de to seasonable changes in the demand for the firms products. A steady or level production policy will cause inventories to accumulate during the off-season periods and the firm will be exposed to greater inventory costs and risks. Thus if the costs and risk of marinating a constant production schedule are high, the firm may adopt a variable production policy, varying its production schedules in accordance with changing demand. 4. Credit policy : The credit policy of the firm affects working capital by influencing the level of debtors. The credit terms to be granted to customers may depend upon the norms of the industry to which the firm belongs. But a firm has the flexibility of shaping its credit policy within the constraint of industry norms and practices. The firm should use discretion in granting credit terms to its customers. Depending on the individual case, different terms may be granted to different customers. A liberal credit policy without rating the credit-worthiness of customers, will be detrimental to the firm and will create a problem of collection later on. mean larger bad debts. In order to ensure that unnecessary funds are not tied up in debtors, the firm should follow a rationalized credit policy based on the credit standing of the customers and other relevant factors. 5. Availability of credit from suppliers : The working capital requirements of a firm are also affected by the credit granted by its suppliers. A firm will need less working capital if liberal credit terms are available to it from suppliers. Suppliers credit finances the firms inventories and reduces the cash conversion period cycle. In the absence of suppliers credit the firm will have to borrow funds from bank. The availability of credit at reasonable cost from banks is crucial;. It influences the working capital policy of a firm. A firm without the suppliers credit, but which can get bank credit easily on favourable terms, will be able to finance its inventories and debtors without much difficulty. 6. Operating efficiency : The operating efficiency of the firm relates to the optimum utilization of all its resources at minimum costs. The efficiency in controlling operating costs and utilizing fixed and current assets leads to operating efficiency. The use of working capital is improved and speed of conversion of current assets into cash improves. utilization of resources improves profitability and thus, helps in releasing the pressure on working capital 7. Price level changes : The increasing shift in price levels makes functions of financial manger difficult. He should anticipate the effect of price level changes on working capital requirements of the firm. Generally rising price levels will require a firm to maintain higher amount of working capital. Same levels of current assets will need increased investment when prices are increasing. ISSUES IN WORKING CPAITL MANAGEMENT : Working capital management refers to the administration of all components of working capital cash, marketable securities, debtors (receivables) and stock (inventories) and creditors (payables). The financial manger must determine levels and composition of current assets. He must see the right sources are tapped to finance current assets, and that Better The firm should e prompt in making collections. A high collection period will


current liabilities are paid in time. There are many aspects of working capital management which make it an important function of the finance manger. They are :

a. b. c. d.

Time : Working capital management requires much of the finance managers time. Investment : Working capital represents a large portion of the total investment in assets. Criticality : Working capital management has great significance for all firms but it is very critical for small firms. Growth : the need for working capital is directly related to the firms growth.

LIQUIDITY vs. PROFITABILITY ; RISK- RETURN TRADE OFF : The firm would make just enough investment in current assets if it were possible to estimate working capital needs exactly. Under perfect certainty, current assets holdings would be at the minimum level. A larger investment in current assets under certainty would mean a low rate of investment for the firm, as excess investment in current assets will not each enough return. A smaller investment in current assets, on the other hand, would mean interrupted production and sales, because of frequent stock-outs and inability to pay to creditors in time due to restrictive policy. As it is not possible to estimate working capital needs accurately, the firm must decide about levels of current assets to be carried. Given a firms technology and production policy, sales and demand conditions operating efficiency etc, its current assets holding will depend upon it working capital policy. It may follow a conservative or aggressive policy. These policies involve risk-return trade-offs. A conservative policy means slower return and risk, while an aggressive policy produces higher return and risk. Important aims of working capital management are : a. b. Profitability and Solvency

Solvency, refers to the firms continuous ability to meet maturing obligations. Lenders and creditors expect prompt settlements of their claims as and when due. To ensure solvency, the firm should be very liquid, which means larger current assets holdings. If the firm maintains a relatively larger investment in current assets, it will have no difficulty in paying claims of creditors when they become due and will be able to fill all sales orders and ensure smooth production. Thus a liquid firm has less risk of insolvency; that is, it will hardly experience a cash shortage or a stock-out situation. However, there is a cost associated with maintaining a sound liquidity position. A considerable amount of the firms funds will be tied up in current assets, and to the extent this investment is idle, the firms profitability will suffer. To have higher profitability, the firm may sacrifice solvency and maintain a relatively low level of current assets. When the firms does so, its profitability ill improve as fewer funs are tied up in idle current assts, but its solvency would be threatened and would exposed to greater risk of cash shortage and stock-outs. The Cost Trade off : A different way of looking into the risk-return-trade-off is in terms of the cost of maintaining a particular level of current assets There are two types of costs involves : a. b. Cost of liquidity and Cost of illiquidity


If the firms level of current assets is very high, it has excessive liquidity. Its return on assets will be low, as funds tied up in idle cash and stock earn nothing and high levels of debtors reduce profitability. Thus the cost of liquidity (though low rates of return) increases with the level of current assets. The cost of illiquidity is the cost of holding insufficient current assets. The firm will not be in a position to hour its obligations if it carries too little cash. This may force the firm to borrow at high rates of interest. This will also adversely affect the creditworthiness of the firm and it will face difficulties in obtaining funds in future. Also this may force the firm into insolvency. ESTIMATING WORKING CAPITAL NEEDS The most appropriate method forecasting the working capital needs of a firm is the concept of operating cycle. However, a number of other methods may be used to determine working capital needs in practice. The three approaches which have been successfully applied in practice are as follows : 1. Current assets holding period : Here working capital requirements are estimated on the basis of average holding period of current assets and relating them to costs based on the companys experience in the previous years. This method is essentially based on the operating cycle concept. 2. 3. Ratio of sales : Working capital requirements are estimated as a ratio of sales is calculated on the assumption that current assets change with sales. Ratio of fixed investments : Working capital requirements are estimated as a percentage of fixed investment.

POLICIES FOR FINANCING CURRENT ASSETS : A firm can adopt different infancies policies vis-avis current assets. Three types of financing may be distinguished :


Long term financing : The sources of long term financing include ordinary share capital, preference share capital, debentures, long term borrowings from financial institutions and reserves and surplus (retained earnings).


Short term financing : The short term financing is obtained for a period les than one year. It is arranged in advance from banks and other suppliers of short-term finance in the money market. Short term finances include working capital funds from banks, public deposits, commercial paper, factoring of receivables, etc.


Spontaneous financing : This refers to the automatic sources of short-term funds arising in the normal course of a business. Trade (suppliers) credit and outstanding expenses are examples of spontaneous financing. There is no explicit cost of spontaneous financing. A firm is expected to utilize these sources of finance to the fullest extent. The real cho8ice of financing current assets, once the spontaneous sources of financing have been fully utilized, is between the long term and short term sources of finances.

Mix of short and long term sources in financing current assets : Depending on the mix of the short and long term financing, the approach followed by a company may be referred to as : a. b. Matching approach Conservative approach



Aggressive approach The firm can adopt a financial plan which matches the expected life of assets with the

a. Matching Approach :

expected life of the source of funds raised to finance assets. Thus, a ten year loan may be raised to finance a plant with an expected life of ten years, stock of goods to be sold in thirty days may be financed with a thirty day commercial paper or a bank loan. The justification for the exact matching is that, since the purpose of financing is to pay for assets, the source of financing and the asset should be relinquished simultaneously. Using long term financing for short term assets is expensive as funds will not be utilized for the full period Similar financing long term assets with short term financing is costly as well as inconvenient as arrangements for the new short term financing will have to be made on a continuing basis. When the firm follows the matching approach (also known as hedging approach), long term financing will be used to finance fixed assets and permanent current assets and short term financing to finance temporary or variable current assets. However, it should be realized that the exact matching is not possible because o the uncertainty about the expected life of assets. b. Conservative Approach : The firm in practice may adopt a conservative approach in financing its current and fixed assets . the financing policy of the firm is said to be conservative when it depends more on long term funds for financing needs. Under a conservative plan, the firm finances its permanent assets and also a part of temporary current assets with long term financing. In the periods when the firm has no need for temporary current, assets, the idle long term funds can be invested in trade able securities to conserve liquidity. The conservative firm relies heavily on long term financing and therefore, the firm has less risk of facing the problem of shortage o funds. The conservative financing policy is shown bellows in the figure given. Note that when the firm has no temporary current assets, [e.g, at (a) and (b)] the long term funds realized can be invested in marketable securities to build up the liquidity position of the firm. c. Aggressive Approach : A firm may be aggressive in financing its assets. An aggressive policy is aid to be followed by the firm when it uses more short-term financing than warranted by the matching plan. Under an aggressive policy, the fin finances a part of its permanent current assets with short term financing. Some extremely aggressive firm may even finance a part of their fixed assets with short term financing. The relatively more use of short-term financing make the firm more risky


Trade credit creates accounts receivables or trade debtors (also referred to as book debts in India) that the firm is expected to collect in the near future. The customers from whom receivable or book debts have to be collected in the future care called trade debtors or simply debtors and represent the firms claim or asset. A credit sale has three characteristics : Involves an element of risk that should be carefully analyzed Based on economic value. Implies futurity.

CREDIT POLICY : NATURE AND GOALS : A firms investment in accounts receivable depends on :


a. The volume of credit sales and b. The collection period. For example, if a firms credit sales are Rs. 30 lakhs per day and customers, on an average, take 45 days to make payment, then the firms average investment in accounts receivable is : Rs. 30 lakhs x 45 = 1,350 lakhs. The volume of credit sales is a function of the firms total sales and the percentage of credit sales to total sales. Total sales depend upon the market size, firms market share, quality of the product, intensity of competition, economic conditions etc. The financial manager has hardly any control over these variables. There is only one way in which the financial manager can affect the volume of credit sales and collection period and consequently investment in accounts receivable. That is through the change in credit policy. The term credit policy is sued to refer to the combinations of three decision variables :


Credit standards : which are criteria to decide the types of customers to whom goods could be sold on credit. If a firm has more slow-paying customers its investment in accounts receivable will increase. The firm will also be exposed to higher risk or default.

b. c.

Credit terms : which specify duration of credit terms of payment by customers. Investment in accounts receivable will be high if customers are allowed extended time period for making payments. Collection efforts : which determine the actual collection period. The lower the collection period, the lower the investment in accounts receivable and vice versa.

GOALS OF CREDIT POLICY A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit policy tends to sell on credit to customers on very liberal terms and standards credit is granted for longer periods even to those customers whose creditworthiness is not fully known or whose financial position is doubtful. In contrast, a firm following a stringent credit policy sells on credit on a highly selective basis only to those customers who have proven credit worthiness and who are financially strong. In practice, firms follow credit policies ranging between stringent to lenient. Necessity for granting credit : Competition Companys bargaining power Buyers requirements Buyers status Relationship with dealers Marketing tool Industry practice Transit delays


OPTIMUM CREDIT POLICY : A MARGINAL COST BENEFIT ANLAYSIS : The firms operating profit is maximized when total cost is minimized for a given level of revenue. Credit policy at appoint A in the above Figure below represents the maximum operating profit since the total cost is minimum). But it is not necessarily the optimum credit policy. Optimum credit policy is one which maximizes the firms value. The value of the firm is maximized when the incremental return of an investment is equal to the incremental cost of funds used to finance the investment.

The goals of the firms credit policy are to maximize the value of the firm. To achieve this goal, the evaluation of investment in accounts receivable should involve the following four step : 1. 2. 3. 4. Estimation of incremental operating profit or contribution Estimation of incremental investment in accounts receivable Estimation of the incremental return on the incremental investment in accounts receivable Comparison of the incremental return with the incremental cost

CREDIT POLICY VARIABLES : In establishing an optimum credit policy, the financial manager must consider the important decision variables which influence the level of receivable. The major variables include : a. b. c. Credit Standards and analysis Credit Terms Collection policy and procedure

Credit standards : which are criteria which a firm follows in selecting customers for the purpose of credit extension. The firm may have tight credit standards that is, it may sell mostly on cash basis, and may extend credit only to the most reliable and financially strong customers. Such standards will result in no bad debt losses and les cost of credit administration. But the firm may not be able to expand sales. The profit sacrificed on lost sales may be more than the cost saved by the firm. On the other hand, if credit standards are loose, the firm may have larger sales. But the firm will have to carry larger receivable. The costs of administering credit and bad debts losses will increase. Thus the choice of optimum credit standards involves a trade-off between incremental return and incremental costs. Credit standards influence the quality of the firms customers. The quality of customers can be measured on the basis of the following parameters : a. b. Average collection period which refers to the time taken by the customers to pay and Default risk which is measured in terms of bad debts losses ratio.

On the basis of the past experience the financial or credit manager should be able to form a reasonable judgment regarding the chance of default. To estimate the probability of default, the finance or credit manager should consider three Cs : a. Character


b. c.

Capacity and Condition

Character refers to the customers willingness to pay. The financial or credit manager should judge whether the customers will make honest efforts to honour their credit obligations. The moral factor is of considerable importance in crdit evaluation in practice. Capacity refers to the customers ability to pay. Ability to pay can be judged by assessing the customers capital and assets which he may offer as security. Condition refers to the prevailing economic and other conditions which may affect the customers ability to pay. Adverse economic conditions can affect the ability or willingness of a customer to pay. Credit terms : The stipulations under which the firm sells on credit to customers are called credit terms. These stipulations include : a. b. The credit period and The cash discount

Credit period : The length of time for which credit is extended to customers is called the credit period. It is generally stated in terms of a net date. For example, if the firms credit terms are net 35, it is expected that customers will repay credit obligations not later than 35 days. Credit period may be governed by the industry norms. But depending on its objective a firm can lengthen the credit period. On the other hand , the firm may also tighten the credit period if customers are defaulting too frequently and bad debts are building up. Cash discounts : A cash discount is a reduction in payment offered to customers to induce them to repay credit obligations within a specified period of time, which will be less than the normal credit period. It is usually expressed as a percentage of sales. Cash discount terms indicate the rate of discount and the period for which ti is available. If the customer does not avail the offer, he must make payment within the normal credit period. In practice credit terms would include : a. b. c. The are of cash discount The cash discount period The net credit period

For example,, credit terms expressed as 2/10, net 30 would mean that a discount of 2% will be granted if the customer pays within 10 days; if he does not avail the offer he must make payment within 30 days. Sources of credit information about the customers : sources : Financial statements a. Bank references Credit information could be obtained from the following


b. c.

Trade references Other sources such as CRISIL, CARE OR ICRA.

MONITORING ACCOUNTS RECEIVABLE : A firm needs to continuously monitor and control its receivable to ensure the success of collection efforts. Two traditional methods of evaluating the management of receivable are : a. b. Average collection period and Aging schedule Debtors x 360 Credit sales The average collection period is compared with the firms stated credit period to judge the collection efficiency. Aging Schedule breaks down receivables according to the length of time for which they have been outstanding. FACTORING Factoring is a continuing arrangement between a financial intermediary called a Factor and a Seller (also called a Client) of goods and services. Based on the type of factoring, the factor performs the following services in respect of the accounts receivables arising from the sale of such goods and services. Purchase of all accounts receivables of the seller for immediate cash Administers the sales ledger of the seller Collects the accounts receivables Assumes the losses which may aisle from bade debts Provides relevant advisory services to the seller

Average Collection period : Average collection period is :

Factors are usually subsidiaries of banks or private financial companies. It is to be noted that factoring in a continuous arrangement and not related to a specific transaction. This mean that the factor handles all the receivables arising out of the credit sales of the seller company and just some specific bills or invoices as is done in a bill discounting agreement. Mechanics of Factoring : The factoring arrangement starts when the seller (client) concludes an agreement with the factor, wherein the limits, charges and other terms and conditions are mutually agreed upon. From then onwards, the client will pass on all credit sales to the factor. When the customer places the order and the goods along with invoices are delivered by the client to the customer, the client sells the customers account to the factor and also informs the customer that payment has to be made to the factor. A copy of the invoice is also sent to the factor. The factor purchases the invoices and makes prepayment, generally up to 80% of the invoice amount. Just as in the case of cash credit, for factoring also a drawing power is fixed based on a margin which is normally around 20%.


The client is free to withdraw funds up to the drawing power. The factors sends monthly statements showing outstanding balances to the customer, copies of which are also sent to the client. The factor also carries follow-up if the customer does not pay by the due date. Once the customer makes payment the factor, the balance amount due to client is paid by the factor. Servicing and Discount Charges : For rendering the services of collection and maintenance of sales ledger, the factor charges a commission which varies between 0.4% to 1% of the invoice value, depending upon the volume of operations. This service charge is collected at the time of purchase of invoices by the factor. For making an immediate part-payment to the client, the factor collects discount charges from the client. The discount charges are comparable to bank interest rates in that it is calculated for the period between the date of advance payment by the factor to the client and the date of collection by the factor from the customers. These are collected monthly. Types of Factoring : Factoring can be classified into many types. The types of factoring prevalent in India today are as follows:


Recourse Factoring : Under recourse factoring, the factor purchases the receivables on the condition that any loss arising out of irrecoverable receivables will be borne by the client. In other words, the factor has recourse to the client if the receivables purchased turn out to be irrecoverable.


Non-recourse or Full Factoring :

As the name implies, the factor has no recourse to the cline if the In this type of factoring, all the

receivables are not recovered, i.e., the client gets total credit protection. the client.

components of service viz., short-term finance, administration of sales ledger and credit protection are available to


Advance Factoring and Maturity Factoring : Under this type of factoring arrangement, the factor does not make any advance or pre-payment. The factor pays the client either on a guaranteed payment date or on the date of collection from the customer. This is as opposed to Advance factoring where the factor makes prepayment of around 80% of the invoice to the client.


Invoice Discounting : Strictly speaking, this is not a form of factoring because it does not carry the service elements of factoring. Under this arrangement, the factor provides a pre-payment to the client against the purchase of accounts receivables and collects interest (service charges) for the period extending from the date of pre-payment to the date of collection. The sales ledger administration and collection are carried out by the client.

Other types of factoring not popular in India :


Bulk/Agency Factoring : This type of factoring is basically used as a method of financing book debts. Under this the client continues to administer credit and operate sales ledger. The factor finances the book debts against bulk either on recourse or without recourse. This sort of factoring become popular with the development of mini-


computers market where marketing and credit management was not a problem but the firms needed temporary financial accommodation. Those companies which have good systems of credit administration, but need finances, prefer this form of factoring.


Non-notification Factoring : In this type of factoring, customers are not informed about the factoring agreement. It involves the factor keeping the accounts ledger in the name of a sales company to which the client sells his book debts. It is through this company that the factor deals with the clients customers. The factor performs all his usual functions without a disclosure to customers that he owns the book debts. This type of factoring is available in the UK to financially strong companies.

INVENTORY MANAGEMENT Inventories Companies hold inventories in the form of raw materials, work-inprocess and finished goods. Inventories represent investment of a firms funds. The objective of the inventory management should be the maximisation of the value of the firm. The firm should therefore consider: (a) costs, (b) return, and (c) risk factors in establishing its inventory policy.

Transaction Motive to Hold Inventory for facilitating smooth production and sales operation. Precautionary Motive to Hold Inventory to guard against the risk of unpredictable changesin usage rate and delivery time. Speculative Motive to Hold Inventory to take advantage of price fluctuations. Ordering Costs requisition, placing of order, transportation, receiving, inspecting and storing and clerical and staff services. Ordering costs are fixed per order. Therefore, they decline as the order size increases. Carrying Costs warehousing, handling, clerical and staff services, insurance and taxes. Carrying costs vary with inventory holding. As order size increases, average inventory holding increases and therefore, the carrying costs increase.

Economic Order Quantity (EOQ) The firm should minimise the total cost (ordering plus carrying). The economic order quantity (EOQ) of inventory will occur at a point where the total cost is minimum. The following formula can be used to determine EOQ: 2AO/C

where A is the annual requirement, O is the per order cost, and c is the per unit carrying cost. The economic order level of inventory, Q*, represents maximum operating profit, but it is not optimum inventory policy. Optimum Inventory Policy The value of the firm will be maximised when the marginal rate of return of investment in inventory is equal to the marginal cost of funds. The marginal rate of return (r) is calculated by dividing the incremental operating profit by the incremental investment in inventories, and the cost of funds is the required rate of return of suppliers of funds. Reorder Point The inventory level at which the firm places order to replenish inventory is called the reorder point. It depends on (a) the lead time and (b) the usage rate. Under perfect certainty about the usage rate, and instantaneous delivery (i.e., zero lead time), the reorder point will be equal to: Lead time x Usage rate.


Safety Stock In practice, there is uncertainty about the lead time and/or usage rate. Therefore, firms maintain safety stock which serves as a buffer or cushion to meet contingencies. In that case, the reorder point will be equal to: Lead time x Usage rate + Safety stock. The firm should strike a trade-off between the marginal rate of return and marginal cost of funds to determine the level of safety stock. Selective Control System A-B-C Analysis A firm, which carries a number of items in inventory that differ in value, can follow a selective control system. A selective control system, such as the A-B-C analysis, classifies inventories into three categories according to the value of items: A-category consists of highest value items, B-category consists of high value items and C-category consists of lowest value items. More categories of inventories can also be created. Tight control may be applied for high-value items and relatively loose control for lowvalue items. Total Quality Management (TQM) System Large numbers of companies these days follow the total quality management (TQM) system which requires companies to adopt JIT and computerised system of inventory management.

Motives for holding Cash :

Transaction Motive for Holding Cash : A firm needs cash to make payments for acquisition of resources and services for the normal conduct of business. Precautionary Motive for Holding Cash A firm keeps additional funds to meet any emergency situation. Speculative Motive for Holding Cash Some firms may also maintain cash for taking advantages of speculative changes in prices of input and output.

Optimum Balance of Cash A firm should hold an optimum balance of cash, and invest any temporary excess amount in short-term (marketable) securities. In choosing these securities, the firm must keep in mind safety, maturity and marketability of its investment. Management of Cash involves three things: (a) managing cash flows into and out of the firm, (b) managing cash flows within the firm, and (c) financing deficit or investing surplus cash and thus, controlling cash balance at a point of time. It is an important function in practice because it is difficult to predict cash flows and there is hardly any synchronisation between inflows and outflows. Cash Budget Firms prepare cash budget to plan for and control cash flows. Cash budget is generally prepared for short periods such as weekly, monthly, quarterly, half-yearly or yearly. Cash budget will serve its purpose only if the firm can accelerate its collections and postpone its payments within allowed limits. The main concerns in collections are: (a) to obtain payment from customers within the credit period, and (b) to minimise the lag between the time a customer pays the bill and the time cheques etc. are collected.


The financial manager should be aware of the instruments of payments, and choose the most convenient and least costly mode of receiving payment. Disbursements or payments can be delayed to solve a firms working capital problem. But this involves cost that, in the long run, may prove to be highly detrimental. Therefore, a firm should follow the norms of the business. Receipts and Disbursements Method is employed to forecast for shorter periods. The individual items of receipts and payments are identified and analyzed. Cash inflows could be categorized as: (i) operating, (ii) non-operating, and (iii) financial.

(ii) (iii)

Cash outflows could be categorised as: (i) (ii) (iii) (iv) operating, capital expenditure, contractual, and discretionary.

Such categorisation helps in determining avoidable or postponable expenditures. Adjusted Income Method uses proforma income statement (profit and loss statement) and balance sheet to work out cash flows (by deriving proforma cash flow statement). As cash flows are difficult to predict, a financial manager does not base his forecasts only on one set of assumptions. He or she considers possible scenarios and performs a sensitivity analysis. At least, forecasts under optimistic, most probable and pessimistic scenarios can be worked out. Concentration Banking and Lock-Box System methods followed to expedite conversion of an instrument (e.g., cheque, draft, bills, etc.) into cash. Marketable Securities The excess amount of cash held by the firm to meet its variable cash requirements and future contingencies should be temporarily invested in marketable securities, which can be regarded as near moneys. A number of marketable securities may be available in the market. The financial manager must decide about the portfolio of marketable securities in which the firms surplus cash should be invested. Baumol Model of Cash Management considers cash management similar to an inventory management problem. The optimum cash balance will increase with increase in the per transaction cost and total funds required and decrease with the opportunity cost. Miller-Orr Model If the firms cash flows fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come back to a normal level of cash balance (the return point). Similarly, when the firms cash flows wander and hit the lower limit, it sells sufficient marketable securities to bring the cash balance back to the normal level (the return point).


SHORT TERM BANK FINANCE : Traditionally, bank finance is an important source for financing the current assets of ac company. Bank finance is available in different forms. Bankers are guided by the credit worthiness of the customers, the form of security offered and the margin requirements on the assets provided as security. Bank finance may be either direct or indirect. Under direct financing the bank not only provides the finance but also bears the risk. Cash credit, overdraft, note lending, purchase/discounting of bills belongs to the category of direct financing. When the bank opens a Letter of Credit in favour of a customers, the bank assumes only the risk of default by the customer and the finance is provided by a third party. Cash credit : Under the cash credit arrangement, the customer is permitted to borrow up to a pre-fixed limit called the cash credit limit. The customer is charged interest only on the amount actually utilized, subject to some minimum service charge of maintaining some minimum balance also known as compensatory balance in the cash credit account. The security offered by the customers is in the nature of hypothecation or pledge. Overdraft : Overdraft arrangement is similar to the cash credit arrangement described above. Under the overdraft arrangement, the customer is permitted to overdraw up to a pre-fixed limit. determined as in the case of cash credit arrangement. Differences between cash credit and overdraft : Cash credit account operates against security of inventory and accounts receivables in the form of hypothecation / pledge. Overdraft account operates against security in the form of pledge of shares and securities, assignment of life insurance policies and sometimes even mortgage of fixed assets. Note lending : Unlike cash credit / overdraft which are running accounts, note lending is for a specified period ranging from two to three months. The customer takes a loan against a promissory note. Interest is charged on the entire amount sanctioned as loan unlike cash credit / overdraft arrangement where interest is not charged on the undrawn portion within the sanctioned limit. However this method is not quire popular. Purchasing / Discounting of Bills : with a view to reducing reliance on cash credit / overdraft arrangement as also to create market for bills which can be purchased by banks with surplus funds and sold by banks with shortage of funds, the RBI has been trying hard for nearly two decades for the creation of an active bills market but with very limited success. Under this arrangement, banks provide finance to the customers either by outright purchase or discounting the bills arising out of sale of finished goods. Obviously, the bank will not pay the full amount but provide credit after deducting its charges. To be on the safer side the banker will scrutinize the authenticity of the bills and the credit worthiness of the concerned organization besides covering the amount under the cash credit/ overdraft limit. Interest is charted on the amount(s) overdrawn subject to some minimum charge as in the case of cash credit arrangement. The drawing power is also


Letter of Credit : Letter of Credit is opened by a bank in favour of its customer undertaking the responsibility to pay the supplier (or the suppliers bank) in case its customer fails to make payment for the goods purchased from the supplier within the stipulated time. Letter of credit arrangement is becoming more and more popular both in domestic and foreign markets. Unlike in other types of fianc, where the arrangement is between the customer and the bank and the bank assumes the risk of non-payment also provides finance, under the letter of credit arrangement the bank assumes the risk while the supplier provides the credit. Security : As mentioned earlier, before taking a decision to provide financial assistance to a company the bank will consider the credit worthiness of the company and the nature of security offered. For providing accommodation towards financing the current assets of a company, the bank will ask for security in the form of hypothecation and / or pledge. Hypothecation : By and large, security in the form of hypothecation is limited to movable property like inventories. Under hypothecation agreement, the goods hypothecated will be in the possession of the borrower. The borrower is under an obligation to prominently display that the items are hypothecated to such and such a bank. In the case of limited companies, the hypothecation charge is required to be registered with the Registrar of Companies of the state. Pledge : Unlike in the case of hypothecation, in a pledge, the goods /documents sin the form of share certificates, book debts, insurance policies, etc. which are provided as security will be in the possession of the bank lending funds but not with the borrowing company. PUBLIC DEPOSITS FOR FINANCING CURRENT ASSETS Regulations imposed on the availability of bank fiancs has induced many companies to explore alternative sources for financing their current assets. Mobilization of funds from general public, especially from the middle and upper middle class people, by offering reasonably attractive rates of interest has become an important sources. The deposits thus mobilized from public by non-financial manufacturing companies are popularly known as Public Deposits or Fixed deposits. These are governed by the regulation of public deposits under the Companies (Acceptance of Deposits) Amendment Rules, 1978. Salient Features of Public Deposits : A company cannot raise more than 10% of its paid up share capita and free reserves as public deposits. Maximum maturity period allowed is three years while the minimum permitted period is six months. A company inviting deposits from the public is required to issue an advertisement disclosing full details of its self and the same has to be filed with the Registrar of Companies before releasing it to the press. Evaluation of Public Deposits from the Companys Point of View : Advantages : Procedure involved in raising public deposits is fairly simple and does not involve underwriting and related issue expenses are minimal. No security is offered in case of public deposits unlike in the case of hypothecation / pledge.


The after tax cost of public deposits is much less that the after tax cost of bank borrowing. (Cheaper source when compared to bank finance). No restrictive covenants like in the case of term loans or bank finance.

Disadvantages : Scope for mobilization of public deposits is somewhat limited. Sine maximum maturity period is 3 years, debt servicing becomes difficult. Some companies may fail to honour their commitment in the repayment of public deposits.

Short-Term Sources of Financing Trade Credit, Deferred Income and Accrued Expenses, and Bank Finance. Two alternative ways of raising shortterm finances in India are: factoring and commercial paper. Spontaneous Sources of Working Capital Finance Trade Credit and Deferred Income and Accrued Expenses are available in the normal course of business, and therefore, they are called spontaneous sources of working capital finance. They do not involve any explicit costs. Non-Spontaneous or Negotiated Sources of Working Capital Finance Bank Finances have to be negotiated and involve explicit costs. They are called non-spontaneous or negotiated sources of working capital finance Trade Credit refers to the credit that a buyer obtains from the suppliers of goods and services. Payment is required to be made within a specified period. Suppliers sometimes offer cash discount to buyers for making prompt payment. Buyer should calculate the cost of foregoing cash discount to decide whether or not cash discount should be availed. A buyer should also consider the implicit costs of trade credit, and particularly, that of stretching accounts payable. These implicit costs may be built into the prices of goods and services. Buyer can negotiate for lower prices for making payment in cash. Accrued Expenses and Deferred Income also provide some funds for financing working capital. However, it is a limited source as payment of accrued expenses cannot be postponed for a long period. Similarly, advance income will be received only when there is a demand-supply gap or the firm is a monopoly. Bank Finance is the most commonly negotiated source of the working capital finance. It can be availed in the forms of overdraft, cash credit, purchase/discount of bills and loan. Each companys working capital need is determined as per the norms. These norms are based on the recommendation of the Tandon Committee and later on, the Chore Committee. The policy is to require firms to finance more and more of their capital needs from sources other than bank. Banks are the largest providers of working capital finance to firms. COMMERCIAL PAPER : Commercial Papers (CPs) are short term usance promissory notes with a fixed maturity period, issued by lending, reputed, well established, large corporations who have a very high credit rating. It can be issued by body corporates whether financial companies or non-financial companies. Hence it is also referred to as Corporate Paper.


CPs are mostly used to finance current transactions of a company and to meet is seasonable need for funds. They are rarely used to finance the fixed assets or the permanent portion of working capital. The rise and popularity of CPs in other countries like USA, UK, France, Canada and Australia, has been a mater of spontaneous response by the large companies to the limitations and difficulties they experience in obtaining funds from banks.