PG MCA Computer Applications 315 21 Accounting and Financial Management 5777

ALAGAPPA UNIVERSITY
[Accredited with ’A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle

and Graded as Category–I University by MHRD-UGC]
(A State University Established by the Government of Tamilnadu)
KARAIKUDI – 630 003
DIRECTORATE OF DISTANCE EDUCATION
MASTER OF COMPUTER
APPLICATION
IV-SEMESTER
31541/34041
ACCOUNTING AND FINANCIAL

MANAGEMENT
Copy Right Reserved For Private use only

Author:
Dr. S. NAZEER KHAN
Assistant Professor
PG & Research Department of Commerce
Dr. Zakir Husain College, Illayankudi
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All rights reserved. No part of this publication which is material protected by this copyright notice
may be reproduced or transmitted or utilized or stored in any form or by any means now known or
hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording
or by any information storage or retrieval system, without prior written permission from the
Alagappa University, Karaikudi, Tamil Nadu.
SYLLABI-BOOK MAPPING TABLE
ACCOUNTING AND FINANCIAL MANAGEMENT
Syllabi Mapping in Book
BLOCK -I: INTRODUCTION – FINANCIAL ACCOUNTING Pages - 1 - 13
UNIT-I Financial Accounting: Meaning and Scope – Principles –
Concepts – Conventions
UNIT-II Accounting Process: Journal – Ledger – Trial Balance- Pages - 14 - 25
Trading Account – Profit and Loss Account – Balance Sheet
UNIT- III Accounting Ratio Analysis – Funds Flow Analysis – Cash
Flow Analysis – Computerized Account Pages - 26 - 40
BLOCK -II: COST AND MANAGEMENT ACCOUNTING
UNIT-IV Introduction: Meaning Scope and Uses of Cost and Pages 41 - 47
Management Accounting – Elements of Cost
UNIT-V Cost Sheet – Marginal Costing and Cost Volume Profit Pages 48 - 66
Analysis
UNIT-VI Break Even Analysis: Concepts, Applications and Pages 67- 70
Limitations
BLOCK- III: STANDARD COSTING AND BUDGETING
UNIT -VII Introduction: Concept and Importance Standard Costing -
Pages 71 - 79
Variance Analysis – Material – Labor – Overhead – Sales – Profit
Variances
UNIT- VIII Budgets and Budgetary Control – Meaning and Types of
Pages 80 - 86
Budgets – Sales Budget – Production Budget
UNIT-IX Budgets: Cash Budget – Master Budget – Flexible Pages 87 - 94
Budgeting – Zero Base Budgeting
BLOCK -IV: FINANCIAL MANAGEMENT
UNIT X Introduction: Objectives and Functions of Financial Pages 95 - 111
Management –Risk – Return Relationship – Time Value of Money
UNIT-XI Capital Budgeting: Basic Methods of Appraisal Pages 112 - 136
Investments
UNIT XII Working Capital: Concepts of Working Capital, Factors Pages 137 - 161
affecting Working CFapital – Estimation of Working Capital
Requirements
BLOCK V: COST OF CAPITAL
UNIT XIII Cost of Capital Structure and Dividend: Meaning and Pages 162 - 173
types of Cost of Capital – Computation of Cost for Debt and Equity
- Sources of Capital and Weighted Average Cost of Capital
UNIT XIV Capital Structure Meaning and types of Capital Structure Pages 174 - 209
– Determinants of Capital Structure – Types of Dividend Policy –
Types of Dividend Decision.
Contents Page
BLOCK 1: INTRODUCTION – FINANCIAL ACCOUNTING
UNIT - I Financial Accounting: 1 - 13
1.1. Introduction
1.2. Definition of Accounting
1.3 Accounting
1.4. Objectives of Accounting
1.5. Classifications of Accounting
1.6. Methods of Accounting
1.7. Accounting Terminology
1.8. Single Entry System of Book-Keeping
1.9. Difference Between Double Entry And Single-Entry System
1.10. Rules of The Double Entry System
1.11. Terms Used In Accounting
1.12. Functions of Financial Accounting
1.13. Accounting Concepts
1.14. Golden Rules of Book –Keeping or Accounting
1.15. Accounting Conventions
1.16. Accounting Equation
UNIT - II Accounting Process 14 - 25
2.1. Journal
2.2. Difference Between Trade Discount and Cash Discount
2.3. Ledger
2.4. Trial Balance
2.5. Trading Account
2.6. Profit and Loss Account
UNIT - III Accounting ratio analysis 26 - 40
3.1. Fund Flow Analysis
3.2. Cash Flow Analysis
3.3 Format of Cash Flow From Investing And Financing Activities
3.4. Treatment of Some Peculiar Items
3.5. Computerized Account
3.6. Objective of Computerized Accounting
3.7. Role of Computerized Accounting
3.8. Features of A Computerised Accounting Program
3.14 Manual Accounting Vs Computerized Accounting
UNIT - IV Cost and Management Accounting 41 - 47
4.1. Introduction
4.2. Meaning and Definitions of Cost Accounting
4.3. Cost Accounting
4.4. Objectives of Cost Accounting
4.5. Nature and Scope of Cost Accounting
4.6. Management Accounting
4.7. Objectives of Management Accounting
4.8. Nature and Scope of Management Accounting
UNIT – V Cost Sheet 48 - 66

5.1. Evolution
5.2. Cost
5.3. Different Types of Cost
5.4. Costing
5.7. Advantages of Cost Accounting
5.8. Limitation of Cost Accounting
5.9. Characteristics of A Good (or) An Ideal Costing System
5.10. Difference Between Cost Accounting And Management Accounting
5.11. Cost Classification
5.12. Elements of Cost
5.13. Components of Total Cost
5.14. Format of a Cost Sheet
5.15. Problems and Solutions
UNIT -IV Break Even Analysis 67 - 70
6.1. Concept
6.2. Application of Break-Even Analysis
6.3. Limitations of Be Analysis
6.4 Advantages of Break-Even Chart
UNIT - VII Standard Costing and Budgeting 71 - 79
7.1 Definition
7.2 Concept and Importance Standard Costing
UNIT - VIII Budgets and Budgetary Control 80 - 86
8.1 Introduction
8.2 Definition of Budget
8.3 Types of Budgeting
UNIT - IX BUDGETS 87 - 94
9.1 Cash Budget
9.2 Procedure For Preparation of Cash Budget
9.3 Master Budget
9.4 Flexible Budget
9.5 Zero Base Budgeting (ZBB)
UNIT – X FINANCIAL MANAGEMENT 95 – 111
10.1 Introduction
10.2 Definition of Financial Management:
10.3 Scope of Financial Management
10.4 Objectives of Financial Management:
10.5 Differences between Profit maximization &Wealth maximization
10.6 Other Objectives
10.7 Position of Finance Manager:
10.8 Role of Finance Manager
10.9 Financial Management and other Functional Areas
10.10 Significance of Financial Management
10.11 The changing scenario of Financial Management in India
UNIT – XI CAPITAL BUDGETING 112 - 136

11.1 Introduction
11.2 Meaning of Capital Budgeting
11.3 Definition of Capital Budgeting
11.4 Features of Capital Budgeting
11.5 Objectives of Capital Budgeting
11.6 Capital budgeting process
11.7 Types of Capital Budgeting Decisions
11.8 Procedure for computation of ARR
11.9 Procedure for computation of NPV
11.10 Procedure for computation of IRR
UNIT - XII WORKING CAPITAL MANAGEMENT 137 - 161
12.1 Introduction
12.2 Meaning of working capital
12.3 Definition of working capital
12.4 Concepts of working capital
12.5 Types of working capital
12.6 Features of Working Capital
12.7 Significance of working capital
12.8 Adequacy of working capital
12.9 Advantages of adequate working capital
12.10 Dangers of Redundant or Excessive Working Capital
12.11 Determinants of working capital requirements
12.12 Working capital management
12.13 Significance of operating cycle
12.14 Sources of working capital
12.15 Advantages of raising funds by issue of equity shares
12.16Advantages of Raising Finance by Issue of Debentures
12.17 Regulation of Bank Credit- Tandon Committee
UNIT - XIII COST OF CAPITAL 162 - 173
13.1 Introduction
13.2 Meaning of Cost of Capital
13.3 Definition of Cost of Capital
13.4 Components of Cost Of Capital
13.5 Factors determining the Cost of Capital
13.6 Types of Cost of Capital
13.7 Computation of cost of capital
13.8 Benefits of market value approach:
13.9 Benefits of book value approach
UNIT - XIV CAPITAL STRUCTURE 174 - 209
14.1 Introduction
14.2 Meaning of Capital Structure
14.3 Definition of Capital Structure
14.4 Type of securities to be used or issued
14.5 Patterns of Capital Structure
14.6 Difference between Capital Structure and Financial Structure
14.7 Difference between Capital structure and Capitalization
14.8 Optimum Capital Structure
14.9 Features of an Appropriate Capital Structure
14.10 Factors determining Capital Structure
14.11 Technique of Planning the Capital Structure
14.12 Point of Indifference
14.13 Theories of Capital Structure
14.14 Dividend Policy
SEMESTER IV
COURSE CODE TITLE OF THE COURSE
31541/34041 ACCOUNTING AND FINANCIAL MANAGEMENT
Unit CONTENTS
No.
BLOCK 1: INTRODUCTION – FINANCIAL ACCOUNTING
1 Financial Accounting: Meaning and Scope – Principles – Concepts – Conventions
2 Accounting Process: Journal – Ledger – Trial Balance- Trading Account – Profit
and Loss Account – Balance Sheet
3 Accounting Ratio Analysis – Funds Flow Analysis – Cash Flow Analysis –
Computerized Account
BLOCK 2: COST AND MANAGEMENT ACCOUNTING
4 Introduction: Meaning Scope and Uses of Cost and Management Accounting –
Elements of Cost
5 Cost Sheet – Marginal Costing and Cost Volume Profit Analysis
6 Break Even Analysis: Concepts, Applications and Limitations
BLOCK 3: STANDARD COSTING AND BUDGETING
7 Introduction: Concept and Importance Standard Costing -Variance Analysis –
Material – Labor – Overhead – Sales – Profit Variances
8 Budgets and Budgetary Control – Meaning and Types of Budgets – Sales Budget –
Production Budget
9 Budgets: Cash Budget – Master Budget – Flexible Budgeting – Zero Base
Budgeting.
BLOCK 4: FINANCIAL MANAGEMENT
10 Introduction: Objectives and Functions of Financial Management – Risk – Return
Relationship – Time Value of Money
11 Capital Budgeting: Basic Methods of Appraisal Investments
12 Working Capital: Concepts of Working Capital, Factors affecting Working Capital
– Estimation of Working Capital Requirements
BLOCK 5: COST OF CAPITAL
13 Cost of Capital Structure and Dividend: Meaning and types of Cost of Capital –
Computation of cost for debt and equity - Sources of Capital and Weighted Average
Cost of Capital
14 Capital Structure Meaning and types of Capital Structure – Determinants of Capital
Structure – Types of Dividend Policy – Types of Dividend Decision.
Financial Accounting
BLOCK- I UNIT -I INTRODUCTION
NOTES
FINANCIAL ACCOUNTING
Structure
1.1. Introduction
1.2. Definition of Accounting
1.3 Accounting
1.4. Objectives of Accounting
1.5. Classifications of Accounting
1.6. Methods of Accounting
1.7. Accounting Terminology
1.8. Single Entry System of Book-Keeping
1.9. Difference Between Double Entry and Single-Entry System
1.10. Rules of The Double Entry System
1.11. Terms Used in Accounting
1.12. Functions of Financial Accounting
1.13. Accounting Concepts
1.14. Golden Rules of Book –Keeping or Accounting
1.15. Accounting Conventions
1.16. Accounting Equation
1.1. INTRODUCTION
A businessman invests capital with the objective of making profit and
thereby increasing his resources. He incurs various expenses like salaries,
rent and Stationery to operate his business. He receives income from
different sources like commission, interest and discount. He deals with
several persons in the course of buying and selling of goods, purchasing
and selling of assets and borrowing money for financing the business. He
acquires various properties and assets like building, machinery, furniture to
generate revenue.
Effective management of business requires control over expenses to reduce
the cost of operation and to make the business profitable. Assets must be
properly maintained to increase their productivity. Liabilities of a business
have to be prepaid in due time. Dealings with customers and suppliers must
be managed properly to keep them satisfied. In order to maintain property
in good condition, to repay debts in time, to reduce the expenses and to
increase sales, the businessman requires complete information about all his
business transactions.
In practice, it is impossible for any businessman to memorise and recollect
all his business dealings. Moreover, he will be interested in knowing at the
end of each year (i) what he owns? (ii) what he owes? (iii) how much profit
he has earned? (iv) what his financial position is? To relieve businessmen
from the burden of memorising all the business dealings and for providing
necessary information, Accounting was developed.
Businessmen also require accounting records to submit in courts to prove
their claims or to defend in courts against claims made by outsiders. They
are required to produce business records to tax authorities whenever
demanded. Similarly, financiers require accounting records of businessmen
to decide about sanctioning of loans. Thus, transactions relating to business
have become so important that their recording has become a necessity.
Self-Instructional Material
1
Financial Accounting 1.2. DEFINITION OF ACCOUNTING
NOTES According to the American Institute of Certified Public Accountants
(AlCPA) "Accounting is the art of recording, classifying and summarizing
in a significant manner and in terms of money transactions and events
which are of a financing character and interpreting the results thereof"
This comprehensive definition highlights in a logical sequence the
difference steps in the accounting process and some important attributes of
accounting. The following detailed explanation makes each of them clear.
1.3 ACCOUNTING
Accounting is a systematic record of the daily events of a business leads to
presentation of a complete financial picture. Accounting in its elementary
stages is called book-keeping. The modern system of accounting was
formulated by Lucas Pacioli an Italian, in the 15th century (1494). The
Institute of Certified Public Accountants defines accounting as the art of
recording, classifying and summarising in a significant manner and in
terms of money transactions and events which are in part at least, of a
financial character and interpreting the results thereof"
1.4. OBJECTIVES OF ACCOUNTING
i) To provide information about the whole activities of the business
enterprise both to the owners and the external groups.
ii) To provide useful information to investors and creditors, so that they
can take decisions on investment and lending.
iii) To effectively direct and control the organisation's human and material
resources.
iv) To facilitate social functions and control.
v) To provide information regarding accounting policies.
1.5. CLASSIFICATIONS OF ACCOUNTING
The following are the categories of accounting
i) Financial Accounting
ii) Cost Accounting and
iii) Management Accounting
i) Financial Accounting: Generally accounting denotes the financial
accounting. The main purpose of financial accounting is to record the
business transactions in the books of accounts which enables the
businessman to know the results.
ii) Cost Accounting: I.C.M.A. London, defines Cost Accounting as an
application of accounting and costing principles, methods and techniques
in the ascertainment of cost and the analysis of savings and / or excesses as
compared with past or with standards".
iii) Management Accounting: It is the method of accounting which useful
for managerial decisions. The data necessary for management accounting
are collected both from 'financial accounting and Cost accounting
1.6. METHODS OF ACCOUNTING
Basically, all methods of accounting are classified under two headings: -
1. Single entry system
2. Double entry system.
1.6.1. Single entry system
The term single entry is vaguely used to define the method of
Self-Instructional Material maintainingaccounts which do not conform to strict principles of double
entry. It is wrong todefine it as system. The term 'single entry' does not
2
mean that there is only oneentry for each transaction. It simply signifies Financial Accounting
that principles of double entry book-keeping have not been observed in all NOTES
cases. Under this system, only the personal accounts of the debtors and
creditors and cash book of the trader are maintained. Impersonal accounts
such as sales accounts, purchase accounts ignored. The absence of the two-
fold etc., as well as the assets accounts are effect of each transaction makes
it impossible to prepare a trial balance and to check the arithmetical
accuracy of the books of accounts, engendering a spirit of laxity and
inviting fraud and misappropriations. Owing to the absence of purchases
and sales accounts, the preparation of trading account is not possible.
Again Profit &Loss account and Balance Sheet cannot be prepared due to
the absence of nominal accounts and real accounts. Hence, single entry is
not only incomplete, but the final results are also not reliable.
Practically this system is followed by those firms whose transactions are
limited and at the same time, who maintain only the essential records.
There is no hard and fast rule for maintaining records under this system.
i.e., it depends the circumstances and the needs of the firm.
1.6.2. Double entry system
This system was invented by an Italian named LucoPacioli in 1494 A.D.
and it has spread all over the world, becoming as popular as Arabic
numerals. According to this system, every transaction has two aspects. One
is receiving aspect or incoming aspect and the other one is benefit giving or
outgoing aspect. The benefit receiving aspect is said to be a 'debit and
benefit giving aspect is said to be a 'credit'. For every transaction, one
accounts is to be debited and another account is to be credited in order to
have a come record of the transaction. Therefore, every transaction affects
two account Opposite direction.
For example, 'if furniture is purchased for cash', it is a monetary
transaction. Furniture is benefit receiving aspect, it is debited. Cash is
benefit giving as it is credited.
Therefore, the basic principle, under this system is that for every debit must
be a corresponding and equal credit and for every credit there must
corresponding and equal debit.
1.6.3. Meaning of debit and credit
The word Debit is derived from the Latin word Debit un which means
Debit that. In short, the benefit receiving aspect of a transaction is known
as de
The word Credit is derived from the Latin word Creditor which means Due
for that. The benefit giving aspect of a transaction is known as credit.
The abbreviations 'Dr' for debit and 'Cr' for credit are usually used.
By convention, the left-hand side of an account is termed as debit side right
hand side of an account is termed as credit side.
1.6.4. Advantages of Double Entry System
(i) Complete record: Double entry system enables businessmen to keep
complete, systematic and accurate record of all business transactions.
Detail any transactions or events can be verified at any time.
(ii) Ascertainment of Profit or loss: The systematic record maintained
under double entry system enables a business to ascertain the result of
business operations for any given period. The owners can know the
profitability of but operations periodically.
3
Financial Accounting (iii) Knowledge of financial position: With the help of Real and Personal
accounts, the financial position of the business can be ascertained with
NOTES
accuracy. This is done by preparing balance sheet.
(iv) A check on the accuracy of accounts: Under the double entry. Every
debit has a corresponding credit'. The arithmetical accuracy of the can be
tested by preparing a statement called 'Trial Balance'.
(v) NO scope for fraud: The firm is saved from frauds and
misappropriations since full information about all assets and liabilities will
be available.
(vi) Tax authorities: The businessmen can satisfy the tax authorities if he
maintains his accounts books properly under the double entry system.
(vii) Amount due from customers: The account books will reveal the
amount due by customers, reminders can be sent to the customers who do
not settle their accounts promptly.
(viii) Amount due to suppliers: The trader can ascertain from the books of
accounts the sums he owes his creditors and make proper arrangements to
pay them promptly.
(ix) Comparative study: Results of one year may be compared with those
of previous years and reasons for the change may be ascertained.
1.7. ACCOUNTING TERMINOLOGY
It is necessary to understand some basic accounting terms which are
routinely used in business world. The following are some of the important
terms which enable a student to comprehend accounting in a better way:
1. Capital: It represents owners' funds invested in a business. It may be the
original amount invested by the owner or original contribution adjusted for
profits and drawings. It is also known as owners’ equity or net worth.
Capital represents owners' claim against the assets of the business. It is
equal to the total assets minus outside liabilities.
2. Liability: It represents temporary interest of outside creditors in the
assets of a business. In the words of Finny and Miller, "Liabilities are
debts; they are amounts owed to creditors; thus, the claims of those who
are not owners are called liabilities"
In simple terms, debts repayable to outsiders by the business are called
liabilities.
4. Revenue: It is defined as the inflow of assets which results in an
increases in the owners' equity. It includes all incomes like sales receipts,
interest, commission, brokerage etc. However, receipts of capital nature
like addition capital, sale of assets etc., are not a part of revenue.
5. Expense: It is any amount spent in order to produce and sell the goods
and services which bring in the revenue. Expense may be defined as the
cost of the use of things or services for the purpose of generating revenue.
Expense can be capital expense and revenue expense. Capital expense
generates revenue over several accounting years. Revenue expense
generates revenue in the current accounting year.
Capital expense includes acquisition of long-term assets like machinery
whereas revenue expense includes current expenses like salary, rent,
lighting etc.,
6. Debtors: A person who receives a benefit without giving money or
money or money’s worth immediately but, liable to pay in future is a
debtor. Debtor can be a 'trade debtor' if he buys goods on credit. Others are
non-trade debtors.
4
7. Creditors: A person who gives a benefit without receiving money or Financial Accounting
money's worth immediately but, liable to claim in future is a creditor. NOTES
Creditor can be a ‘trade creditor' if he supplies good son credit. Others are
non-trade creditors.
8. Tangible Assets: Assets which have physical existence. i.e., they can be
seen on felt or touched, are termed as tangible assets. Examples: cash,
machinery, buildings.
9. Intangible Assets: Assets which have no physical existence. i.e., they
cannot be seen or felt or touched, are termed as intangible assets.
Examples: goodwill, patent rights, copyrights.
10. Fictitious Assets: Items shown along with other assets on the assets
side of a balance sheet, but representing unadjusted losses are termed as
fictitious assets. Examples: preliminary expenses, profit and loss account
debit balance etc.
11. Wasting Assets: Those assets which certainly lose value with usage are
earned as wasting assets. Mines, forests etc., become waste once the
mineral usefully extracted or the timber is fully cut.
12. Fixed Assets: Assets acquired for income generation, but not for resale
are called fixed assets. The benefit from them is derived for a longer period
than one year. (e.g.,) machinery.
13. Current or Floating Assets: Those assets which are converted into
cash on normal course of business in less than one year are termed as
current or floating assets. (e.g.,) stock, debtors.
14. Purchases: Buying of goods with the intention of resale is called
purchases. If cash is paid immediately for the purchase, it is cash
purchases. If the payment is postponed, it is credit purchases.
15. Sales: Selling of goods in the normal course of business is termed
assets. If the sale is for immediate cash payment, it is cash sales. If
payment for sales is postponed, it is credit sales.
16. Stock: The term 'stock' refers to goods lying unsold on a specified date.
The stock of goods at the end of the accounting period is called 'closing
stock and the stock of goods at the beginning of an accounting period is
called 'opening stock'.
17. Losses: 'Loss' really indicates something against which a firm receives
no benefit. It represents money given up without any return. It may be
noted that expense leads to revenue, but losses do not. (e.g.,) loss due to
fire, theft and damages payable to others.
18. Drawings: Any amount of money or money's worth withdrawn by the
owners of the business is termed as drawings. It is usually subtracted from
capital.
19. Invoice: It is a statement prepared by a seller of goods to be sent to the
buyer. It shows details of quantity, price, value etc., of the goods and any
discount given, finally showing the net amount payable by the buyer.
20. Voucher: It is the written record and evidence of a transaction. So,
documentary evidence of any transaction is called a voucher. Vouchers are
essential for audit of accounts. Example: cheque book counterfoils, cash
receipts, invoices.
21. Goods: The term 'goods' includes all merchandise, commodities etc., in
which a trader deals in the normal course of business. Thus, commodities
bought for resale are treated as goods. For a furniture dealer, furniture is
goods but for other firms’ furniture is an asset.
5
Financial Accounting 22. Current liability: Those liabilities which are payable within one year
in the normal course of a business are termed as current liabilities.
NOTES
Example: creditors, bills payable.
23. Long term Liabilities: Liabilities repayable beyond a period of one
year are treated as long term liabilities. Example: bank loans, mortgage
loans.
24. Solvent: A person who has assets with realisable values which exceed
his liabilities is solvent.
25. Insolvent: A person whose liabilities are more than the realisable
values of his assets is called an insolvent.
1.8. SINGLE ENTRY SYSTEM OF BOOK-KEEPING
It is the method of maintaining accounts which does not exactly follow the
principles of double entry system. Under this system, only the cash book
and personal ledgers are maintained, i.e., the real and nominal accounts are
not maintained under this system. No fixed assets, purchases, sales,
expenses income accounts etc., can be found under this system.
As Trial Balance can't be prepared, the accuracy of accounts can't be
ascertained. Also, it is not possible to prepare the final account and Balance
Sheet under this system. Therefore, this system is an unscientific system
1.9. DIFFERENCE BETWEEN DOUBLE ENTRY AND
SINGLE-ENTRY SYSTEM
S.No Double entry system Single entry system
1 Both debit and credit aspects of a Only one aspect of a transaction is
transaction are recorded. recorded.
2 All the three accounts namely Only personal accounts and cash
Personal, Real and Nominal – are accounts are maintained.
maintained.
3 For every debit there is a There may be a debit without a
corresponding and equal credit. corresponding and equal credit.
4 Trial Balance can be prepared. Trial Balance can't be prepared.
5 Trading, Profit & loss a/c and Trading, Profit & loss a/c and balance
balance-sheet can be prepared sheet can't be prepared directly.
6 Accurate net profit can be Only approximate profit can be
calculated. calculated.
7 It is a perfect and scientific It is an imperfect and unscientific
system. system.
8 It involves more clerical work. It involves less clerical work.
9 Tax authorities accept this Tax authorities do not accept as such.
method.
10 Arithmetic accuracy can be No arithmetic accuracy can be checked.
checked.
1.10. RULES OF THE DOUBLE ENTRY SYSTEM
Types of Accounts: -
A business may have dealings
i) with persons, firms, institutions, companies etc.,
ii) with assets and liabilities
iii) expenses and income
Based on these dealings the accounts are classified into three
category, namely,
a) Personal Account b) Real Accounts c) Nominal
Accounts
6
a) Personal Accounts: It deals with accounts relating to persons, firms, Financial Accounting
companies and man-made institutions. It is further classified into three as NOTES
shown below:
Personal Accounts
Natural Person’s Artificial Persons’ Representatives’

personal Account Personal Account personal Accounts. It
(e.g. customers, (e.g. Banks, firms, represents the
Bala, Mohan etc.,) companies Clubs persons. ( e.g. Capital
etc.,) Drawings,
outstanding Liabilities
b)Real Account: It deals with accounts relating to the properties
ets.,) and assets
of the business. (e.g., Cash a/c, furniture a/c, land and buildings a/c,
machinery a/c, shares a/c, goods (purchases and sales) a/c.
Real Account
Tangible Intangible
C) Nominal Account: It deals with those items which exist in names only.
i.e., it deals with items of income and expenditures. (e.g. rent, salary,
commission, discount, dividend received, depreciation, etc.,).
1.11. TERMS USED IN ACCOUNTING
i) Business Transactions:
Any exchange of money or money's worth as goods and services between
two parties is called a business transactions.
ii) Capital:
This is the owner's financial holding in the business.
iii) Assets:
Any physical thing or right owned that has a money value is an asset.
iv) Liabilities:
The equities of creditors represent debts of the business are called
liabilities.
v) Debtors:
A person who owes money to the business is called debtors.
vi) Debt:
The amount due from a debtor is called debt.
vii) Book debt:
The amount due from a person as per the books of account is called a book
debt.
viii) Creditor:
A person to whom money is payable is called a creditor.
ix) Goods:
This includes all articles, commodities or merchandise a business deals. Self-Instructional Material
x) Income:
7
Financial Accounting Income is the favourable change in owner's equity results from business
operations.
NOTES
xi) Expense:
It is an expenditure whose benefit is enjoyed immediately.
xii) Drawings:
Any amount or goods withdrawn by the owner of a business for personal
use is called drawings.
xii) Turnover:
Total trading income from cash sales and credit sales is called turnover
1.12. FUNCTIONS OF FINANCIAL ACCOUNTING
The following are the functions of financial accounting.
a) Record Keeping Function:
The primary function of financial accounting relates to recording,
classification and summary of financial transaction and preparation of
financial statements.
b) Protection of Properties Function:

Another important function of financial accounting is to protect
'he properties of the business. This is done for proper utilisation of the asset
and its proper valuation in the books of the accounts.
c) Communication of Results Function:
It is the duty of accountant to communicate the results obtained by
arranging and classifying data to interested parties like proprietors,
investors, creditors, employees and government.
d) Legal Requirement Function:
Auditing is compulsory in case of registered firms. Auditing is not
possible without accounting. Thus, accounting becomes compulsory to
comply with legal requirements. Accounting is a base and with its help
various returns, documents, statements and the like are prepared.
1.13. ACCOUNTING CONCEPTS
Accounting is the language of business. The basic assumptions of
conditions upon which the science of accounting is based on the concepts
of accounting. The different concepts of accounting are given below:
i) Business Entity concept: This concept denotes that a business unit is
separate and distinct from the owners. Therefore, it is necessary to record
the business transactions separately to distinguish from the owner's
personal transactions. This concept has now been extended to accounting
for various divisions of a firm in order to ascertain the results of each
division.
ii) Going concern concept: It is assumed that the business will exist for a
long time and transactions are recorded from this point of view. That
people may come and go, but business remains, is the principle of this
concept Hence, proper classification of expenses (capital and revenue) is to
be made.
iii) Money measurement concept: Accounting records only those
transactions which are expressed in terms of money. The use of building
and the use of clerical services can be added up only through money values
and not otherwise
iv) Cost concept: The transactions are entered in the books of accounts at
the amounts involved. For example: if a firm purchases a land for Rs.
Self-Instructional Material 2,00,000 but considers it as worthy Rs. 4,00,000 the purchase will be
8
recorded at Rs. 2,00,000 and not at anymore. This is one of the most Financial Accounting
important concepts. NOTES
v) Dual - Aspect Concept: Each transaction has two aspects. If a business
has acquired an asset, the asset which comes in this is one aspect. To
acquire the asset the business has to pay money (cash or bank) which goes
out – this is another aspect. If it is acquired for credit, a liability arises to
that extent. Thus, if there is an increase in assets, there will be an increase
in liability also.
Assets = Liabilities + Capital (or) Capital = Assets - Liabilities.
vi)Realisation concept: Accounting is a historical record of transactions. It
records what has happened. Unless money has been realised - cither cash
has been received or legal obligation to receive from the customer - no sale
can be said to have taken place and no profit or income can be said to have
arisen
1.14. GOLDEN RULES OF BOOK –KEEPING OR ACCOUNTING
As a every transaction has two aspects (i.e., debt aspect, credit
aspect) to record, which aspect is to be debited and which is to be credited
is to be analysed. They are to be recorded based on the following rules:
Personal Accounts DEBIT THE RECEVIER
CREDIT THE GIVER
Real Accounts DEBIT WHAT COMES IN
CREDIT WAS GOES OUT
Nominal Accounts DEBIT ALL EXPENSES AND LOSSES
CREDIT ALL INCOME AND GAINS
1.15. ACCOUNTING CONVENTIONS
1.15.1. Convention of Full Disclosure
According to this convention, all accounting statements should be prepared
honestly. This should be evident through the transparency of the
statements. The statement should disclose fully all the significant
information. Facts, figures and the details which are of material interest to
the owners, investors, creditors etc., must be clearly presented in the
financial statements. This type of disclosure needs proper classification,
summarisation, aggregation and explanation of the numerous business
transactions.
The convention of disclosure is gaining importance due to the shift in the
growth of business organisations. Modern business world is dominated by
joint stock companies where ownership is completely separated from the
management The Companies Act 1956, has made several provisions for the
disclosure of essential information by companies. Detailed form and
schedules are prescribed by the Act. The basis for valuation of investments
and inventories has to be specifically stated. Contingent liabilities have to
be listed out. The scope for concealment of information by joint stock
companies is very limited.
The footnotes, comments, descriptive captions, supplementary
schedulesDal etc., in the accounting reports are an invaluable aid for full
disclosure. For example, market value of investments may be given as a
foot note. Revaluation reserves included in the reserves and surpluses may
be indicated through a separate caption. The full disclosure does not imply
providing any information required by anybody or revealing trade secrets
and strategies. But the legitimate demands for information of the interested
parties like shareholders and creditors should usefully satisfied.
9
Financial Accounting 1.15.2. Convention of Consistency
The basic aim of the doctrine of consistency is to preserve the
NOTES
comparability and reliability of financial statements. According to this
convention, the rules, practices and concepts used in accounting should be
continuously observed and applied year after year. Comparisons of results
among different accounting periods can be significant and meaningful only
when consistent practices were followed in ascertaining them. Valuation of
stock can be done in different acceptable ways like average price method
or cost price method. It can also be based on cost or market price
whichever is lesser. Similarly, depreciation can be provided under different
methods; investments can be valued in several ways. Whichever method or
practice is followed, it should be followed regularly. If any change is
implemented it must be clearly indicated with reasons for the change.
According to E.L. Kohler, consistency can be at three levels - vertical,
horizontal and dimensional.
Vertical consistency refers to consistency in the various aspects of financial
statements in the same year in a firm.
Horizontal consistency refers to consistency of practices between different
years in a firm
Dimensional consistency refers to consistent accounting practices in the
financial statements of different firms in the same industry.
Consistency serves the purpose of eliminating personal bias, whims and
fancies of the accountants. They will have to follow consistent rules,
practices and methods. The convention of consistency makes the financial
statements more reliable and comparable for the needs of the end users.
1.15.3. Convention of Materiality
Materiality means 'relative importance'. All-important items and facts
should be disclosed in accounting statements. Unimportant and immaterial
details need not be separately given. Otherwise, the accountant becomes
overburdened with unnecessary details. For example, a plastic container for
drinking water can be clubbed with general expenses instead of separately
being disclosed as an asset.
According to the American Accounting Association (AAA) "An item
Should be regarded as material if there is reason to believe that knowledge
of it Would influence the decision of informed investor". The test of
materiality can be applied to three aspects. (i) information,(ii) amounts and
(iii) procedures.
(i) Loans to directors and employees can be material information and
should be separately disclosed, as per Banking Companies Regulation Act.
(ii) Adjusting amounts to the nearest Rupee is based on materiality of
amounts.
(iii) Disclosing procedural changes in valuation of inventories is based on
materiality of procedures.
The term 'Material' is subjective, amenable for interpretation of individual
accountants. Similarly, what is material in one firm may be immaterial for
another firm. What is material in one accounting year may not be so in the
subsequent years. Despite these limitations, maximum possible material
details should be provided in the financial statements.
1.15.4. Convention of Conservatism
Conservatism is a policy of caution or ‘playing safe’. It demands taking a
'gloomy' view of a situation. Conservatism is the defensive accounting
mechanism against 'uncertainty'. According to Kohler, "Conservatism is a
10
guideline which chooses between acceptable accounting alternatives for Financial Accounting
recording events and transactions so that the least favourable immediate NOTES
effect on assets, income and owner's equity is reported".
Uncertainty is unavoidable in the estimation of useful life of assets,
contingent liabilities, realisation of receivables etc. The convention of
conservatism demands that the least favourable situation to the firm will
materialise and precaution should be taken on that basis.
When stocks are valued, the usual principle followed is 'cost or market
price whichever is lower'. If market price is more than cost, stock is shown
at cost only All provisions like provision for doubtful debts, provision for
discount on debtors, provision for contingencies are based on the
convention of conservatism. Conservatism may result in understatement of
assets and income and overstatement of provisions and liabilities. This may
result in secret reserves. Over emphasis on conservatism may bring about a
conflict with the convention of full disclosure. Conservatism, within limits,
serves a useful purpose. It should not be taken to extremes where it can
distort the operating results and financial position of a business unit.
1.16. ACCOUNTING EQUATION
Accounting equation is a statement of equality between debits and the
credits. It explains that the assets of a business are always equal to the total
of liabilities and capital. It is also called balance sheet equation.
Assets = liabilities +capital (or) A = L + C
Assets are the total value of the properties owned by the business.
Liabilities are the rights of third parties to the properties of the
business or the among due by the business to the third parties.
Capital is the initial amount or assets contributed by the proprietor
to start the business.
Dual aspect concept is the basis for rules of debit and credit used in the
Double entry system of book - keeping. According to this concept, every
business transaction recorded in accounts has two aspects-giving of benefit
and receiving of benefit. The former is the credit aspect and the latter the
debit aspect. Both the aspects have to be recorded in accounts
appropriately. American accountants have derived the rules of debit and
credit through a 'novel' medium i.e., accounting equation. The equation is
as follows: Assets= Equities.
The basis for the equation is the principle of 'Rights'. Accounting deals
with property and rights to property. The total of the properties owned by a
business’s equal to the total of the Rights' to the properties. The properties
owned by a business are called assets. The rights to properties are called
equities.
Equities can be sub-divided into equity of the owners which is known as
capital and equity of creditors who represent the debts of the business
known as liabilities. These equities may also be called internal equity and
external equity. Internal equity represents the owners' equity in the assets
and external equity represents the outsiders' interest in the assets. Based on
the bifurcation of equity, the accounting equation can be restated as
follows:
Assets Liabilities+ Capital (or) Capital Assets - Liabilities.
When a business is started, entire resources needed may be supplied by the
owner or owners. Later on, additional funds may be mobilised through
credit purchases and loans. For example, Gokul starts a business with a Self-Instructional Material
capital of Rs. 10,000, the accounting equation will be
11
Financial Accounting Gokul's Capital Rs. 10,000 Cash Rs. 10,000
The Balance Sheet on that date appears as follows:
NOTES
Balance Sheet of Gokul as on……….
Capital & Liabilities. Amount (Rs.) Property & Assets Amount (Rs.)
Gokul's capital 10,000 Cash 10,000
The balance sheet of a business is an expression of the accounting
equation.
It is also called balance sheet equation. It shows the relationship between
assets of the business and capital and liabilities.
1.16.1. Rules for Accounting Equation
The following 'rules' help in understanding the accounting equation clearly.
(1) Capital: When capital is increased, it is credited, when capital is
withdrawn, it is debited.
(2) Outsiders' liabilities: When liabilities increase, outsiders' accounts are
credited. When liabilities decrease, their accounts are debited.
(3) Revenue Income: Owner's equity is increased by the amount of revenue
income.
(4) Revenue Expense: Owner's equity is decreased by the amount of
revenue expenses.
(5) Assets: If there is increase in assets, the assets, accounts are debited. If
there is decrease in assets, the assets' accounts are credited.
1.16.2. Interaction between assets and liabilities and their effect on
Accounting Equation:
(a) Sometimes, one asset decreases, and another asset increases due to
transaction. For example, when debtors are collected, debtors decrease and
cash increases. This does not change the accounting equation.
(b) One liability decrease, and another liability increases due to a
transaction for example, creditors are paid through bank overdraft.
Creditors decrease and bank overdraft increases. This transaction also does
not alter the total figures in the accounting equation.
(c) Assets may increase and correspondingly liabilities may increase due to
some transactions. For example, loan taken from bank increases cash on
the assets side and bank loan on the liabilities side. This transaction alters
the total figures in the accounting equation.
(d)Assets decrease and liabilities also decrease correspondingly due some
transactions. For example, creditors paid in cash decreases creditors on
liabilities side and cash on the assets side.
1.16.3. Check Your Progress
1. What is accounting? What are its objectives?
2. Explain the golden rules of bookkeeping.
1.16.4. Answers to Check Your Progress Questions
1. Accounting is a systematic record of the daily events of a business leads
to presentation of a complete financial picture.
Objectives:
i) To provide information about the whole activities of the business
enterprise both to the owners and the external groups.
ii) To provide useful information to investors and creditors, so that they
can take decisions on investment and lending.
iii) To effectively direct and control the organisation's human and material
resources.
iv) To facilitate social functions and control.
v) To provide information regarding accounting policies.
12
2. Financial Accounting
Personal Accounts DEBIT THE RECEVIER NOTES
CREDIT THE GIVER
Real Accounts DEBIT WHAT COMES IN
CREDIT WAS GOES OUT
Nominal Accounts DEBIT ALL EXPENSES AND LOSSES
CREDIT ALL INCOME AND GAINS
Self-Assessment Questions and Exercise:
1) What is Double entry system of book-keeping? Explain its advantages?
2) What is accounting equation?
3) What are accounting concepts and conventions? How are they evolved?
4) What are accounting conventions? Explain them.
5) What are the functions of financial accounting?
6) How does double entry system of accounting differ from single entry
system of accounting?
Further Reading:
1. Financial Accounting, Paul, S.K. 4th ed, New Central Book Agency
Pvt. Ltd.
2. Financial Accounting, Jain S.P., Narang K.L., Kalyani Publishers,
Delhi
3. Advanced Accountancy, Hrishikesh Chakraborty, Oxfort
University Press
4. Fundamentals of Advanced Accounting, R.S.N. Pillai Bagavathi,
Sultan Chand Publications
13
Accounting Process
NOTES
UNIT II– ACCOUNTING PROCESS
Structure
2.1. Journal
2.2. Difference Between Trade Discount and Cash Discount
2.3. Ledger
2.4. Trial Balance
2.5. Trading Account
2.6. Profit and Loss Account
2.1. JOURNAL
Journal is derived from the French word ‘Jour’ which means a day. Journal
means a daily record. It is a book original record to record every
transaction in the first instance before it is posted to the ledger. The form in
which it is recorded is called journal entry and recording or entering a
transaction in the journal is known as journalising.
Below each journal entry, a brief explanation of the transaction is given
within brackets. This is called ‘Narration’.
2.1.1 Rules for journalising
The journal has five columns as given below:
Date Particulars l.F DebitRs. CreditRs.
(1) (2) (3) (4) (5)
Year Name of the a/c to be Rs. P. Rs. P.
Month debited Name of the a/c Amount Amount
Date credited (narration)
Column: 1 The date of transaction is written in the first column with the
year on the top.
Column: 2 In this column the accounts to be debited and credited are
written.
Column: 3 L.F means Ledger Folio. This column cannot be filled, when
rerecord the transaction; but only when the entries are posted to certain
pages of the ledger, we can fill in ‘Ledger Folio’ column. The debit aspect
goes to a specified a/c found on a certain page of the ledger. On the other
hand, the credit aspect is taken to a different a/c found on a different page.
These page numbers are written in L.F column so that we can have a cross
reference.
2.1.2. Compound Journal
Suppose there are two or more transactions of a similar nature
occurring on the same day and either Debit or Credit account is common.
Such transactions can be conveniently recorded in the form of one journal
entry instead of making a separate entry for each transaction. Such entries
are called compound Journal entries.
Example: Stationery a/c Dr.
Rent a/c Dr.
Salaries a/c Dr.
To cash a/c
(Being payment of stationery, Rent and salaries made)
2.1.3. Advantages of Journal
i. It provides a chronological record of all transactions and hence acts
as a permanent record.
ii. It provides the information of debit and credit in an entry and an
explanation for a proper understanding.
iii. It reduces the possibility of error as both aspects of a business
transaction are written side by side.
iv. It provides information relating to various aspects like, transfer Accounting Process
entries and closing entries. NOTES
2.1.4. Limitations of Journal
i. All transactions in the journal, make it too long and unwieldy.
ii. It is not possible to ascertain daily cash balance, from the journal.
iii. It becomes difficult in practice to post each and every transaction
from the journal to the ledger. Hence, in order to make the
accounting easier and systematic, transactions are recorded in total
in different books.
2.2. DIFFERENCE BETWEEN TRADE DISCOUNT AND CASH
DISCOUNT
Trade Discount Cash Discount
It is allowed at the time of sales (or) It is allowed at the time of payment.
purchase
It is given to promote sale It is allowed to encourage early cash
payment
It is shown as a deduction in the It has nothing to do with the invoice
invoice.
Entry is not made in the account book. Entry is made in the account book.
Separate ledger accounts are opened for
‘Discount received’ and for ‘Discount
allowed”.
The object is to enable the buyer to sell The object is to induce the debtors to
at the catalogue price. pay their dues promptly.
It is allowed or not allowed according It is allowed only one a condition. The
to sales policy followed by a business dues should be paid within the
concern. stipulated time. If not, the debtors are
not eligible for cash discount.
It is usually given in percentage. It is It may be given in percentage or in
given on the list price or catalogue absolute figure.
price or retail price.
Illustration 1
Journalise the following transactions: 2008 Jan.
11 Purchased goods for Rs. 1,500.
12 Purchased goods from GK stores Rs. 900
13 Sold goods for Rs. 1,100
14 Sold goods to Raju Rs. 250
15 Bought furniture for cash Rs. 2,000
16 Bought furniture from JFA furniture mart Rs. 800
17 Goods returned to GK stores Rs. 200
18 Raju returned goods worth Rs. 100
19 Drew for private use Rs. 500
20 Electric charges amounted to Rs. 120
Solution: Journal Entries
Date Particulars l.F Debit Rs. Credit Rs.
2008 Purchases a/c Dr. 1,500
Jan. To cash 1,500
11 (Being cash purchase made)
Purchases a/c Dr. 900
12 To GK stores 900
(Being credit purchase made)
Cash a/c Dr. 1,100
13 To sales 1,100 Self-Instructional Material
(Being cash sales made)
15
Accounting Process Raju a/c Dr. 250
NOTES
14 To sales 250
(Being credit sales made)
Furniture a/c Dr. 2,000
15 To cash 2,000
(Being the furniture purchased for
cash)
Furniture a/c Dr. 800
16 To JFA furniture mart 800
(Being the furniture purchased on
credit)
Gk Stores a/c Dr. 200
17 To Purchase return 200
(Being the goods returned to GK
stores)
Sales return a/c Dr. 100
18 To Raju 100
(Being the goods returned from
Raju)
Drawings a/c Dr. 500
19 To cash 500
(Being the cash drew for private
use)
Electric charges a/c Dr. 120
20 To cash 120
(Being electric charges paid)
Illustration 2
Give journal entries for the following transactions.
1. Start business with cash Rs. 60,000.
2. Opened a business bank account with a deposit of Rs. 20,000.
3. Purchased machinery for Rs. 22,000 pay cash of Rs. 15,000 and the
balance on account.
4. Earned commission in cash Rs. 900.
5. Withdrew cash Rs. 2,700 from bank.
6. Paid office rent Rs. 1,100.
Solution: Journal Entries
Date Particulars l.F Debit Rs. Credit Rs.
1. Cash a/c Dr. 60,000
To Capital 60,000
(Being cash brought in to start
business)
2. Bank a/c Dr. 20,000
To Cash 20,000
(Being bank a/c opened)
3. Machinery a/c Dr. 22,000
To Cash 15,000
To Supplier account 7,000
(Being the machinery purchased
by paying a cash of Rs. 15,000 and
the balance on credit)
4. Cash a/c Dr. 900
To Commission earned 900
(Being the commission earned in
cash)
5. Cash a/c Dr. 2,700
To Bank 2,700
(Being the cash withdrew from
bank) Accounting Process
6. Rent a/c Dr. 1,100
NOTES
To cash 1,100
(Being the office rent paid)
2.3. LEDGER
Ledger is a register with of pages numbered consecutively. Each account is
allotted one or more pages in the ledger. If one page is complete, the
account will be continued in the next or some other page. An index of
various accounts opened in the ledger is given at the beginning of the
ledger for the purpose of easy reference.
2.3.1. Advantages of keeping a ledger
1. Ledger gives information regarding all transactions of a particular
account whether it is a personal a/c, Real a/c or Nominal a/c
2. The final effect, of a series of transactions of a certain customer (or)
a certain property (or) a certain expenses is known at a glance.
3. Leger provides immediately the totality of certain dealings. For
(e.g) Total purchases, Total sales, Total expenditure on a specified
head etc.
4. It is useful in preparation of trial balance.
5. It facilitates the preparation of the final statement such as trading
a/c, profit & loss a/c and balance sheet.
2.3.2. Ledger account
A ledger account is nothing but a summary statement of all
transactions relating to a person, asset, expense or income, which have
taken place during a given period of time showing their net effect.
Proforma of a Ledger account
Dr. Name of the account Cr.
Date Particular J. Amount Date Particular J. Amount
F F
year To (Name if Rs. p year To (Name if Rs. p
Month credit element) Month debit element)
date date
2.3.3. Methods of Balancing a Ledger Account
a) The bigger total is taken first and it is written on both sides of the
account. One the smaller side the balance is written above the total
next to the last entry on that side. This method is more commonly
used.
b) In the next method the totals are written on both sides, one sides
showing smaller and the other side showing bigger amount. The
difference is written in the smaller side below the smaller total.
After doing so, grand totalling is made on both sides. Obviously,
they will be equal. This method is used only in certain concerns like
the electricity companies.
2.3.4. Differentiate Journal from Ledger
Journal Ledger
It is the book of original entry It is the main book of accounts
Entries are made as and when Entries are posted at eh convenience
transactions occur. of the trader.
Transactions are entered in the Transaction are recorded on the basis
chronological order (ie) according to of the account to which they belong.
the dates of transaction.
Transactions pertaining to a person Transactions relating to a particular
(or) property (or) expenses are spread account are found together on a
over a number pages. particular page or pages even if they
17
Accounting Process have occurred on different dates.
NOTES The final position of a customer The final position can be ascertained
(Debtor or Creditor) Cannot be found just at a glance as the transaction are
out unless one wades through the written together on a page or pages in
entire book the appropriate sides (Debit and
Credit side) of the account
It is so ruled as to show the total It is so rules as to show the dates on
number of transactions that occur day which a particular a/c is debited or
after day. credited
Journal losses its importance after the It will never lose its importance
transactions are posted to the ledger. because it is the main book of
accounts which is relied upon.
Tax authorities do not rely upon this Tax authorities rely on the ledger for
book. assessment purpose.
Illustration 1
Prepare ledger accounts for the following transactions: 2009 May
1 Mr. Ajith started business with cash Rs. 75,000
1 Purchased machinery for Rs. 12,000
3 He opened an account with Indian Bank Rs. 20,000
5 Goods purchase form kamala Rs. 15,000
10 Paid to kamala in full settlement Rs. 14,500
14 Goods sold to Mr. Balaji Rs. 20,000
16 Cash received from Mr. Balaji Rs. 5000
18 Goods purchased for Rs. 10,000
25 Goods sold for Rs. 25,000
31 Interest on capital @ 10% for the month.
31 Depreciate machinery @ 10% for the month.
Solution
Dr. Cash account Cr.
Date Particular J. Amount Date Particular J. Amount
F F
2009 2009
May To Capital a/c 75,000 May 1 By Machinery 12,000
1 To Balaji 5,000 3 By Indian 20,000
16 To Sales 25,000 5 Bank 14,500
18 By kamala 10,000
25 By Purchases 48,500
31 By Balance c/d
1,05,000 1,05,000
June To Balance b/d 48,500
1
Dr. Capital account Cr.

Date Particular J.F Amount Date Particular J.F Amount
2009 2009
May To Balance c/d 75,625 May By cash 75,000
31 1 By Int. on. cap 625
75,625 75,625
Dr. Machinery account Cr.

2009 2009
Self-Instructional Material May To Cash 12,000 May By 100
1 1 Depreciation 11,900
By Balance
c/d
12,000 75,625 Accounting Process
Dr. Indian Bank account Cr. NOTES

2009 2009
May To Cash 20,000 May By Balance 20,000
3 31 c/d
20,000 20,000
1
Dr. Purchase account Cr.

2009 2009
May To Kamala 15,000 May By Balance 25,000
5 To Cash 10,000 31 c/d
25,000 25,000
1
Dr. Kamala account Cr.

2009 2009
May To Cash 14,500 May By Purchase 15,000
10 To Discount 500 5
15,000 15,000
Dr. Discount account Cr.

2009 2009
May To Balance 500 May By Kamala 500
31 c/d 10
500 500
June By Balance 500
1 b/d
Dr. Sales account Cr.

2009 2009
May To Balance 45,000 May By Balaji 20,000
31 c/d 14 By Cash 25,000
May
25
45,000 45,000
June 1 By Balance 45,000
b/d
Dr. Balaji account Cr.

2009 2009
May To sales 20,000 May By cash 5,000
14 16 By Balance 15,000
31 c/d
20,000 20,000
1 Self-Instructional Material
19
Accounting Process Dr. Interest on capital account Cr.
NOTES Date Particular J.F Amount Date Particular J.F Amount
2009 2009
May To Capital 625 May By Balance 625
31 31 c/d
625 625
June To Balance b/d 625
1
Dr. Interest on capital account Cr.

2009 2009
May To Machinery 100 May By Balance 100
31 31 c/d
100 100
June To Balance b/d 100
1
2.4. TRIAL BALANCE
A trial balance is the list of balances extracted from the ledger account
prepared to check the arithmetic of accounts.
2.4.1. Objectives of Trial balance
i. The trail balance is prepared to check the arithmetic accuracy of
accounts.
ii. Errors in the accounts are disclosed. But there are some errors that
are not disclosed by trial balance.
iii. It is useful in the preparation of the final account.
iv. It helps to prepare the trading, profit and loss account.
v. It also helps to prepare the balance sheet.
vi. It is the lucid form of the accounts prepared.
2.4.2. Definition
Trial balance can be defined as “A list of all balances standing on
the ledger accounts and cash books of a concern at any given time”.
2.4.3. Specimen form of a Trial balance
Trial Balance as on .....
S. No. Name of accounts L.F Debit Credit
1.
Total
2.4.4. Preparing Trial Balance
As the balances are to be extracted from the ledger accounts, first
go to the ledger accounts of each and every head of accounts, see the
amount appearing in the ‘balance c/d’ and the side it appears.
Post it to the Trail Balance by writing the name of account to the
respective side.
Now total the debit column and credit column in the Trial balance.
Both the totals should tally with each other if not verify the posting,
totalling, carry forward and transferring to the Trial Balance.
For this purpose, the following rules are worth remembering
Debit balances Credit balances
Assets Liabilities
Expenses Incomes
Losses Gains
Self-Instructional Material Drawings Capital
Opening stock Reserves & Provisions
2.4.5. Methods of Trial Balance Accounting Process
1. Balance Method NOTES
2. Total Method
1. Balance Method
This method is used in preparing the trial balance from the ledger
account. Under this method the ledger accounts are balanced, and the
balance is carried forward to trial balance. The excess of debit over credit
is called debit balance and written in the debit is called credit balance and
written on the credit side of the trial balance. Both the debit side and the
credit side of the trial balance total should tally.
2. Total Method
Under this method, the total of the debit side and the credit side of
every ledger account is separately written in the debit and credit column of
the trial balance.
Suspense account
When the trial balance does not agree with each side, the different
is placed to a temporary account called suspense account. This suspense
account will be closed after locating the errors and the same have been
rectified.
Illustration 1
From the under mentioned balances, prepare a trial balance as on 31.3.2007
Particulars Rs. Particulars Rs.
Cash in hand 4,800 Furniture 60,000
Purchases 4,80,000 Bills receivable 80,000
Opening stock 1,40,000 Salaries 80,000
Sundry creditors 96,000 Capital 4,00,000
Machinery 2,40,000 Bills payable 88,000
Wages 64,000 Sundry debtors 2,00,000
Sales 8,04,000 Rent 40,000
Solution:
Trial Balance as on 31.3.2007
Name of Accounts Rs. Name of Accounts Rs.
Cash in hand 4,800 Sundry creditors 96,000
Purchases 4,80,000 Sales 8,04,000
Opening stock 1,40,000 Capital 4,00,000
Machinery 2,40,000 Bills payable 88,000
Wages 64,000
Furniture 60,000
Bills receivable 80,000
Salaries 80,000
Sundry debtors 2,00,000
Rent 40,000
13,88,800 13,88,800
2.5. TRADING ACCOUNT
Trading means buying and selling. The trading account shows the
results of buying and selling of goods. It is the first part in the final
accounts, and it gives the trading result. Trading account considers the cost
of goods sold during a period on the one hand and on the other, the value
of goods sold.
Specimen form Trading account for the year ended ....
Particulars Debit Rs. particulars Credit Rs
To Opening stock xxx By sales xxx
To purchases Less: Returns xxx Self-Instructional Material
xxx xxx By closing stock xxx
21
Accounting Process Less: Returns xxx By Gross loss xxx
NOTES
xxx xxx
To Factory expenses xxx
To Direct expenses
To Gross profit
xxx xxx
2.6. PROFIT AND LOSS ACCOUNT
The profit & Loss account is credited with gross profit transferred
from the trading account (or with gross loss which is debited to the profit &
loss a/c). After this all, expenses and losses (which have not been dealt
with while preparing the trading a/c) are transferred to the debit side of the
profit & loss a/c. If there are any incomes or gains, like rent received,
interest received on investment, discount received from suppliers, these
will bne credited to the profit and loss a/c.
Specimen form Profit and loss account of ...... for the year ended
Particular Debit Rs. Particular Credit Rs.
To Gross loss b/d By gross profit b/d
Office & By discount received
Administrative Exp. By commission
To salaries earned
To office lighting By Interest received
To Rent, Rates & taxes By interest from
To printing & stationery investment
To Postage, fax & By apprentice
telegram premium
To Insurance premium By Rent from tenants
To General expenses By Interest on
To Loss by fire or theft Drawings
To legal expenses By profit on sale of
To trade expense assets
Selling & Distribution
Exp.
To salesman’s salary
To Commission paid
To advertising expenses
To Carriage outwards
To Travelling expenses
To Bad debts
To packing expenses
Financial Expenses:
To interest on capital
To Interest in loan
To Discount allowed
Maintenance Exp.
To Repairs &
maintenance
(of van, car, & other
assets)
To Depreciation on
assets
To Loss on sale of
assets
Other Expenses:
To provision for bad
Self-Instructional Material debts By net loss a/c
To Net profit c/d
Specimen form of a Balance sheet Balance of sheet of ....... As on ... Accounting Process
Liabilities Rs. Rs. Assets Rs. Rs.
NOTES
Outstanding xxx Cash in hand xxx
expenses xxx Cash at bank xxx
Income received xxx Prepaid expenses xxx
Bank overdraft xxx Bills receivable xxx
Bills payable xxx Sundry debtors xxx
sundry creditors xxx Closing stock xxx
Loans xxx Investment xxx
Mortgage xxx Furniture & Fitting xxx
Reserve fund xxx Less: Depreciation xxx xxx
Capital xxx
Add: Net profit xxx Loose tools xxx
Interest on cap xxx Less: Depreciation xxx xxx
Plant & Machinery xxx
Less: Drawings Land & Building xxx
xxx Less: Depreciation xxx xxx
Interest on
drawing xxx xxx Business premises xxx
xxx Less: Depreciation xxx xxx
Income tax Patents &trademark xxx
xxx Good will xxx
xxx xxx
Illustration 1
From the following Trial Balance prepare a Trading and profit and loss a/c
for the year ending 31st March 2009.
Stock 1stApril, 2008 5,000 Rent, Rates and Taxes 800
wages 3,000 Salaries 2,000
Discount allowed 200 Purchases 10,000
Bad debts 500 Office expenses 2,500
Repairs 300 Interest received 600
Depreciation 1,000 Sales 17,000
Solution: Trading account for the year ended 31-3-2009
Particulars Rs. Particulars Rs.
To Opening stock 5,000 By sales 17,000
To purchases 10,000 By Closing stock 10,000
To Wages 3,000
To Gross profit c/d 9,000
27,000 27,000
Profit and loss account for the year ended 31-3-2009
Particulars Debit Assets Credit
Rs. Rs.
To salaries 2,000 By Gross profit b/d 9,000
To Rent, Rates and Taxes 800 By interest received 600
To Office expenses 2,500
To Repairs 300
To Depreciation 1,000
To Bad Debts 500
To Discount allowed 200
To Net profit transferred to
capital a/c 2,300
9,600 9,600
23
Accounting Process
2.7. Check Your Progress
NOTES 1. What are the differences between trade discount and cash discount?
2. What is meant by trading account?
2.8. Answers to Check Your Progress Questions
1.
Trade Discount Cash Discount
It is allowed at the time of sales (or) It is allowed at the time of payment.
purchase
It is given to promote sale It is allowed to encourage early cash
payment
It is shown as a deduction in the It has nothing to do with the invoice
invoice.
Entry is not made in the account book. Entry is made in the account book.
The object is to enable the buyer to sell The object is to induce the debtors to
at the catalogue price. pay their dues promptly.
It is usually given in percentage. It is It may be given in percentage or in
given on the list price or catalogue absolute figure.
price or retail price.
2.
Trading means buying and selling. The trading account shows the results of
buying and selling of goods. It is the first part in the final accounts, and it
gives the trading result. Trading account considers the cost of goods sold
during a period on the one hand and on the other, the value of goods sold.
A. Short answer
1. What is profit and loss account?
2. What is trading account?
3. Explain ledger account?
4. Define journal.
B. Long answer
1. Prepare ledger accounts and Trail balance for the following
transactions:
2011 May
1 Mr. Z started business with cash Rs. 85,000
1 Machinery purchased for cash Rs. 13,000
3 He opened a bank account with SBI Rs. 10,000
5 Bought Goods form kamalesh Rs. 15,000
10 Paid to kamalesh in full settlement Rs. 14,500
14 Sold Goods to Mr. B Rs. 22,000
16 Cash received from Mr. B Rs. 7000
18 Goods purchased for Rs. 10,000
25 Goods sold for Rs. 25,000
31 Interest on capital @ 8% for the month.
31 Depreciation on machinery @ 10% for the month
2. The following are the account balance of ABC agency after preparing
trading and profit and loss a/c for the year ending 31st December 2004.
Land & Building 20,000 Furniture& Fittings 6,000
Closing stock 13,000 B/P 14,000
Cash in hand 7,500 Bank loan 15,000
Cash in bank 2,200 Sundry creditors 16,000
Sundry debtors 12,000 Salaries outstanding 1,200
Self-Instructional Material B/R 5,300 Drawings 3,000
Insurance prepaid 200 Capital 30,000
Machines 14,000 Net profit of the year 7,000
Prepare Balance sheet of ABC Agency.
Accounting Process
Further Reading:
NOTES
1. Financial Accounting Dr. V.K. Goyal, Published by Excel Books
2. Financial Accounting, Grewal, Shukla, Sultan Chand Publications,
Delhi
3. Financial Accounting, Paul, S.K. 4th ed, New Central Book Agency
Pvt. Ltd.
Delhi
5. Advanced Accountancy, Hrishikesh Chakraborty, Oxfort
University Press
6. Principles and Application of financial Accounting, Amitabh Basu
25
Accounting Ratio Analysis
UNIT - III ACCOUNTING RATIO
NOTES
ANALYSIS
Structure
3.1. Fund Flow Analysis
3.2. Cash Flow Analysis
3.3 Format of Cash Flow from Investing and Financing Activities
3.4. Treatment of Some Peculiar Items
3.5. Computerized Account
3.6. Objective of Computerized Accounting
3.7. Role of Computerized Accounting
3.8. Features of A Computerised Accounting Program
3.14 Manual Accounting Vs Computerized Accounting
3.1. FUND FLOW ANALYSIS
Prof. Foulke defines, “A statement of sources and applications of fund is
technical devices designed to analyse the change in the financial condition
of a business enterprise between two dates.”
Fund Flow statement is a financial statement. It is a report on movement of
funds or working capital during a period. It explains the way in which the
working capital raised and used during the period.
This statement consists of sources (receipts) and application (payment) of
funds. It is supplement to the financial statements. The business
transactions which cause an increase in the working capital are considered
as sources of funds and which causing a decrease in the working capital are
application on funds.
3.1.1. Merits of fund flow statement
1. It shows how the funds were raised collected and disbursed (used)
during a period.
2. It helps to formulated financial policies like dividends declaration,
creating reserve etc.
3. It points out the reasons for changes in working capital.
4. It shows the financial strength and weakness of the firm.
5. It helps to assess the credit worthiness and repaying capacity of the
firm.
6. It lays down the plan for efficient use of scare resources in future.
3.1.2. Demerits of fund flow statement
1. It is not an original statement. It is only a re-arrangement of
financial data.
2. It shows only the past position and not future.
3. When both the aspects of a transaction are current or non-current,
they are not included in this statement.
4. It is not an ideal tool for financial analysis.
Schedule of Changes in Working Capital
A statement shows the changes in current assets and current liabilities of
two periods is known as “Schedule of Changes in Working Capital”. This
statement is prepared with current assets and current liabilities as appeared
in the balance sheet. The net increase or decrease of working capital is
arrived at the end. The format is given below.
26
Particulars Previous Current Effect of Working Accounting Ratio Analysis
year year value capital
NOTES
value Increase Decrease
Current Assets:
Cash XXX XXX XXX
Bank XXX XXX XXX
Debtors XXX XXX XXX
Bills Receivable XXX XXX XXX
C.A XXX XXX
Current liabilities:
Creditors XXX XXX XXX
Bills payable XXX XXX XXX
Bank overdraft XXX XXX XXX
C.L XXX XXX
Net working capital XXX XXX XXX XXX
Net Increasing or Decrease Increase Decrease Increase Decrease
Total XXX XXX XXX XXX
3.1.4. Funds from operation
Funds from operation is the only internal sources of funds. The net profit
earned by the business in known as internal sources. However, to find out
the real funds from operation the non-operating incomes and expenditures
are adjusted with the net profit because non-operating items, do not affect
the working capital. There are two methods to find out funds from
operations.
I. Statement FUNDS FROM OPERATIONS
Rs. Rs.
Net profit (Current year – Last year) XXX
Add: Non-operating expenses:
a) Depreciation on fixed assets XXX
b) Preliminary expenses written off XXX
c) Goodwill written off XXX
d) Discount on issue of shares XXX
e) Patents written off XXX
f) Loss on sale of fixed assets XXX
g) Transfer to reserves XXX
h) Interim dividend XXX
i) Proposed dividends XXX
j) Provision for taxation XXX
(If taken as non-current item) XXX
Less: Non-operating Income:
a) Profit on sale of fixed assets XXX
b) Refund of income tax XXX
c) Dividend received XXX
d) Rent received XXX
e) Interest on investment XXX XXX
Fund from operation XXX
II. Account form
Adjusted profit & loss account is the alternative account format for
the calculation of funds operation. The format is:
Dr. Adjusted profit and loss account Cr.
Rs. Rs.
To Depreciating XXX By Net profit or last year XXX
To Good will, pattern, preliminary XXX By Transfer form excess
exp provision XXX
To Transfer to reserve, dividend XXX By Appreciation in the
equalisation fund, sinking fund XXX value of fixed asset XXX
27
Accounting Ratio Analysis etc. XXX By Dividend received XXX
To Interim dividend paid By Profit on sale of fixed XXX
NOTES To Dividend paid XXX asset
To Proposed dividend (If taken as By Funds from operations XXX
non-current item) XXX (Bal.fig)
To Provision for taxation (If taken XXX
as non-current item)
To Loss on sale of any assets
3.1.5. Sources and applications of funds
While preparing fund flow statement, it is necessary to find out the
sources and applications of funds. The sources of funds can be both
internal and external sources. Internal sources of funds from operations.
The external sources are:
a) Issue of shares and debentures.
b) Long term borrowing.
c) Sale of fixed assets.
d) Income from investment.
e) Decrease in working capital (as per schedule of changes in
working capital).
The application of funds means disbursement or payment of funds.
They are:
a) Purchase of fixed assets.
b) Redemption of preference shares and debentures.
c) Repayment of loans.
d) Payment of dividends.
e) Increase in working capital (as per schedule of changes)
3.1.6. Formats of Fund Flow Statement
There are three approaches are available for preparation of funds
flow statement.
i) Accounts form or T-form
ii) Vertical form, and
iii) Vertical form reconciliation type
i) Accounts form or T-form Fund Flow Statement
Sources of Funds Rs. Application of Funds Rs.
Funds from operations XXX Funds lost in operations XXX
Sale of fixed assets/ XXX Purchase of fixed assets/
Investments etc. XXX investments XXX
Issue of shares XXX Redemption of preference
Raising long-term loan shares/ debentures XXX
Non-trading income, (eg.) XXX Repayment of long-term XXX
dividend XXX loans XXX
Decrease in working capital Payment of tax XXX
Payment of Dividend XXX
Increase in working capital
XXX XXX
ii) Vertical Form: Fund Flow Statement
Particulars Rs.
Sources of Funds
Funds from operations XXX
Sale of fixed assets/ Investments etc. XXX
Issue of shares / Debentures XXX
Proceeds from long term loans XXX
Non-trading income XXX
Self-Instructional Material Decrease in working capital XXX
XXX
28
Application of Funds Accounting Ratio Analysis
Funds lost in operations XXX
NOTES
Purchase of fixed assets XXX
Redemption of preference shares/ debentures XXX
Repayment of long-term loans XXX
Payment of tax XXX
Payment of Dividend XXX
Non-trading losses XXX
Increase in working capital XXX
Fund From operations XXX
ii) Vertical Form – Reconciliation Type Fund Flow Statement
Particulars Rs. Rs.
Working Capital at the beginning of the year XXX
Add: Sources of Funds:
Funds from operations XXX
Sale of fixed assets/ Investments etc. XXX
Issue of shares / Preference share/Debentures XXX
Long term liabilities XXX XXX
XXX
Less: Application of Funds
Funds lost in operations XXX
Purchase of fixed assets XXX
Redemption of shares/ preference shares/ debentures XXX
Repayment of long-term loans XXX XXX
Working capital at the end of the year XXX
Illustration 1 From the following prepare a schedule of changes in
working capital.
Liabilities Rs. Rs. Assets Rs. Rs.
Share capital 2,00,000 2,10,000 Land 1,00,000 1,20,000
P & L a/c 28,000 49,000 Investment 28,000 48,000
Bank Loan - 10,000 Stock 58,000 54,000
creditors 39,000 30,000 Debtors 53,000 59,000
Cash 28,000 18,000
2,67,000 2,99,000 2,67,000 2,99,000
SOLUTION:STATEMENT OF CHANGES IN WORKING CAPITAL
Particulars 2006 2007 Effect of Working capital
Rs. Rs. Increase Decrease
Current Assets:
Stock 58,000 54,000 - 4,000
Debtors 53,000 59,000 6,000 -
Cash at Bank 28,000 18,000 - 10,000
C.A 1,39,000 1,31,000
Current Liabilities
Creditors 39,000 30,000 9,000
C.L 39,000 30,000
Net working capital (CA-CL) 1,00,000 1,01,000 15,000 14,000
Net Increase in working cap. 1,000 - - 1,000
1,01,000 1,01,000 15,000 15,000
Illustration 2From the following Profit and Loss, a/c compute the funds
from operations.
Dr. Profit and Loss A/c Cr.
Rs. Rs.
To salaries 13,000 By Gross profit 2,00,000
To Rent 3,000 By Profit on sale of 5,000
To Provision for 14,000 machinery 5,000 Self-Instructional Material
depreciation 20,000 To Refund of tax
29
Accounting Ratio Analysis To Transfer to Reserve 10,000
To Provision for tax 5,000
NOTES To Loss on sale of 5,000
investments 20,000
To Preliminary expenses 1,20,000
To Selling expenses
To Net profit
2,10,000 2,10,000
Solution Calculation of funds from operations
Rs. Rs.
Net profit 1,20,000
Add: Provision for depreciation 14,000
Transfer to Reserve 20,000
Provision for tax 10,000
Loss on sale of investment 5,000
Preliminary expenses 5,000 54,000
Less: Profit on sale of machine 5,000 1,74,000
Refund of tax 5,000
Fund from Operations 1,64,000
Illustration 3
Prepare Fund flow statement from the following Balance sheet and other
details.
Liabilities Rs. Rs Assets Rs. Rs.
Equity share 3,00,000 4,00,000 Good will 1,15,000 90,000
capital
Redeemable pref. 1,50,000 1,00,000 Land & 2,00,000 1,70,000
Buildings
General Reserve 40,000 70,000 Plant 80,000 2,00,000
Profit & Loss A/c 30,000 48,000 Debtors 1,60,000 2,00,000
Proposed Divid. 42,000 50,000 Stock 77,000 1,09,000
Creditors 55,000 83,000 B/R 20,000 30,000
Bills payable 20,000 16,000 Cash in hand 15,000 10,000
Prov. for Taxation 40,000 50,000 Cash at Bank 10,000 8,000
6,77,000 8,17,000 6,77,000 8,17,000
Additional Information:
a) Depreciation of Rs. 10,000 and Rs. 20,000 have been charged.
b) A dividend of Rs. 20,000 has been paid.
c) Income-tax of Rs. 35,000 has been paid.
Solution Statement of changes in working capital
Particulars 2006 2007 Effect of Working capital
Rs. Rs.
Increase Decrease
Current Assets:
Debtors 1,60,000 2,00,000 40,000
Stock 77,000 1,09,000 32,000 -
Bills Receivable 20,000 30,000 10,000 -
Cash in hand 15,000 10,000 - 5,000
Cash in Bank 10,000 8,000 - 2,000
C.A 2,82,000 3,57,000
Current Liabilities:
Creditors 55,000 83,000 - 28,000
Bills payable 20,000 16,000 4,000
C.L 75,000 99,000
Networking cap (CA-CL) 2,07,000 2,58,000 86,000 35,000
Self-Instructional Material Net Increase in working cap. 51,000 - - 51,000
2,58,000 2,58,000 86,000 86,000
30
Accounting Ratio Analysis
Dr. Plant Account Cr.
Rs. Rs. NOTES
To Opening 80,000 By Depreciation 10,000
Balance 1,30,000 By Closing Balance 2,00,000
To Cash purchase
2,10,000 2,10,000
Dr. Plant Account Cr.

Rs. Rs.
To Opening 2,00,000 By Depreciation 20,000
Balance By Cash sales 10,000
By Closing Balance 1,70,000
2,00,000 2,00,000
Dr. Land and Building Account Cr.

Rs. Rs.
To Opening 80,000 By Depreciation 10,000
Balance 1,30,000 By Closing 2,00,000
To Cash purchase Balance
2,10,000 2,10,000
Dr. Proposed Dividend Account Cr.

Rs. Rs.
To Bank (Dividend 20,000 By Opening Balance 42,000
paid) 50,000 By Adj. Profit & 28,000
To Closing Balance Loss A/c (Bal. fig)
70,000 70,000
Dr. Provision for taxation Account Cr.
Rs. Rs.
To Bank (Tax paid) 35,000 By Opening Balance 40,000
To Closing Balance 50,000 By Adj. Profit & 45,000
Loss A/c (Bal. fig)
85,000 85,000
Funds from Operations
Net profit (48,000 – 30,000) 18,000
Add: Non- operating expenses:
Depreciation – plant 10,000
Depreciation – Land 20,000 30,000
Tax provided during the year 45,000
Dividend provided during the year 28,000
General Reserve transfer during the year 30,000
Good will written off 25,000
Fund from operation 1,76,000
Fund Flow Statement
Sources Rs. Applications Rs.
Fund from operations 1,76,000 Purchase of Plant 1,30,000
Issue of Equity shares 1,00,000 Redemption of preference 50,000
Sale of Land and 10,000 shares 20,000
Buildings Payment of Dividend 35,000
Payment of Income Tax 51,000
Increase in Working capital
2,86,000 2,86,000
31
Accounting Ratio Analysis 3.2. CASH FLOW ANALYSIS
Cash flow means incoming and outgoing of cash in an organisation during
NOTES
a period.
“It is a statement which discloses the changes in cash position between two
periods”.
Yes, the revised AS-3 (Accounting Standard – 3) has made it mandatory
for all listed companies to prepare and present a cash flow statement along
with other financial statements on annual basis.
A cash flow statement is one which provides information about the
historical changes in cash and cash equivalents of an enterprise by
classifying cash flow into operating, investing and financing activities.
3.2.1. Various terms used in cash flow statement
a) Cash – “It comprises cash on hand and demand deposits with banks”.
b) Cash equivalents – “They are short term highly liquid investments that
are readily convertible into known amounts of cash and which are subject
to an insignificant risk of changes in value”.
c) Cash flows – “Inflow and outflows of cash and cash equivalents”.
d) Operating activities – “They are the principal revenue producing
activities of the enterprise.
e) Investing activities – “They are the acquisition and disposes of long-
term assets and other investments not included in cash equivalents”.
f) Financing activities – “Activates that result in changes in the size and
composition of the owners’ capital and borrowings of the enterprise”.
3.2.2. Objectives of Cash flow statement
1. To provide useful information about cash flows and outflows of an
enterprise.
2. To help for short-term planning.
3. To provide the users of financial statements with a basis to assess
the ability of the enterprise to generate cash and cash equivalents.
4. The heads of the enterprise to utilize those cash flows.
3.2.3. Advantages of cash flow statement
i) Helps in efficient cash management:
It helps to provide information about the liquidity and solvency
information of an organisation and to determine how much cash will be
available at a particular point of time to meet obligation.
ii) Helps in internal financial management:
It enables the management to make available enough cash
whenever needed and invest surplus cash in productive and profitable
opportunities.
iii) Discloses the movement of cash:
It discloses the sources and application of the cash of an
organisation and cash flows in the different segment of the business.
iv) Comparison between two organisation:
It is useful to compare the projected cash flow with the actual cash
flow for controlling and for taking remedial actions.
v) Comparison between two organisation:
It increases the comparability of the reporting of operating
performance by different organisation.
vi) Cash planning:
It helps to evaluate the current cash position and plan the financial
policies for future.
32
vii) Analysis of profitability and net cash flow: Accounting Ratio Analysis
It explains the reasons for low cash balance in spite of huge profits NOTES
and vice-versa.
3.2.4. Limitations of Cash Flow statement
i) It ignores non-cash items; hence it cannot be equated with the
income statement.
ii) The cash balance as disclosed by the cash flow statement may
not represent the true liquid position of the organisation.
iii) Working capital concept gives complete picture than cash flow
concept.
3.2.5. Difference between Cash flow statement and Fund flow
statement
Cash Flow Statement Fund Flow Statement
It starts with opening balance and No such balance.
ends with closing balance.
It deals with cash receipts and It deals with increase or decrease in
payments. working capital.
It shows the changes in cash. It shows the changes in working
capital.
It is useful for short-term financial It is useful for long-term financial
analysis. analysis.
Flow of cash means definitely be Flow of funds does not mean flow
flow of funds. of cash.
Cash is a part of working capital. Working capital may not necessarily
mean cash.
3.2.6. Difference between Cash Flow Statement and Cash Book
Cash Flow Statement Cash Book
It is present the amount of cash flow It prevents only the actual cash
from operation with careful study receipts and cash payments.
and interpretation.
Good will written off, preliminary These items will not appear in cash
expenses, depreciation etc, are to be book.
recorded in cash flow statement.
Items for which on payment is Items for which no payment is made
made, but which incur losses are to do not appear in cash book.
be shown in cash flow statement.
It reveals the analysis and re- It reveals only the continuous day-
investigation of the items appearing to-day monetary transactions.
in the financial statement.
3.2.7. Presentation of cash flow statement
As per AS-3 the cash flow statement is presented in three categories.
i) Operating activity
ii) Investing activity
iii) Financing activity
Classification by activities provides information which may be used
to evaluate the relationship among these activities and the impact of those
activities on the financial position of the organisation.
A single transaction may include mix of cash flows that are
classified differently. Example:
a) Instalment paid on fixed asset: This includes both interest and
principal, interest is classified under financing activities and the principal Self-Instructional Material
under investing activities.
33
Accounting Ratio Analysis 1. Operating activities
Cash flow from operating activities are primarily derived from the
NOTES
principal revenue producing activities of the enterprise that enter into the
determination of net profit or net loss. Example for cash flows from
operating activities:
Cash inflows from operating activities

i. Cash receipts from the sale of goods or services.
ii. Cash receipts from royalties, fees, commission and other revenue.
iii. Cash received from the insurance enterprise towards claims,
annuities and other policy benefits.
iv. Refund of income tax.
Cash outflow from operating activities
i. Cash payments to suppliers for goods and services.
ii. Cash payments to and on behalf of employees.
iii. Cash payments relating to future contract, forward contracts, for
dealing of trading purpose.
iv. Cash payment towards insurance premium.
v. Cash payment of income tax.
2. Investing activities
The activities of acquisition and disposal of long-term assets and
other investments intended to generate future income and cash flows.
Cash inflows from investing activities
i. Cash receipts from disposal of shares, debenture, interests in joint
venture etc. of other companies held as investment.
ii. Cash receipts from the repayment of advance and loans made to
third parties (other than financial enterprise).
Cash outflow arising from investing activities
i. Cash payments to acquire fixed assets including intangible assets.
ii. Cash payments relating to capitalized research and development
cost and self-constructed fixed assets.
iii. Cash payments to acquire shares, debentures, interests in joint
venture etc. of other companies for investment purpose.
iv. Cash advance and loans made to third parties (other than financial
enterprise)
Financing Activities
Financing activities are those activities which result in change in
the equity capital and the borrowed funds of the organisation.
Cash inflow from financing activities
i. Cash proceeds from issuing equity/preference shares.
ii. Cash proceeds from issuing debentures, loans, bonds and other
short/long-term borrowing.
Cash outflow from financing activities
i. Cash repayments of amounts borrowed.
ii. Interest paid on debenture and long-term loans and advances.
iii. Dividends paid on equity and preference capital.
3.3. Methods of converting net profit
There are two methods of converting net profit into net cash flows
from operating activities. 1) Direct method and 2) Indirect method.
1. Direct Method:
Under direct method actual cash receipts from operating revenues
and actual cash payments for operating expenses are arranged and
34
presented in the cash flow statement. The difference between cash receipts Accounting Ratio Analysis
and cash payments is the net cash flow from operating activities. NOTES
Under direct method items lie depreciation, amortisation of
intangible assets, preliminary expenses, debenture discount are ignored
from cash flow statement, since the direct method includes only cash
transactions and non-cash items are omitted.
likewise, no adjustment is made for loss or gain on the sale of fixed
assets and investments.
FORMAT OF CASH FLOW FROM OPERATING ACTIVITIES
DIRECT METHOD (Option: 1)
Particulars Rs. Rs.
Cash flow from operating activities
Cash receipts from customers XXX
Less: Cash paid to suppliers and employees XXX
Cash generated from operations XXX
Less: Income tax paid XXX
Cash flow before extraordinary items XXX
Less: Extraordinary items (earthquake direct settlement XXX XXX
etc.)
Net cash from operating activities (A) XXX XXX
ii) Indirect Method:
In this method the net profit is used as the base then adjusted for
items that affected net profit but did not affect cash.
Non-cash and non-operating charges in debit side of the profit and
loss account are added back to the net profit while non-cash and non-
operating credit are deducted to calculate operating profit before working
capital changes. It is a partial conversion of accrual basis profit to cash
basis profit.
Further necessary adjustments are made for increase or decrease in
current assets and current liabilities to obtain net cash from operating
activities.
Format of cash flow from operating activities Indirect Method (Option: 2)
Particulars Rs. Rs.
CASH FLOW FROM OPERATING ACTIVITIES:
Net profit before tax and Extraordinary item(or) xxx
Closing balance of profit & loss xxx (or)
Less: Opening balance of profit & Loss xxx xxx
Add: Transfer red. to Reserve xxx
Provision for Taxation made during the current year xxx
Proposed dividend made during the current year xxx
Interim dividend paid during the year xxx
Any extraordinary expenses debited to P&L xxx
Less: Refund Tax’ xxx
Any extra ordinary income credited to P&L xxx xxx
Add: Non-operating expenses / items xxx
Depreciation of Fixed assets
Loss on sale of fixed assets xxx
Preliminary expenses, Discount on issue of shares and xxx
debentures (written off) xxx
Goodwill, Patent, Trademark Amortised (Written off) xxx
Less: Non-operating Income/Items xxx xxx
Interest and dividend received xxx
Profit on sale of fixed assets xxx
Rental Income xxx Self-Instructional Material
Operating profit before adjustment for working capital xxx
35
Accounting Ratio Analysis changes xxx
Add: Decrease in current assets xxx
NOTES Increase in current liabilities
Less: Increase in current assets xxx xxx
Decrease in current liabilities xxx xxx
Opening profit after charging working capital changes xxx
Less: Income tax paid (Net of capital tax refund received xxx
Operating profit before charging extra ordinary items xxx
Add/ Less: Extraordinary items xxx
Net cash flow from operating activities (A) xxx
3.3 FORMAT OF CASH FLOW FROM INVESTING AND
FINANCING ACTIVITIES
Particulars Rs. Rs.
CASH FLOW FROM INVESTING ACTIVITIES xxx
Add: Proceeds from sale of fixed assets (Including
intangible assets/ goodwill) xxx
Dividend and interest received (non-financial companies)
Less: Purchase of Fixed assets (including intangible xxx xxx
assets) xxx
Purchase of investment xxx
Loan to subsidiaries xxx
Net cash from investing Activities (B) xxx
Cash Flow from Financing activities xxx
Add: Proceeds from issue of shares and debentures xxx
Proceeds from other long-term Borrowings
Less: Final Dividend paid xxx xxx
Interim dividend paid xxx
Interest on debenture and long-term loan paid xxx
Redemption of shares and debentures xxx
Repayment of other long-term loan xxx xxx
Net cash from Financing activities (c) xxx
Net Increase / Decrease in cash and cash equivalent (A+ xxx
B + C)
Add: Opening cash and cash equivalents xxx
Cash in hand xxx
Cash at bank xxx
Short-term deposit xxx
Marketable securities
Less: Bank O/D xxx
xxx
Closing cash and cash equivalent xxx
3.4. TREATMENT OF SOME PECULIAR ITEMS
i) Extraordinary items
Extraordinary items are not regular phenomenon and they are non-
recurring in nature. As far as possible classify them into operating,
investing and financing activities.
Example: Bad debts recovered, claims from insurance companies, winning
of a lawsuit, winning of lottery etc.
ii) Interest and Dividends
a) In case of a non-financial enterprise:
Interest paid and dividend paid-Financing activities (cash out flow)
Interest received and dividend received – Investing activities (cash
inflow)
b) In case of financial enterprise:
Interest paid – Operating activities (cash out flow)
36
Interest and dividend received – Operating activities (Cash inflow) Accounting Ratio Analysis
Dividend paid – Financing activities (cash out flow) NOTES
c) Interest paid on working capital loans – Operating activities (cash
outflow)
iii) Taxes on Income:
It should be classified as cash flows from operating activities unless
they can be specifically identified with financing and investing activities.
Tax on net profit – Operating activities (cash out flows)
Tax paid on dividend – Financing activity along with dividend paid
iv) Non - cash transactions
Investing and financing transactions that do not require the use of
cash or cash equivalent should be excluded from a cash flow statement.
Example: Acquisition of assets by issue of shares (or) debentures,
conversion of debts into equity etc.
Procedure in Preparation of cash flow statement
The following procedure are used to prepare the cash flow statement
i. Calculation of net increase or decrease increase or decrease in cash
and cash equivalents:
The difference between cash and cash equivalents for the period
may be computed by comparing these accounts given in the
comparative balance sheets.
ii. Calculation of the net cash provided (or) used by operating
activities:
It is calculated by the analysis of profit and loss a/c, comparative
balance sheet and selected additional information.
iii. Final preparation of a cash flow statement:
The net cash flow provided or used in operating activities (a)
investing activities (b) and financing activities (c) are highlighted
and the aggregate of net cash flow is equal to net increase or
decrease in cash and cash equivalents.
Illustration 1 Calculate cash flow from operating activities:
Total sales for the year 10,00,000
Total purchase for the year 6,50,000
Commission received during the year 10,000
Office expenses for the year 15,000
Administrative expenses for the year 20,000
Income Tax paid during the year 12,000
Solution: Cash flow from operating activities
Particulars Rs. Rs.
Add: Commission received 10,000
Less: Total purchase for the year 6,50,000 10,10,000
Administrative expenses 20,000 6,85,000
Cash generated from operations 3,25,000
Less: Income tax paid 12,000
Net cash from operating activities (A) 3,13,000
3.5. COMPUTERIZED ACCOUNT
Computerized Accounting involves making use of computers
and accounting software to record, store and analyse financial data.
A computerized accounting system brings with it many advantages that are
unavailable to analogue accounting systems.
37
Accounting Ratio Analysis Computerized accounting systems are software programs that are stored on
a company's computer, network server, or remotely accessed via the
NOTES
Internet. Computerized accounting systems allow you to set up income and
expense accounts, such as rental or sales income, salaries, advertising
expenses, and material costs.
3.6. OBJECTIVE OF COMPUTERIZED ACCOUNTING
3.6.1. Labour Saving:
Labour saving is the main aim of introduction of computers in accounting.
It refers to annual savings in labour cost or increase in the volume of work
handled by the existing staff.
3.6.2. Time Saving:
Savings in time is another object of computerization. Computers should be
used whenever it is important to save time. It is important that jobs should
be completed in a specified time such as the preparation of pay rolls and
statement of accounts. Time so saved
by using computers may be used for other jobs.
3.6.3. Minimization of Frauds:
Computer is mainly installed to minimize the chances of frauds committed
by the employees, especially in maintaining the books of accounts and
handling cash.
3.6.4. Effect on Personnel:
Computer relieves the manual drudgery, reduces the hardness of work and
fatigue, and to that extent improves the morale of the employees.
3.6.5. Accuracy:
Accuracy in accounting statements and books of accounts is the most
important in business. This can be done without any errors or mistakes
with the help
of computers. It also helps to locate the errors and frauds very easily.
3.7. ROLE OF COMPUTERIZED ACCOUNTING
1. The manual system of recording accounting transactions requires
maintaining books of accounts such as journal, cash book, special purpose
books, and ledger and so on. From these books, summary of transactions
and financial statements are prepared manually.
2. The advanced technology involves various machines, which can perform
different accounting functions, for example a billing machine. This
machine is capable of
computing discount, adding net total and posting the requisite data to the
relevant accounts.
3.8. FEATURES OF A COMPUTERISED ACCOUNTING
PROGRAM
1. Inputting invoices, credit notes, receipts and payments
2. By entering one transaction all the double entry is completed for you.
(Because a computerised accounting system is fully integrated)
3. There may be a separate payroll program
4. Generating Management reports
3.8.1. Advantages
1.All banking activities are done by using computer system
2. Transaction can be done anywhere and anytime
3. It takes shorten time for any banking process
3.8.2. Dis-advantages
1. Cost of computerized system is very high
38
2. High cost for maintenance Accounting Ratio Analysis
3. The system can be infected by viruses NOTES
4. Member of workers have to be reduced as they are no longer needed
3.9 MANUAL ACCOUNTING vs COMPUTERIZED
ACCOUNTING
Manual Accounting Computerized Accounting
Manual accounting is the system in In this system of accounting, we use
which we keep physical register of computer and different accounting
journal and ledger for keeping the software for digital record of each
records of each transaction. transaction.
In manual accounting, all calculation In computerized accounting, our duty is
of adding and subtracting are done to record the transactions manually in
manually. the database. All the calculations are
done by computer system.
In manual accounting, we check the Computerized accounting system will
journal and then we transfer figures to automatically process the system and
related accounts debit or credit side will make all the accounts ledgers
through manual posting. because we have passed the voucher
entries under its respected ledger
account.
Both adjustment journal entries and its Only adjustment entries will pass in the
posting in the ledger accounts will be computerized accounting system,
done manually one by one. posting in the ledger accounts will be
done automatically.
We have to make the financial We need not prepare financial statement
statements manually by careful manually; financial statements will
transferring trial balance’s figures in become automatically.
income statement and balance sheet.
1. What do you mean by computerized accounting
2. What is fund from operation?
3. Calculate cash flow from operating activities:
1.Computerized Accounting involves making use of computers
and accounting software to record, store and analyse financial data.
A computerized accounting system brings with it many advantages that are
unavailable to analogue accounting systems.
2. Funds from operation is the only internal sources of funds. The net profit
earned by the business in known as internal sources.
3. Solution: Cash flow from operating activities
Particulars Rs. Rs.
Add: Commission received 10,000
Less: Total purchase for the year 6,50,000 10,10,000
Administrative expenses 20,000 6,85,000
Cash generated from operations 3,25,000
Less: Income tax paid 12,000 Self-Instructional Material
Net cash from operating activities (A) 3,13,000

39
Accounting Ratio Analysis Self-Assessment Questions and Exercise:
A. Short answer
NOTES
1. What is computerized accounting?
2. Define Fund flow analysis.
3. Explain the cash flow analysis.
4. Explain the merits and demerits of fund flow analysis.
5. What are the objectives of cash flow statement?
B. Long Answer
1. Calculate cash flow from operating activities:
2. What are the difference between manual accounting and computerized
accounting?
3. what are the differences between fund flow statement and cash flow
statement?
4. From the following information, calculate cash flow from operating
activities using indirect method.
Statement of Profit and Loss A/c
for the year ended on March 31, 2016
Particular Rs. Rs.
Revenue from operations 4,40,000
Expenses:
Cost of materials consumed 2,40,000
Employees benefits expenses 60,000
Depreciation 40,000
Other expenses:
Insurance premium 16,000
Total expenses 3,56,000
Profit before tax 84,000
Less: Income tax 20,000
Profit after tax 64,000
Particular 31.3.2015 31.3.2015
Trade Receivables 66,000 72,000
Trade Payables 34,000 30,000
Inventory 44,000 54,000
Outstanding employees’ benefits 4,000 6,000
Prepaid insurance 10,000 11,000
Income tax payable 6,000 4,000
Further Reading:
1. Financial Accounting Dr. V.K. Goyal, Published by Excel Books
2. Financial Accounting, Grewal, Shukla, Sultan Chand Publications,
Delhi
Delhi
5. Financial Management, Khan & Jain – Tata McGraw Hill
6. Cost and Management Accounting, Jain S.P. & Narang, K.L.
Kalyani Publishers, Delhi
40
Cost and Management Accounting
BLOCK II NOTES
UNIT IV - COST AND MANAGEMENT

ACCOUNTING
Structure
4.1. Introduction
4.2. Meaning and Definitions of Cost Accounting
4.5. Nature and Scope of Cost Accounting
4.6. Management Accounting
4.7. Objectives of Management Accounting
4.8. Nature and Scope of Management Accounting
4.1. INTRODUCTION
A business enterprise must keep a systematic record of what
happens from day- tot-day events so that it can know its position clearly.
Most of the business enterprises are run by the corporate sector. These
business houses are required by law to prepare periodical statements in
proper form showing the state of financial affairs. The systematic record
of the daily events of a business leading to presentation of a complete
financial picture is known as accounting. Thus, Accounting is the
language of business. A business enterprises peaks through accounting.
It reveals the position, especially the financial position through the
language called accounting.
Accounting is the process of recording, classifying, summarizing,
analysing and interpreting the financial transactions of the business for
the benefit of management and those parties who are interested in
business such as shareholders, creditors, bankers, customers, employees
and government. Thus, it is concerned with financial reporting and
decision-making aspects of the business.
The American Institute of Certified Public Accountants Committee
on Terminology proposed in 1941 that accounting may be defined as,
“The art of recording, classifying and summarizing in a significant
manner and in terms of money, transactions and events which are, in
part at least, of a financial character and interpreting the results
thereof”.
4.2. MEANING AND DEFINITIONS OF COST
ACCOUNTING
“Cost accounting is a quantitative method that accumulates,
classifies, summarizes and interprets information for three major
purposes: (i) Operational planning and control; (ii) Special decision; and
(iii) product decision.” – Charles T. Horngren.
“Cost accounting is the process of accounting for costs from the
point at which the expenditure is incurred of committed to the
establishment of its ultimate relationship with cost units. In its widest
sense, it embraces the preparation of statistical data, the application of
cost control methods and the ascertainment of the profitability of the
activates carried out or planned is defined as the application of
accounting and costing principles, methods and techniques in the Self-Instructional Material
ascertainment of costs and the analysis of saving and or excess of
41
Cost and Management Accounting compared with previous experience or with standards.” – Institute of
NOTES Cost and Management Accountants of London.
“Cost accounting is defined as the application of costing and cost
accounting principles, methods and techniques to the science, art and practice
of cost control and the ascertainment of profitability. It includes the
presentation of information derived therefore for the purposes of managerial
decision making. – Wheklon.
4.3. COST ACCOUNTING
An accounting system is to make available necessary and
accurate information for all those who are interested in the welfare of
the organization. The requirements of major it the mare satisfied by
means of financial accounting. However, the management requires far
more detailed information than what the conventional financial
accounting can offer. The focus of the management lies not in the past
but on the future.
For a businessman who Manu factures goods or renders services,
cost accounting is a useful tool. It was developed on account of
limitations of financial accounting and is the extension of financial
accounting. The advent of factory system gave an impetus to the
development of cost accounting. It is a method of accounting for cost.
The process so recording and accounting for all the elements of cost is
called cost accounting.
The Institute of Cost and Works Accountants, London defines
costing as, “the process of accounting for cost from the point at which
expenditure is in corridor committed to the establishment of its ultimate
relationship with cost centres and cost units. In its wider usage it
embraces the preparation of statistical data, the application of cost
control methods and the ascertainment of the profitability of activities
carried out or planned”.
The Institute of Cost and Works Accountants, India defines cost
accounting as, “the technique and process of ascertainment of costs.
Cost accounting is the process of accounting for costs, which begin with
recording of expenses or the bases on which they are calculated and
ends with preparation of statistical data”.
To put it simply, when the accounting process is applied or the
elements of costs (i.e., Materials, Labour and Other expenses), it
becomes Cost Accounting.
4.4. OBJECTIVES OF COST ACCOUNTING
Cost accounting was born to fulfil the needs of manufacturing
companies. It is a mechanise accounting through which costs of good,
so eservices are ascertained and controlled for different purposes. It
helps to ascertain the true cost of every operation, through watch, say,
cost analysis and allocation. The main objectives of cost accounting are
as follows: -
4.4.1. Cost Ascertainment
The main objective of cost accounting is to find out the cost of product,
process, job, contract, service or any unit of production. It is done through
various methods and techniques.
4.4.2. Cost Control
Self-Instructional Material The very basic function of cost accounting is to control costs. Comparison
of actual cost with standards reveals the discrepancies (Variances). The
42
variances reveal whether cost is within control or not. Remedial actions are
suggested to control the costs which are not within control. NOTES
4.4.3. Cost Reduction
Cost reduction refers to the real and permanent reduction in the unit cost of
goods manufactured or services rendered without affecting the use
intended. It can be done with the help of techniques called budgetary
control, standard costing, material control, labour control and overheads
control.
4.4.4. Fixation of Selling Price
The price of any product consists of total cost and the margin required.
Cost data are useful in the determination of selling price or quotations. It
provides detailed information regarding various components of cost. It also
provides information in terms of fixed cost and variable costs, so that the
extent of price reduction can be decided.
4.4.5. Framing business policy
Cost accounting helps management in formulating business policy and
decision making. Break even analysis, cost volume profit relationships,
differential costing, etc are helpful in taking decisions regarding key areas
of the business like-
a. Continuation or discontinuation of production b. Utilization of
capacity
c. The most profitable sales mix D Key factor
e. Export decision
f. Make or buy
g. Activity planning, etc.
4.5. NATURE ANDSCOPE OF COST ACCOUNTING
Cost accounting is concerned with ascertainment and control of
costs. The information provided by cost accounting to the management
is helpful forecast control and cost reduction through function so
planning, decision making and control. Initially, cost accounting
confined itself to cost ascertainment and presentation of the same mainly
to find out product cost. With the introduction of large-scale production,
the scope of cost accounting was widened and providing information for
cost control and cost reduction has assumed equal significance along
with finding out cost of production. To start with cost accounting was
applied in manufacturing activities but now it is applied in service
organizations, government organizations, local authorities, agricultural
farms, extractive industries and soon.
Cost accounting guides for ascertainment of cost of production.
Cost accounting discloses profit able and unprofitable activities. It helps
management to eliminate the unprofitable activities. It provides
information for estimate and tenders. It discloses the losses occurring in
the form of idle times pillage or scrap etc. It also provides a per petal
inventory system. It helps to make effective control over inventory and
for preparation of inter in financial statements. It helps in controlling the
cost of production with the help of budgetary control and
standardcosting.Costaccountingprovidesdataforfutureproductionpolicies.
It discloses there relative efficiencies of different workers and for
fixation of wages to workers.
4.6. MANAGEMENT ACCOUNTING
Management accounting is not a specific system of accounting. It
could be any form of accounting which enables a business to be
43
Cost and Management Accounting conducted more effectively and efficiently. It is largely concerned with
NOTES providing economic information to mangers for achieving organizational
goals. It is a next tension of the horizon of cost accounting towards
newer areas of management. Much management accounting information
is financial in nature but has been organized in a manner relating direct ly
to the decision non hand.
Management accounting is comprised of t w o words
“Management and Accounting”. It means the study of managerial aspect
of accounting. The emphasis of management accounting is to re design
accounting in such a way that it is helpful to the management
information of policy, control of execution and appreciation of
effectiveness.
Management accounting is of recent origin. This was first used
in1950bya team of accountants visiting U.S. A under the us paces of
Anglo-American Council on Productivity.
Anglo-American Council on Productivity defines Management
Accounting as, “the presentation of accounting information in such a
way as to assist management to the creation of policy and the day today
operation of an undertaking”.
The American Accounting Association defines Management
Accounting as “the methods and concepts necessary for effective
planning for choosing among alternative business actions and for control
through the evaluation and inter pre station of performances”.
The Institute of Chartered Accountants of India defines
Management Accounting as follows: “Such of its techniques and
procedures by which accounting mainly seeks to aid the management
collectively has come to be known as management accounting”
From these definitions, it is very clear that financial data is
recorded, analysed and presented to the management in such a way that
it becomes useful and helpful in planning and running business
operations more systematically.
4.7. OBJECTIVES OF MANAGEMENT
ACCOUNTING
The fundamental objective of management accounting is to enable
the management to maximize profits or minimize losses. The evolution
of management accounting has given a new approach to the function of
accounting. The main objectives of management accounting are as
follows:
4.7.1. Planning and policy formulation
Planning involves fore casting on the basis of available information,
setting goals; framing polices determining he alternative courses of
action and deciding on the programme of activities. Management
accounting can help greatly in this direction. It facilitates the preparation
of statements in the light of past results and gives estimation for the
future.
4.7. 2. Interpretation process
Management accounting is to present financial information to the
management. Financial information is technical in nature. Therefore, it
must be presented in such a way that it is easily understood. It presents
accounting information with the help of statistical devices like charts,
diagrams, graphs, etc.
4.7.3. Assists in Decision-making process
44
With the help of various modern techniques management
accounting makes decision-making process more scientific. Data relating NOTES
to cost, price, profit and savings for each of the available alternatives are
collected and analysed and provides a base for taking sound decisions.
4.7.4. Controlling
Management accounting is a useful for managerial control.
Management accounting tools like standard costing and budgetary
control are helpful in controlling performance. Cost control is affected
through the use of standard costing and departmental control is made
possible through the use of budgets. Performance of each and every
individual is controlled with the help of management accounting.
4.7.5. Reporting
Management accounting keeps the management fully informed
about the latest position of the concern through reporting. It helps
management to take proper and quick decisions. The performance of
various departments is regularly reported to the top management.
4.7.6. Facilitates Organizing
“Return on Capital Employed” is one of the tools of management
accounting.
SincemanagementaccountingstressesmoreonResponsibilityCentreswitha
view to control costs and responsibilities, it also facilitated centralization
to a greater extent. Thus, it is helpful in setting up effective and
efficiently organization framework.
4.7.7. Facilitates Coordination of Operations:
Management accounting provides tools for overall control and
coordination of business operations. Budgets are important means of
coordination.
4.8. NATURE AND SCOPE OF MANAGEMENT
ACCOUNTING
Management accounting involves furnishing of accounting data to
the management for basing its decisions. It helps in improving efficiency
and achieving the organizational goals. The following paragraphs
discuss about the nature of management accounting.
4.8.1. Provides accounting information
Management accounting is based on accounting information.
Management accounting is a service function and it provides necessary
information to different levels of management. Management accounting
involves the presentation of information in a way it so its managerial
needs. The accounting data collected by accounting department is used
for reviewing various policy decisions.
4.8.2. Cause and effect analysis
The role of financial accounting is limited to find out the ultimate
result, i.e., profit and loss; management accounting goes a step further.
Management accounting discusses the cause and effect relationship.
There as on for the loss are probed and the factors directly influencing
the profitability are also studied. Profits are compared to sales, different
expenditures, current assets, interest payables, share capital, etc.
4.8.3. Use of special techniques and concepts
Management accounting uses special techniques and concepts
according to necessity to make accounting data more useful. The
techniques usually used include financial planning and analyses,
45
Cost and Management Accounting standard costing, budgetary control, marginal costing, project appraisal,
NOTES control accounting, etc.
4.8.4. Taking important decisions
It supplies necessary information to the management which may be
useful for its decisions. The historical data issued to see its possible
impact on future decisions. The implications of various decisions are
also taken into account.
4.8.5. Achieving of objectives
Management accounting uses the accounting information in such a
way that it helps in formatting plans and setting up objectives.
Comparing actual performance with targeted figures will give an idea to
the management about the performance of various departments. When
there are deviations, corrective measures can be taking not once with the
help of budgetary control and standard costing.
4.8.6. No fixed norms
No specific rules are followed in management accounting as that of
financial accounting. Though the tools are the same, their use differs
from concern to concern. The deriving of conclusions also depends upon
the intelligence of the management accountant. The presentation will be
in the way which suits the concern most.
4.8.7. Increase in efficiency
The purpose of using accounting information is to increase
efficiency of the concern. The performance appraisal will enable the
management top in-point efficient and inefficient pots. Effort is made to
take corrective measures so that efficiency is improved. The constant
review will make the staff cost conscious.
4.8.8. Supplies information and not decision
Management accountant is only to guide and not to supply
decisions. The data is to be used by the management for taking various
decisions. ‘How is the data to be utilized’ will depend upon the calibre
and efficiency of the management.
4.8.9. Concerned with forecasting
The management accounting is concerned with the future. It
helps the management in planning and forecasting. The historical
information is used to plan future course of action. The information is
supplied with the objector guide management for taking future decisions.

1. Define Cost Accounting.
2. Write short note on nature and scope of management accounting
1. “Cost accounting is defined as the application of costing and cost accounting
principles, methods and techniques to the science, art and practice of cost
control and the ascertainment of profitability. It includes the presentation of
information derived therefore for the purposes of managerial decision making. –
Wheklon.
2. Provides accounting information, increase in efficiency, Achieving of
objectives, Cause and effect analysis, Use of special techniques

Self-Instructional Material Short answer
1. Define Cost Account?
46
2. What is Management Accounting?
3. List down nature and scope of Management accounting. NOTES
Essay Type Questions:

1. What are the objectives of cost accounting?
2. What are the differences between cost accounting and Management
accounting?
3. What are the characteristics of Management accounting?
Further Reading:
47
Cost Sheet
NOTES
UNIT – V COST SHEET
Structure
5.1. Evolution
5.2. Cost
5.3. Different Types of Cost
5.4. Costing
5.7. Advantages of Cost Accounting
5.8. Limitation of Cost Accounting
5.9. Characteristics of A Good (or) An Ideal Costing System
5.10. Difference Between Cost Accounting and Management Accounting
5.11. Cost Classification
5.12. Elements of Cost
5.13. Components of Total Cost
5.14. Format of a Cost Sheet
5.15. Problems and Solutions
5.1. EVOLUTION
Today business is a dynamic organism. Every businessman must
face tough competitions, uncertainty and risk prevailing in the trade. A
business may be altered because of technological development, economic
situations, political changes, social considerations etc. Increase in
population may be turned into more demand, and thus new enterprises take
birth to meet the demands. When may enterprises come up, there arises
widespread competition, and this will cause the business more and more
complex? Thus, the sellers must be ready to face survival situations and
stiff competitions. In the ordinary situations of business, in the past, the
businessman or the entrepreneur was in close touch with his customers and
suppliers. He was able to have a close observation and measure the
efficiency of his business. But, when the business grows and begins to
function through stiff competition, uncertainty and risk, the businessman
looks into the accounting information. The accounting information profit
and loss account and balance sheet is aimed to serve the interests of
owners, shareholders, bankers, agencies, government etc. The proprietors,
who invest money can be satisfied when they know the income accruing to
them; the law of a country also needs such financial statements. Thus,
financial accounting is mainly concerned with external reporting.
It is rightly admitted that the financial statements profit, and loss
account and balance sheet are also used as medium of control. They
provide historical information. The main purpose of financial accounting
is to record the transactions in books in order to reveal the results of a
concern for a period. An assessment of the financial statements helps us to
understand the overall progress of a concern strength or weakness. But the
management of a concern needs more and more information as the
financial information fails to give all the needed information.
Every businessman tries to reduce the cost of manufacture to the
minimum in the stage of complexity and competition more particularly in
the large-scale production. Therefore, the businessman looks for
information to study the cost of a manufacture in the past, and on this basis,
Self-Instructional Material he assesses what it will cost in the future. Therefore, more importance is
given to profit and loss account, which is prepared on the cost principle.
48
Cost Sheet
5.2. COST
The word ‘cost’ is used very often in our day-to-day affairs. The NOTES
committee on Terminology, American Institute of Certified Public

Accountants defined cost as:
“Cost is the amount, measured in money, of cash expended or other
property transferred, capital stock issued, services performed, or liability
incurred, in consideration of goods or services received or to be received”.
Cost represents the resources that have been or must be sacrificed
to attain objective. “Cost may be defined as a total of all expenses
incurred, whether paid or outstanding, in the manufacture and sale of a
product. We say that the cost of a sofa set is Rs. 800, which means we
have spent an amount or Rs. 800 in making the sofa set. In other words,
we can say that we spent Rs. 800 towards the cost of materials, labour and
other expenses. Thus, cost means an amount of expenditure on a given
thing, here the sofa set costs Rs. 800.
5.3. DIFFERENT TYPES OF COST
Cost varies with purpose the same cost data cannot serve all
purpose equally well. The word cost is used in such a wide variety of ways
that it is advisable to use it with an adjective or phrase, which will convey
the meaning intended. Certain types of cost are briefly discussed below:
1. Historical costs are ‘post-mortem’ costs which are collected after they
have been incurred. These costs report past events and the time-lag
between event and its reporting makes the information out-of-date and
irrelevant for decision-making.
2. Future costs are costs expected to be incurred later.
3. Replacement cost is the cost of replacement in the current market.
4. Standard cost is a scientifically pre-determined cost which is arrived at
assuming a level of efficiency in utilisation of material, labour and indirect
services.
5. Estimated cost is an approximate assessment of what the cost will be. It
is based on past averages adjusted to anticipated future changes.
6. Product cost is the cost of a finished product built up from its cost
element.
7. Production cost it represents prime cost-plus absorbed production
overhead.
8. Direct cost is a cost which can be economically identified with a
specific saleable cost unit.
9. Prime cost is the aggregate of direct material cost and direct labour cost.
10. Indirect cost is the cost which cannot be directly identified t the unit of
output or to the segment of a business operation.
11. Fixed cost/Fixed overhead/Period cost. It is cost which is incurred for
a period, and which, within certain output and turnover limits, tends to be
unaffected by fluctuations in the levels of activity (output or turnover).
Examples are rent, rates, insurance and executive salaries.
12. Variable cost is the cost which tends to vary with the level of activity.
13. Opportunity cost is the value of a benefit sacrificed in favour of an
alternative course of action.
14. Controllable cost is the cost which can be influenced by budget main
product.
15. Non-controllable cost is the cost which is not subject to control at any
level of managerial supervision.
49
Cost Sheet
16. Joint cost is the cost of process which results in more than one main
NOTES product.
17. Sunk cost CIMA defines it as the past cost not considered in decision
making.
18. Postponable cost is that cost which can be shifted to the future with
little or no effect on the efficiency of current operations.
19. Out-of-pocket cost is that cost which involves the cash outflow due to
a management decision. Depreciation on assets is an item of cost which
will not form part of out-of-pocket cost, because it does not entail cash
outflow.
20. Differential cost is the difference in total cost between alternatives
calculated to assist decision making.
21. Conversion cost is the cost incurred for converting the raw material
into finished product i.e., direct labour, direct expenses and factory
overhead. It is also referred to as the production cost excluding the cost of
direct materials.
22. Avoidable cost is the specific costs of an activity or sector of a
business which would be avoided if that activity or sector did not exist.
23. Marginal cost is the cost of one unit of product or service which would
be avoided if that unit were not produced or provided.
24. Relevant costs: CIMA defines relevant costs as “costs appropriate to a
specific management decision.”
5.4. COSTING
Costing is different from cost accounting. It is referred to “as classifying,
recording and appropriate allocation of expenditure for the determination
of the costs of products or services”. Costing is the technique and process
of ascertaining cost. The technique means and consists of principles and
rules which govern the procedure of ascertaining costs of a product or
service. The process of costing ‘is the day-to-day routine of ascertaining
costs, whatever the costs ascertained may be and whatever be the means by
which the costs are determined”.
Staubus observes, “costing is the process of determining the cost of
doing something i.e., the cost of manufacturing and article, rendering a
service or performing a function.”
The techniques of costing used in industries for ascertaining the
cost of products and services:
Historical costing, i.e., ascertainment of costs after they have been
incurred. This costing is based on recorded data and the costs arrived at
are verifiable by past events.
Standard costing, CIMA defines it as “a control technique which
compares standard costs and revenues with actual results to obtain
variances which are used to stimulate improved performance.”
Marginal costing, Marginal costing is the accounting system in which
variable costs are charged to cost units and fixed costs of the period are
written-off in full against the aggregate contribution. Its special value is in
decision-making.
Direct costing, under direct costing, a unit cost is assigned only the direct
cost. All indirect costs are charged to profit and loss account of the period
in which they arise. Indirect costs are disregarded for inventory valuation
as well. Basically, the terms direct costing and marginal costing are two
Self-Instructional Material different terms. While direct costing is based on traceability of cost to cost
objective, marginal costing is based on variability of cost. Unlike marginal
50
Cost Sheet
cost, direct cost may include a part of fixed cost which is directly
identifiable. NOTES
Absorption costing is a technique that assigns all costs, i.e., both fixed
cost and variable cost, to product cost or cost of service rendered.
Uniform costing CIMA defines it as “the use by several undertakings of
the same costing system, i.e., the same basic costing methods, principles
and techniques.”
5.5. COST ACCOUNTING
The institute of Cost and Works Accountants, India defines “Cost
Accounting is the technique and process of ascertainment of costs. “Cost
Accounting is the technique and process of ascertainment of costs. Cost
accounting is the process of accounting for costs, which begins with
recording of expenses or the bases on which they are calculated and ends
with preparation of statistical data.”
5.5.1. Definition
The Official Terminology of the Chartered Institute of Management
Accountants (CIMA), London, defines Cost Accounting as “the
establishment of budgets, standard costs and actual cost of operations,
processes, activities or products; and the analysis of variances, profitability
or the social use of funds”.
5.5.2. Various methods of Cost Accounting

No. Methods Examples (Applied in)
1. Job Costing Printing press, Engineering,
industries, etc.
2. Contract Costing Construction of bridges,
buildings, dams, roads, etc.
3. Batch Costing Manufacturers of biscuits,
Readymade garments; etc.
4. Unit/Single Costing Industries like mines, oil
drilling, etc.
5. Process Costing Industries like sugar, Chemicals,
Textiles, etc.
6. Operating Costing Transport Company, Power
Houses, etc.
7. Operation Costing Toy making industries, etc.
5.6. OBJECTIVES OF COST ACCOUNTING
Cost accounting was born to fulfil the needs of management of
manufacturing companies for a detailed information about the cost. Cost
accounting is a mechanism of accounting by means of which costs of
services or products are ascertained and controlled in a manufacturing firm
for different purposes. The main objectives or purposes are as follows:
1. Ascertainment of cost. It enables the management to ascertain
the cost of product, job, contract, service or unit of production so as to
develop cost standard. Costs may be ascertained, under different
circumstances, using one or more types of costing principles—standard
costing, marginal costing, uniform costing etc.
2. Fixation of Selling Price. Cost data are useful in the
determination of selling price or quotations. Apart from cost
ascertainment, the cost accountant analyses the total cost into fixed and Self-Instructional Material
variable costs. This will help the management to fix the selling price;
51
Cost Sheet
sometimes, below the total cost but above the variable cost. This will
NOTES increase the volume of sales—more sales than previously, thus leading to
maximum profit. The scientific way of reducing the prices is possible in an
industry only where a sound costing system exists. In other words, cost
reduction, in the absence sound costing system, may cause to shut down
the industries.
3. Cost Control. The object is to minimise the cost of
manufacturing. Comparison of actual cost with standards reveals the
discrepancies—variances. If the variances are adverse, the management
enters into investigation so as to adopt corrective action immediately.
4. Matching Cost with Revenue. The determination of
profitability of each product, process, department etc. Is the important
object of costing.
5. Special Cost Studies and Investigations. It undertakes special
cost studies and investigations, and these are the basis for the management
in decision-making or policies. This will also include pricing of new
products, contraction or expansion programmes, closing or continuing a
department, product mix, price reduction in depression etc.
6. Preparation of Financial Statements, Profit and Loss
Account, Balance Sheet. To prepare these statements, the value of stock,
work-in-progress, finished goods etc., are essential; in the absence of the
costing department, when we have to close the accounts it rather tales too
much time. But a good system of costing facilitates the preparation of the
statements, as the figures are easily available; they can be prepared
monthly or even weekly.
5.7. ADVANTAGES OF COST ACCOUNTING
It offers a few advantages, and the following are the main
advantages:
5.7.1. To the Management
1. Action Against Unprofitable Activities. It reveals unprofitable
activities, inefficiencies such as wastage of materials—spoilage, leakage,
pilferage, scrap etc, and wastage of resources—inadequate utilisation etc.
The management can concentrate on profitable jobs and consider change or
closure of unprofitable jobs.
2. Facilitates Decision-Making. It provides necessary data along
with information to the management to take decision on any matter,
relating to the business.
3. Assistant is Fixing Prices. The various types of cost accounting
are much helpful in fixing the cost and selling price of product. Thus the
desired volume of production is secured at the minimum possible cost.
4. Improves Efficiency. Through the standard cost and budgetary
control, remedial action can be chosen in order to improve the efficiency
and implement new principles.
5. Facilitates Cost Control. It facilitates cost control possible by
comparisons, product-wise or firm-wise.
6. Establishes Standard Cost. It enables the mangers to find out
the cost of each job and to know what it should have cost; it indicates
where the losses and wastes occur before the work is finished. Standard
cost is a pre-determined cost and offers several advantages to the
management.
52
Cost Sheet
7. Inventory Control. An effective system and check are provided
on all materials and stores. Interim profit and loss account, and balance NOTES
sheet can be prepared without checking the physical inventory.
8. Prevents Fraud. An effective costing system prevents frauds
and manipulation and supplies reliable cost data to the management.
9. Future Prospects. The cost accountant not only provides the
present trend, the future prospects also. On this basis, bankers, debenture
holders, financial agencies etc., form an idea of the soundness of the firm
before granting credits.
10. Budgeting. As cost accounting reveals actual cost, estimate
cost and standard cost of products, preparation of budget is easy. Effective
budget control is also possible. Thus “Cost accounting is a system of
5.7.2. To the Employees
1. Sound wages policy: Cost accounting introduces incentive wage
scheme, bonus plans etc. Which bring better reward to sincere and
efficient workers. Cost data aid the management in devising a suitable
wage policy for the workers. Time wage system and piece rate system can
be blended to provide higher wages and at the same time increasing
productivity rate.
2. Higher Bonus Plans: Cost accounting leads to an increase in
productivity, lowering of costs and increase in profitability. Workers get
their share in profits in the form of bonus. Higher profits naturally allow
higher bonus distribution.
3. Distinction Between Efficient and Inefficient Workers: Cost
accounting provides standards for the measurement of efficiency of
workers. Efficient workers can be distinguished, and their efficiency
recognised and rewarded. Employees have been initiated and
recommended for higher promotions.
4. Security of Job: Employees get better remuneration, security of
job etc., due to the increasing prosperity of the industries. Monetary
appreciation of the efficiency of a worker is good tonic which leads to
higher rate of productivity.
5.7.3. To the Creditors
Bankers, creditors, investors etc., can have a better understanding
of firm, as regards the progress and prosperity, before they offer financial
lending’s.
5.7.4. To the Government
1. The proper systems of cost accounting are of great use in the
preparation of national plans, economic developments etc.
2. By studying the trend of cost, the government can make policies
like taxation, import, export, price selling, granting subsidy etc.
3. Costing system has stability and cost reduction in industries.
Cost audit is important, and industries have to keep books of accounts to
show the utilisation of materials, labour and other costs.
5.7.5. To the Public
1. Cost accounting removes all types of wastages and inefficiencies.
These will enable the consumers to get goods at better quality the cheaper
rates.
2. The public feels that the costing system facilitates the customers
to pay fair price.
3. Development and prosperity of industries will create Self-Instructional Material
employment opportunities.
53
Cost Sheet
5.8. LIMITATION OF COST ACCOUNTING
NOTES 1. It is expensive.
2. It is a failure and criticised as defective.
3. It involves too much paper works.
4. It is unnecessary.
5. Its applicability is restricted.
5.9. CHARACTERISTICS OF A GOOD (OR) AN IDEAL COSTING
SYSTEM
1. It should be simple and easy to operate.
2. It must be economical.
3. It should be flexible to adopt new requirements.
4. It should be suitable to the nature of business.
5. It provides suitable methods for effective control of material and
wages.
6. Proper allocation, apportionment and absorption of overheads.
7. Facilitate periodic reconciliation of cost accounts and financial
accounts.
5.10. DIFFERENCE BETWEEN COST ACCOUNTING AND
MANAGEMENT ACCOUNTING
Cost Accounting Management Accounting
1. Objectives To ascertain and To help the management in
control of cost of decision-making, planning,
products control, etc.
2. Scope Deals with cost data Deals with both cost and
revenue. It includes financial
accounting, cost accounting,
budgeting, etc. Its scope is
wider than cost accounting.
3. Nature Uses both past and Concerned with the
present figures. projection of figures for
future.
4. Purpose Both internal and Internal purposes only.
external purposes
5. Recording of Only quantitative Both quantitative and
information aspect is recorded. qualitative aspects are
recorded.
Mention the steps that should be taken to install cost accounting
1. Study the nature of the organisation of the business.
2. Technical aspects of the business should be taken into
consideration.
3. Should be simple and easy to operate.
4. Should be capable of reconciliation.
5. Should be designed after careful analysis of the nature of
operations involved.
Mention the difficulties involved in installation of a costing system

1. Lack of support from top management.
2. Refusal from the existing accounting staff.
3. Non-cooperation at other levels or organisation.
Self-Instructional Material 4. Shortage of trained staff in costing department.
5. Requires additional cost for installation.
54
Cost Sheet
5.11. COST CLASSIFICATION
NOTES
Cost classification is the process of grouping cost according to their
common characteristics. Costs are to be classified suitably to identify with
cost centre or cost unit. In a manufacturing concern, the total operating
cost is divided into two:
(a) Manufacturing cost or production cost or factory cost, is the
summary of the costs of direct material, direct labour and factory overhead.
(b) Commercial expenses are of selling and general expenses. The
important classifications are:
5.12. ELEMENTS OF COST
5.12.1. Classification According to Nature or Element. The terminology
defines as “the primary classification of costs according to the factors upon
which expenditure is incurred material cost, labour cost and expenses”.
According to this classification, the costs are divided into three categories;
i.e., materials, labour and expenses. Material cost means the cost of
commodities supplied to an undertaking. Labour cost or wages mean the
cost of remuneration, such as wages, salaries, bonuses etc. of the
employees of the undertaking. Expense means cost of services provided to
and undertaking and notional cost of the use of owned asset i.e.,
depreciation etc. Further subdivision of the three elements is possible and
is as follows.
5.12.2. Classification According to the Function of Companies. Under

this, costs are classified according to the purpose for which they are
incurred. On the basis of activity, the classification leads to different
groups. They are production cost, administrative cost, selling cost and
distribution cost.
5.12.3. Classification According to Variability. Costs are also classified
into fixed, variable and semi-variable on the basis of variability of cost in
the volume of production.
(a) Fixed Cost. Fixed cosy means that the cost tends to be
unaffected with the volume of output. Fixed cost depends upon the
passage of time and does not vary directly with the volume of output. It is
also known as period cost, e.g., rent and rates of factory buildings,
insurance of buildings, depreciation of buildings, etc.
(b) Variable Cost. Variable cost tends to vary directly with the
volume of output. It varies almost in direct proportion to the volume of
production. The examples of such expenses are the cost of direct materials,
direct labour, direct chargeable expenses such as power, repairs etc. If
production increases, the costs will also increase and vice versa. Fixed cost
remains constant per unit of time and variable cost remains constant per
unit of output. Self-Instructional Material
55
Cost Sheet
(c) Semi-Variable Costs are those which are partly fixed and partly
NOTES variable. In other words, both fixed and variable elements are present in
these costs; they are also known as semi-fixed costs.
Examples are depreciation of plant and machinery which is not
doubled on account of production doubling; telephone rent, repairs etc.
5.12.4. Classification According to Capital and Revenue. Capital costs
are those costs incurred in the acquisition of assets, either to earn income or
increase the earning capacity of the business. For example, cost of plant,
machinery etc. Revenue costs are those costs incurred to maintain the
earning capacity of the firm. In costing only revenue expenditure is taken
into account while capital cost is ignored.
5.12.5. Classification According to Normality Costs. Normal cost is a
cost which is normally incurred at a given level of output in the conditions
in which that level of output is normally attained. Abnormal costs are not
normally incurred at a given level of output in the conditions in which that
level of output in normal. Normal cost is taken as an item of cost of
production; but it excludes abnormal cost from cost of production.
5.13. COMPONENTS OF TOTAL COST
Prime Cost Direct Material + Direct Labour + Direct
Expenses
Works/ Factory Cost Prime Cost + Works Overheads + Opening work-
in-progress – Closing Work-in-progress.
Cost of Production Works Cost + Office & Administration
Overheads
Cost of Goods Sold Cost of Production + Opening Finished Goods –
Closing Finished Goods
Cost of Sales Cost of Goods Sold + Selling and Distribution
Overheads
In order to exercise proper control of costs for sound managerial
decisions, the management may be provided with necessary data. For this
reason, the total cost of the product is analysed by the elements of cost—
nature of expenses. Traditionally, the product cost is divided into three—
material, labour and other overhead expenses and these can further be
analysed into different elements, as shown in Table.
The total expenditure consisting of material, labour and expenses
can further be analysed as under.
Prime Cost = Direct materials + Direct Labour + Direct expenses
Work Cost (Factory) = Prime Cost + Factory overhead
Cost of Production = Factory Cost + Administration overhead
Total Cost (Cost of sales) = Cost of production + Selling and
distribution overhead
Each element of cost is explained in detail, as below:
1. Direct Material Cost. Direct material is material that can be
directly identified with each unit of the finished product. Direct material is
that material which becomes a part of the product. Raw materials, semi-
finished materials, components etc. Which become part and parcel of the
product are known as direct materials. For example, cloth in garments,
leather in shoemaking, spare parts in assembling of radio, cycle, scooter,
etc.
Direct material includes the following:
Self-Instructional Material 1. Materials including component parts, specially purchased for the
job.
56
Cost Sheet
2. Material transferred from one cost centre to another, one process
to another process. NOTES
3. Primary packing materials like cartons, wrappings, card-board
boxes etc.
2. Direct Wages. All labour expenses in altering, composition,
construction, conformation etc., of the product are included in direct
wages, they include the payment made to the following group of labour;
1. Labour engaged on the actual production of the product; i.e.,
carrying out the operation or process.
2. Labour engaged in aiding the operation; i.e., supervision,
foreman, wafers of internal transport personnel, shop clerks etc.
3. Inspectors, analysts etc., especially needed for the production.
Direct wages are also known as direct labour, productive labour,
process labour or prime cost labour.
3. Direct or Chargeable Expenses. Expenses other than direct
material, direct labour, which can be identified with and allocated to cost
units or cost centres as they are specially incurred for a particular product
or process, form a part of prime cost. Direct expenses are also known as
chargeable expenses, prime cost expenses, process expenses or productive
expenses. The following groups of expenses fall under direct expenses:
1. Cost of special drawing, designs or layout
2. Hire charge, repair and maintenance of special equipment hired
3. Experimental expenses of a job
4. Excise duty, Royalty
5. Architect or surveyor’s fee
6. Travelling expense connected to the job
7. Cost of rectifying defective work.
4. Indirect Materials. Indirect materials are those materials which
cannot be traced as part of the product.
Examples are:
(a) Stores items used in maintenance of machinery like lubricant,
cotton waste, grease, oil, stationery etc.
(b) Small tools for general use.
(c) Some minor items or materials, treated as indirect materials, due
to their small costs, such as cost of thread in dressmaking, cost of nails in
shoemaking etc.
5. Indirect labour. Labour whose wage cannot be allocated, but
which can be apportioned to or absorbed by the cost centre or cost units is
known as indirect labour. In other words, wages which cannot be directly
identified with a job; are generally treated as indirect wages. Examples
are: Salaries and wages of foremen, supervisors, inspectors, maintenance
labour, storekeepers, clerical staff, watch and ward, internal transport etc.
6. Indirect Expenses. These are expenses which cannot be
allocated but can be apportioned to or absorbed by the cost centres or cost
units. In other words, expenses other than indirect material and labour are
indirect expenses. The following are examples of indirect factory
expenses:
(a) Rent, rates and insurance in relation to factory
(b) Depreciation, repairs, maintenance on factory building, plant
etc.
7. Overheads. All expenses other than the direct material cost, Self-Instructional Material
direct wages and direct expenses are known ad indirect expenses or
57
Cost Sheet
overheads. According to Weldon, overhead means “the cost of indirect
NOTES materials, indirect labour and such other expenses, including services as
cannot conveniently be charged direct to specific cost units”. In other
words, overhead means the aggregate of indirect material cost, indirect
labour and indirect expenses. In general, overheads may be sub-divided
into the following groups:
(a) Production overhead or works overheads or factory overhead or
manufacturing overhead
(b) Administrative overhead
(c) Selling overhead
(d) Distribution overhead.
All expenses relating to product are extracted from financial
accounts and analysed under expense heads in the form of statement. This
tabulated statement is called cost sheet. Cost sheet is a document which
provides for the assembly of the detailed cost of a cost centre or cost unit.
Cost sheet is a statement showing the details of the total cost of a job,
operation or order. It brings out the composition of total cost in a logical
order, under proper classifications and sub-divisions. The period covered
by the cost sheet may be a week, a month, or so. It should present cost
information in total as well as per unit. It would be better, for comparison,
if the information for the previous year also is given.
Advantages
1. It exhibits total cost and cost per unit of the product.
2. Break up cost details can be collected.
3. Helpful for preparation of estimates/ tenders.
4. Helps in fixing the selling price.
5. Comparison of data with previous period is possible.
5.14. FORMAT OF A COST SHEET
Cost Sheet of ...... Limited for the period ending .......
Particulars Rs. Rs.
Raw materials Consumed/ Direct Material:
(Opening Stock of materials Add Purchases
Less Closing Stock of Materials) XXX
Direct Labour XXX
Direct Expenses XXX XXX
Prime Cost XXX
Factory (or) Works Overheads;
Indirect Materials like oil, Consumable Stores;
Indirect Labour like Foreman salary; and
Indirect Expenses like power, Factory rent,
Depreciation, Repairs, etc. XXX
XXX
Add: Opening Work-in-Progress (W.I.P.) XXX
XXX
Less: Closing W.I.P and sale of Scrap if any XXX XXX
Factory (or) Works cost XXX
Office & Administration Overheads:
Office lighting, Rent, Depreciation on premises,
Manager’s Salary, telephone Charges, etc. XXX XXX
Cost of production XXX
Selling & Distribution Overheads:
Travelling Expenses, Advertisement, Carriage
58
Cost Sheet
outwards, warehouse charges, salesman salary and
commission, etc. XXX XXX NOTES
Cost of sales XXX
Profit XXX
Sales XXX
5.15. PROBLEMS AND SOLUTIONS
PROBLEM – 1:
From the following calculate the value of raw material consumed:
Raw material purchases Rs. 88,000
Opening stock of Raw Materials Rs. 1,00,000.
Closing stock of Raw Materials Rs. 1,23,500.
Solution: Value of Raw Material Consumed:
Rs.
Opening Stock 100000
Add: Purchases 88000
188000
Less: Closing Stock 123500
Raw Material Consumed 64500
PROBLEM – 2:
From the particulars given below, calculate works cost:
Raw materials Rs. 60,000.
Wages Rs. 40,000
Direct expenses Rs. 10,000
Factory overhead Rs. 50,000
Solution:
Calculation of Work Cost Rs.
Raw materials 60000
Wages 40000
Direct Expenses 10000
Prime cost 110000
Factory Overheads 50000
Works Cost 160000
PROBLEM – 3:
From the following prepare statement of cost account.
Materials consumed Rs. 45,500; Direct wages Rs. 23,000; Factory
overheads Rs. 9,200; Administration overheads Rs. 3,000. Selling
distribution overheads Rs. 2000 and sales Rs. 90,000.
Solution:
Statement of Cost Account
Rs.
Materials 45500
Direct Wages 23000
Prime Cost 68500
Factory Overheads 9200
Factory Cost 77700
Administration Overheads 3000
Cost of Production 80700
Selling & Distribution Overheads 2000
Cost of Sales 82700
Profit (B/F) 7300 Self-Instructional Material
Sales 90000
59
Cost Sheet
NOTES PROBLEM – 4:
Prepare a Cost Sheet:
Raw material consumed – Rs. 80,000
Wages – Rs. 20,000
Factory expenses is charged at 100% of wages
Office overheads charged at 20% on Factory cost
Solution:
Cost Sheet
Raw Materials consumed Rs.
Wages 80,000
Prime Cost 20,000
Factory Expenses: 100% of Wages 1,00,000
Factory Cost (FC) 20,000
Office Overheads: 20% on FC (1,20,000×20%) 1,20,000
Cost of Production 24,000
1,44,000
PROBLEM – 5:
From the following particulars, prepare a cost sheet:
Rs.
Opening stock of raw materials 60,000
Raw materials purchased 9,00,000
Wages paid 4,60,000
Factory overheads 1,84,000
Work-in-Progress (Opening) 24,000
Work-in-progress (Closing) 30,000
Raw materials (Closing stock) 50,000
Finished goods (Opening) 1,20,000
Finished goods (Closing) 1,10,000
Selling and distribution expenses 40,000
Sales 18,00,000
Administration expenses 60,000
Solution:
Cost Sheet
Rs. Rs.
Raw Materials:
Opening 60,000
Add: Purchase 900000
960000
Less: Closing 50000 910000
Wages 460000
Prime Cost 1370000
Factory overheads 184000
1554000
Add: Opening Work in progress 24000
1578000
Less: Closing Work-in-progress 30000
Work Cost 1548000
Administration Expenses 60000
Self-Instructional Material Cost of production 1608000
Add: Opening Finished goods 120000
60
Cost Sheet
1728000
Less: Closing Finished goods 110000 NOTES
Cost of Goods Sold 1618000
Selling & Distribution Expenses 40000
Cost of Sales 1658000
Profit (B/F) 142000
Sales 1800000
PROBLEM – 6:
From the following particulars, prepare a statement showing (a)
Prime Cost (b) Factory cost (c) Cost of production (d) Cost of goods sold
and (e) Profit.
Rs.
Direct labour 3,00,000
Direct materials (31.12.90) 40,000
Finished goods (31.12.91) 1,50,000
Finished goods (31.12.90) 1,00,000
Work-in-progress (31.12.90) 10,000
Work-in-progress (31.12.91) 14,000
Materials purchased 4,00,000
Direct materials (31.12.91) 50,000
Manufacturing overheads 2,14,000
Selling and distribution overheads 3,30,000
Sales 12,00,000
Solution: Statement of Cost Sheet
Rs. Rs.
Direct Materials:
Opening (31.12.90) 40000
Add: Purchases 4,00,000
440000
Less: Closing (31.12.91) 50000 390000
Direct Labour 300000
(a) Prime cost 690000
Manufacturing Overheads 214000
904000
Add: Opening Work-in-Progress (31.12.90) 10000
914000
Less: Closing work-in-progress (31.12.91) 14000
(b) Factory Cost 900000
Office Overheads Nil
(c) Cost of Production 900000
Add: Opening Finished Goods (31.12.90) 100000
1000000
Less: Closing Finished Goods (31.12.91) 150000
(d) Cost of goods sold 850000
Selling & Distribution overheads 330000
Cost of Sales 1180000
(e) Profit (B/F) 20000
Sales 1200000
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Cost Sheet
PROBLEM – 7:
NOTES Meenambigai Engineering company has received and enquiry for
the supply of 10,000 units. The costs are estimated as follows:
Raw materials 1,00,000 kgs at Re. 1 per kg.
Direct wages 10,000 hours at Rs. 4 per hour
Variable overheads:
Factory overheads at Rs. 2.40 per labour hour
Selling and distribution Rs. 16,000
Fixed overheads:
Factory Rs.8,000
Selling and distribution Rs. 20,000
Prepare a statement showing the price to be fixed which will give a
profit of 20% on selling price.
Solution:
Quotation Price
(for 10000 units)
Rs. Rs.
Raw materials (100000 kgs @ Re. 1 per kg) 100000
Direct Wages (10000 hours @ Rs. 4 Per hr) 40000
Prime Cost 140000
Factory Overheads:
Variable (10000 hours @ Rs. 2.40 per Labour 24000
hour
Fixed 8000 32000
Work cost & Cost of Production 172000
Selling & Distribution Overheads:
Variable 16000
Fixed 20000 36000
Cost of sales 208000
Profit (20% on selling Price (or) 25% on cost of
Sales (208000×25/100) 52000
Sales 260000
Selling Price per unit

=260000/10000 = Rs. 26 per Unit.
PROBLEM – 8:
In a factory two types of ceiling fans viz. Usha and Crompton are
produced. Ascertain the cost and profit per unit sold from the particulars
given below:
Usha (Rs.) Crompton (Rs.)
Materials 16,400 18,900
Wages 8,900 9,800
Works overhead is 60% of wages and office overhead 20% on work
cost. The selling expenses per fan sold is Rs. 2. The selling price of Usha
and Crompton are Rs. 550 and Rs. 800 respectively. 80 fans of Usha and
100 fans of Crompton are sold. There is no opening or closing stock.
Solution: Cost Sheet
Usha Fans Crompton Fans
Total 80 Per unit Total Per unit
Self-Instructional Material No. Rs. Rs. 100 No. Rs.
Rs.
62
Cost Sheet
Materials 16400 205.00 18900 189.00
NOTES
Wages 8900 111.25 9800 98.00
Prime cost 25300 316.25 28700 287.00
Works Overheads –
(60% of wages) Works 5340 66.75 5880 58.80
cost
Work Cost 30640 383.00 34580 345.80
Office overheads – (20% 6128 76.60 69196 69.16

of Works cost)
Cost of Production 36768 459.60 41496 414.96
Selling Expenses (Rs. 2
per Fan sold) 160 2.00 200 2.00
Cost of sales 36928 461.60 41696 416.96
Profit 7072 88.40 38304 383.04
Sales 44000 550.00 80000 800.00
PROBLEM – 9:
From the following details of ALPHA Company Ltd., prepare Cost Sheet.
Particulars Rs.
Purchase of Raw materials 2,40,000
Rent, insurance premium, factory expenses 80,000
Direct wages 2,00,000
Carriage inwards 2,880
Stock on 1.1.1996:
Raw materials 40,000
Work-in-progress 9,600
Finished goods ( 2,000 T) 32,000
Stock on 31.12.1996:
Raw materials 44,480
Work-in-progress 32,000
Finished goods (4,000 T) 64,000
Sales 6,00,000
Factory – Supervision 16,000
Total production 32,000 Tonnes
Selling & Distribution expenses Rs. 2/ Tonnes
Find out (a) Net profit (b) Net profit per tonne (c) Total production cost.
Solution:
Cost Sheet – Alpha Company Ltd.
(for 32000 tonnes)
Rs. Rs.
Raw Materials:
Opening Materials 40000
Add: Purchases 240000
Add: Carriage Inwards 2880
282880
Less: Closing Materials 44480 238400
Direct wages 200000 Self-Instructional Material
Prime Cost 438400
63
Cost Sheet
Factory Overheads – Rent, Insurance,
NOTES Premium, Factory Expenses 80000
Factory Supervision 16000 96000
534400
Add: Opening works-in-progress 9600
544000
Less: Closing Work-in-progress 32000
Works Cost & Cost of Production 512000
Statement of Sales and Profit Total Per Ton
Cost of Production (512000 / 32000 =16) 512000 16.00
Add: Opening Finished goods 32000
544000
Less: Closing finished goods 64,000
Cost of Goods sold for 30000 Tonnes
(ie 32000 + 2000 – 4000 Tonnes) 480000 16.00
Selling & Distribution Expenses @ Rs. 2 per
ton for 30000 tons) [Refers Notes] 60000 2.00
Cost of sales 540000 18.00
Profit (B/F) 60000 2.00
Sales 600000 20.00
Notes:
No. Of Units Sold = Opening Finished Goods + Units Produced – Closing
Finished Goods
= 2000 + 32000 + 4000 Tonnes = 30000 Tonnes
Selling & Distribution Expenses @ Rs. 2 per to for 30000 tons = Rs.
60000.
PROBLEM – 10:
The Oriental Electrical Suppliers give you the following figures for
the three months ending 31st December 2003. These figures relate to the
manufacture of Ceiling Fans,
Rs.
st
Completed Stock on 1 October 2003 Nil
Completed Stock on 31st December 2003 20,250
st
Stock of Raw Materials, 1 October 2003 5,000
st
Stock of Raw Materials, 31 December 2003 3,500
Factory wages 75,000
Indirect charges 12,500
Materials purchased 32,500
Sales 1,12,500
The number of fans manufactured during the three months was 3,000.
Prepare a statement showing the cost per fan.
Solution:
Oriental Electrical suppliers statement showing the cost per fan for 3
month ending 31st Dec.2003
(For 3000 Fans)
Rs. Rs.
Raw Materials:
Opening stock (1st Oct 2003) 5000
Self-Instructional Material Add: Purchase 32500
37500
64
Cost Sheet
Less: Closing Stock (31st Dec 2003) 3500 34000
Direct wages: Factory wages 75000 NOTES
Prime Cost 109000
Factory Overheads: Indirect Charges 12500
Works Cost & Cost of production 121500
Total cost 121500
Cost per fan= ---------------------------- = ------------------ = Rs. 40.50
No. of fan manufactured 3000
Statement of sales and profit
Rs.
Cost of production 121500
st
Add: Opening finished stock (1 Oct 2003) Nil
121500
st
Less: Closing finished stock (31 Dec 2003) 20250
Cost of goods sold 101250
Profit 11250
Sales 112500
1. What are the components of total cost?
2. What are the different types of cost? Explain in brief.
3. Prepare a Cost Sheet from the following information
Wages – Rs. 20,000
1.
Prime Cost Direct Material + Direct Labour + Direct
Expenses
Works/ Factory Cost Prime Cost + Works Overheads + Opening work-
in-progress – Closing Work-in-progress.
Cost of Production Works Cost + Office & Administration
Overheads
Cost of Goods Sold Cost of Production + Opening Finished Goods –
Closing Finished Goods
Cost of Sales Cost of Goods Sold + Selling and Distribution
Overheads
2. Historical cost, Future costs, Replacement cost, Standard cost, Estimated

cost, Product cost, Production cost, Direct cost, Prime cost. Indirect cost,
Fixed cost/Fixed overhead/Period cost, Variable cost, Marginal Cost etc.,
3.
Cost Sheet
Raw Materials consumed Rs.
Wages 90,000
Prime Cost 20,000
Factory Expenses: 100% of Wages 1,10,000
Factory Cost (FC) 20,000
Office Overheads: 20% on FC (1,20,000×20%) 1,30,000
Cost of Production 24,000
1,54,000
65
Cost Sheet
NOTES
Short Questions:
1. What is cost sheet?
2. What is prime cost?
3. What is works cost?
4. What do you mean by costing
5. What is meant by replacement cost?
Long Answer Questions:

1. What are the various methods of costing?
2. Briefly explain the elements of cost
3. What are the different types of cost?
4. In a factory two types of fans namely Orient and Luminas are produced.:
Orient (Rs.) Luminas (Rs.)

Materials 32,800 37,800
Wages 17,800 19,600
Works overhead is 60% of wages and office overhead 20% on work

cost. The selling expenses per fan sold is Rs. 2. The selling price of Usha
and Crompton are Rs. 550 and Rs. 800 respectively. 80 fans of Usha and
100 fans of Crompton are sold. There is no opening or closing stock.
Find the cost and profit per unit sold from the above particulars.
Further Reading:
4. Financial Management: Pandey, I. M. Viksas
5. Theory & Problems in Financial Management: Khan, M.Y. Jain,
P.K. TMH
66
Break Even Analysis
UNIT -VI BREAK EVEN ANALYSIS

Structure
NOTES
6.1. Concept
6.2. Application of Break-Even Analysis
6.3. Limitations of Be Analysis
6.4 Advantages of Break-Even Chart
6.1. CONCEPT
Break- Even point is a very significant concept in Economics and
business, especially in Cost Accounting. Break- Even point is
a point where the cost of production and the revenue from sales are exactly
equal to each other; which means that the firm has neither made profits nor
has incurred any losses. A break-even analysis is a useful tool for
determining at what point your company, or a new product or
service, will be profitable. Put another way, it's a financial calculation used
to determine the number of products or services you need to sell to at least
cover your costs.
6.2. APPLICATION OF BREAK-EVEN ANALYSIS
Break even analysis not only highlights the areas of economic strength and
weakness in the firm but also helps in finding out the ways which can
enhance its profitability. With the help of this analysis management of
production firm can take decisions related to the following:
(i) Safety margin. It decides the extent to which the firm can afford to
decline in sales, before it starts incurring losses.
(ii) Volume needed to attain target profit.
(iii) Change in price, and its affect.
(iv) Whether to expand production capacity or not.
(v) Whether to add a new product or drop production of any product.
(vi) Whether to make or buy.
(vii) Selection of production machinery to get maximum profit for a
particular volume of the product out of the available machineries.
(viii) Improving profit performance by:
a. Increasing the volume of sales, and or
b. Increasing the selling prices, and or
c. Reducing the variable expenses per unit, and or
d. Reducing the fixed costs.
6.3. LIMITATIONS OFBE ANALYSIS
1. The basic assumptions are at times baseless. For example, we can say
that the fixed costs cannot remain unchanged all the time. And the
constant selling price and unit variable cost concept are also not
acceptable.
2. It is difficult to segregate the cost components as fixed and
variable costs.
3. It is difficult to apply formulate in a company.
4. It is a short-run concept and has a limited use in long range planning.
5. It is a static tool since it gives the relationship between cost, volume
and profit at a given point of time and
6. It fails to pre duct future revenues and costs.
67
Break Even Analysis The following illustration will help to understand the whole principle:
NOTES
Method of Preparation:
(a) Draw fixed cost of Rs. 40,000 line parallel to ‘X’ axis. Then plot the
variable cost line over fixed cost level at various level of activity and join
the variable cost line with fixed cost line at zero level of activity which will
indicate total cost line—variable cost being over fixed cost line.
At the same time, ascertain sales value at various activity level and plot
them on the graph paper and then join to zero which line indicates the
volume of sales. It is interesting to note that where the sales line intersects
the total cost line, that is known as Break-Even Point.
Needless to mention here that RES will be ascertained by dropping a

perpendicular to ‘X’ axis from the point of intersection which measures the
horizontal distance from the zero point from where the perpendicular is
drawn. Similarly, in order to find out BES value, another perpendicular to
the ‘Y’ axis from the point of intersection is drawn.
Comments:
From the above BEC, it becomes clear that profit/loss at different levels of
activity can be understood from this chart. For example, if we find the sales
line is about the total cost lines, there will be profit, and vice versa.
Similarly, if total cost is equal to total sales, there is no profit or no loss,
i.e., break-even point. In the above diagram, 50% level of activity brings
break-even level.
6.4 Advantages of Break-Even Chart:
The following advantages may be offered by a BEC:
(i) Easy to Construct and Easy to Understand:
A Break-Even Chart gives us a very clear-cut information which helps the
management to take correct decisions as it depicts a detailed picture of the
entire undertaking.
68
Break Even Analysis
(ii) Useful Tool to Help Management:
We know that a BEC gives us the relationship between Cost, Volume and
Profit. Thus, the same may present the effect of changes in cost and selling
NOTES
price due to the change in variable cost and fixed cost.
(iii) Helps to Select the Most Profitable Product Mix:
No doubt a BEC helps us to select the most profitable product mix or sales
mix for earning more profits.
Problem 1
Pepsi Company produces a single article. Following cost data is given
about its product: ‐ Selling price per unit Rs.40 Marginal cost per
unit Rs.24 Fixed cost per annum Rs. 16000 Calculate:(a) P/V ratio (b)
break even sales (c) sales to earn a profit of Rs. 2,000 (d) Profit at sales of
Rs. 60,000 (e) New break-even sales, if price is reduced by 10%.
Solution: We know that (S‐v) /S= F + P OR s x P/V Ratio =
Contribution
So,
(A) P/V Ratio = Contribution/sales x 100
= (40‐24)/40 x 100 = 16/40 x 100 OR 40%
(B) Break even sales S x P/V Ratio = Fixed Cost
(At breakeven sales, contribution is equal to fixed cost)
Putting this values: s x 40/100 = 16,000
S = 16,000 x 100 / 40 = 40,000 OR 1000 units
(C) The sales to earn a profit of Rs. 2,000
S x P/V Ratio = F + P
Putting this values: s x 40/100 = 16000 + 2000
S = 18,000 x 100/40 S = Rs. 45,000OR 1125 units
(D)Profit at sales of 60,000 S x P/V Ratio = F + P
Putting this values: Rs. 60,000 x 40/100 = 16000 + P
24,000 = 16000 + P
24,000 – 16,000 = P
8,000
(E) New break-even sales, if sale price is reduced by10%
New sales price = 40‐10% = 40‐4 = 36
Marginal cost = Rs. 24 Contribution = Rs. 12 P/V Ratio =
Contribution/Sales = 12/36 x100 OR 33.33%
Now, s x P/V Ratio = F (at B.E.P. contribution is equal to fixed cost) S
x 100/300 = Rs.16000
S = 16000 x 300/100
S= Rs.48,000.
A company has a machine No. 9 which can produce either product A or B.
The cost data relating to machine A and B are as follows:
Problem 2
Particulars Product A Product B
Selling price Rs. 20.00 Rs. 30.00
Variable expenses Rs. 14.00 Rs. 18.00
Contribution Rs. 6.00 Rs. 12.00
a. Capacity of machine No. 9 is 1, 000 hrs.
b. In one hrs machine No. 9 can produce 3 units of A and 1 unit of B.
Which product should machine No. 9 produced?
69
Break Even Analysis
Solution:
NOTES Statement showing contribution per hour for machine No. 9
Particulars Product A Product B
Sales 20.00 30.00
Variable expenses 14.00 18.00
Contribution per unit 6 12
Contribution per hour 18.00 12.00
Contribution per 1, 000 units 18, 000 12, 000
From the above table we can see that company should produce product A
with the help of machine No. 9.

1. Write short on BEP analysis.
2. What are the disadvantages of BEP?
1. Break- Even point is a point where the cost of production and the
revenue from sales are exactly equal to each other, which means that the
firm has neither made profits nor has incurred any losses.
2. It is difficult to apply formulate in a company. It is a short-run

concept and has a limited use in long range planning. It is a static
tool since it gives the relationship between cost, volume and profit at
a given point of time and It fails to pre duct future revenues and
costs.

Short Questions:
1. What is break even analysis
2. What is breakeven point of sale
3. what are the advantages of BEP
4. What are the limitations of BEP
5. Draw a BEP Chart.
Long answer questions.
6. A manufacturer produces 1500 units of products annually. The marginal
cost of each product is Rs. 960 and the product is sold for Rs. 1200. Fixed
cost incurred by the company is Rs. 48, 000 annually. Calculate P/V Ratio
and what would be the break ‐ even point in terms of output and in terms
of sales value?
7. From the information given below, calculate P/V Ratio, Fixed expenses,
expected profit if sales are budgeted at Rs. 90, 000.
Year sales Profit
2004 1, 80, 000 30, 000
2005 2, 60, 000 50, 000
Further Reading:
1. Principles of financial management: Inamdar, S.M. Everest
70
Break Even Analysis
NOTES
71
Standard Costing and Budgeting
UNIT - VII STANDARD COSTING AND NOTES
BUDGETING
Structure
7.1 Definition
7.2 Concept and Importance Standard Costing
7.1 Definition
STANDARD: According to Prof. Erie L.Kolder, “Standard is a desired
attainable objective, a performance, a foal, a model”.
STANDARD COST: Standard cost is a predetermined estimate of cost to
manufacture a single unit or a number of units during a future period. The
Chartered Institute of Management Accountants, London, defines Standard
Cost as, “a pre-determined cost which is calculated from managements
standards of efficient operation and the relevant necessary expenditure. It
may be used as a basis for price fixing and for cost control through
variance analysis”.
STANDARD COSTING: It is defined by I.C.M.A. Terminology as,
“The preparation and use of standard costs, their comparison with actual
costs and the analysis of variances to their causes and points of incidence”.
According to the Chartered Institute of Management Accountants, London
Standard Costing is “the preparation and use of Standard Cost, their
comparison with actual costs, and the analysis of variances to their causes
and points of incidence”.
The study of standard cost comprises of:
1. Ascertainment and use of standard costs.
2. Comparison of actual costs with standard costs and measuring the
variances.
3. Controlling costs by the variance analysis.
4.Reporting to management for taking proper action to maximize the
efficiency.
7.2 Concept and Importance Standard Costing:
7.2.1 Variance Analysis:
Computation of variances
The causes of variance are necessary to find remedial measures;
and therefore, a detailed study of variance analysis is essential. Variances
can be found out with respect to all the elements of cost, i.e., direct
material, direct labour and overheads. The following are the common
variances, which are calculated by the management. Sub-divisions of
variances really give detailed information to the management in order to
control the cost.
1. Material variances
2. Labour variances
3. Overhead variances (a) variable (b) fixed
7.2.2 Material Variance Self-Instructional Material
The following are the variances in the case of materials
71
Standard Costing and Budgeting a) Material Cost Variance (MCV). It is the difference between the
NOTES standard cost of direct materials specified for the output achieved and the
actual cost of direct materials used. The standard cost of materials is
computed by multiplying the standard price with the standard quantity for
actual output; and the actual cost is computed by multiplying the actual
price with the actual quantity. The formula is:
Material Cost Variance (or) MCV:
(Standard cost of materials - Actual cost of materials used) (or)
(Standard Quantity for actual output x Standard Price) - (Actual Quantity x
Actual Rate) (or) (SO x SP) - (AQ x AP)
b) Material Price Variance (MPV). Material price variance is that portion
of the direct materials cost variance which is the difference between the
standard price specified and the actual price paid for the direct materials
used. The formula is:
Material Price Variance:
(Actual Quantity consumed x Standard Price) – (Actual Quantity
consumed x Actual Price) (or) Actual Quantity consumed (Standard Price -
Actual Price) (or) MPV= AQ (SP-AP)
c) Material Usage (Quantity) Variance (MUV). It is the deviation caused
by the standards due to the difference in quantity used. It is calculated by
multiplying the difference between the standard quantity specified and the
actual quantity used by the standard price. Thus, material usage variance is
“that portion of the direct materials cost variance which is the difference
between the standard quantity specified for the production achieved,
whether completed or not, and the actual quantity used, both valued at
standard prices”.
Material Usage or Quantity Variance:
Standard Rate (Standard Quantity Actual Quantity) (or) MUV = SR (SQ-
AQ)
d) Material Mix Variance (MMV). When two or more materials are used
in the manufacture of a product, the difference between the standard
composition and the actual composition of material mix is the material mix
variance. The variance arises due to the change in the ratio of material and
the standard ratio. The formula is:
Material Mix Variance = Standard Rate (Standard Mix – Actual Mix)
Standard is revised due to the shortage of a particular type of material. The
formula is:
MMV = Standard Rate (Revised Standard Quantity - Actual Quantity)
Revised Standard Quantity (RSQ) =
Total weight of actual mix
------------------------------------- x Standard Quantity
Total weight of standard mix
After finding out this revised standard mix it is multiplied by the revised
standard cost of standard mix and then the standard cost of actual mix is
Self-Instructional Material subtracted form the result.
72
Example:1
The standard cost of material for manufacturing a unit a particular product NOTES
is estimated as 16kg of raw materials @ Re. 1 per kg. On completion of the
unit, it was found that 20kg. of raw material costing Rs. 1.50 per kg. has
been consumed. Compute Material Variances.
Answer:
MCV = (SQ x SP) - (AQ x AP) = (16 x Rs.1) - (20 x Rs.1.50)
#NAME?
= Rs. 14 (Adverse) MPV = (SP – AP) x AQ = (1 – 1.50) x 20

= Rs. 10 (Adverse) MUV = (SQ – AQ) x SP = (16 – 20) x 1=
Rs. 4 (Adverse)
Example:2
Calculate the materials mix variance from the following:
Material Standard Actual
A 90 units at rs12 each 100 units at rs. 12 each
B 60 units at rs.15 each 50 units at rs. 16 each
Answer:
Qty Rate Amount Qty Rate Amount
A 90 12 1080 100 12 1200
B 60 15 900 50 16 800
150 1980 150 2000
MMV = SR (SQ-AQ)
Material A: MMV = Rs.12 (90-100)
= Rs 12 x10
= Rs. 120(A)
Material „B‟: MMV = Rs. 15 (60-50)
= Rs. 15 x 10
= Rs 150 (F) Total MMV = Rs. 120(A) + Rs. 150 (F)= Rs. 30 (F)
(e) Material Yield Variance: It is that portion of the direct material usage
variance which is due to the difference between the standard yield
specified and the actual yield obtained. The variance arises due to
abnormal contingencies like spoilage, chemical reaction etc. Since the
variance is a measure of the waste or loss in the production, it known as
material loss or waste variance.
ICMA, LONDON, it is defined as “The difference between the
standard yield of the actual material input and the actual yield, both
valued at the standard material cost of the produce”. in case actual yield
is more than the standard yield, the material yield variance is favourable
and, if the actual yield is less than the standard yield, the variance is
unfavourable or adverse.
(i) When actual mix and standard mix are the same, the formula is: MYV =
Standard Yield Rate (Standard Yield - Actual Yield)
(or) = Standard Revised Rate (Actual Loss - Standard Loss) Self-Instructional Material
Here Standard Yield Rate =

73
Standard Costing and Budgeting Standard cost of standard mix
NOTES ---------------------------------------
Net standard output
Net standard output = Gross output – Standard loss

(ii) When the actual mix and the standard mix differ from each other, the
formula is:
Standard Rate = Standard cost of revised standard mix
----------------------------------------------------
Net Standard Output
Material Yield Variance=

Standard Rate (Actual Standard Yield – Revised Standard Yield)
7.2.3 Labour Variances
Labour Variances arise because of (I) Difference in Actual Rates and
Standard Rates of Labour and (Ii) The variation in Actual Time taken y
workers and the Standard Time allotted to them for performing a job.
These are computed on the same pattern as that of Material Variances.
For Labour Variances by simply putting the word “Time” in place of
“Quantity” in the formula meant for Material Variances. The various
Labour Variances can be analysed as follows:
(A) Labour Cost Variance
(B) Labour Rate Variance
(C) Labour Time or Efficiency Variance
(D) Labour Idle Time Variance
(E) Labour Mix Variance or Gang Composition Variance
a) Labour Cost Variance (LCV)
This variance represents the difference between the Standard Labour Costs
and the Actual Labour Costs for the production achieved. If the Standard
Cost is higher, the variation is favourable and vice versa. It is calculated as
follows:
Labour Cost Variance: = (Standard Cost of Labour - Actual Cost of
Labour)
#NAME?
#NAME?
b) Labour Rate Variance (LRV)
It is the difference between the Standard Rate of pay specified and the
Actual Rate Paid. According to ICMA, London, the variance is “the
difference between the standard and the actual direct Labour Rate per hour
for the total hours worked. If the standard rate is higher, the variance is
Favourable and vice versa.
Labour Rate Variance = Actual Time (Standard Wage Rate X Actual Wage
Rate)
=AT (SR-AR)
74
C) Labour Time or Labour Efficiency Variance (LEV)
It is the difference between the Standard Hours for the actual production NOTES
achieved and the hours actually worked, valued at the Standard Labour
Rate. When the workers finish the specific job in less than the Standard
Time, the variance is Favourable. If the workers take more time than the
allotted time, the variance is Adverse.
Labour Efficiency Variance (LEV):
=Standard Rate (Standard Time - Actual Time)
=SR (ST-AT)
d) Idle Time Variance: It arises because of the time during which the
Labour remains idle due to abnormal reasons, i.e. power failure, strikes,
machine breakdown, shortage of materials, etc. It is always an Adverse
variance
Labour Idle Time Variance = Actual Idle Time x Standard Hourly Rate
e) Labour Mix Variance or Gang Composition Variance (LMV):
It is the difference between the standard composition of workers and the
actual gang of workers. It is a part of labour efficiency variance. It
corresponds to material mix variance. It enables the management to study
the labour cost variance occurred because of the changes in the
composition of labour force.
The rates of pay of the different categories of workers-skilled, semi-skilled
and unskilled are different. Hence, any change made in composition of the
workers will naturally cause variance. How much is variance due to the
change, is indicated by Labour Mix Variance.
(i) When the total hours i.e. time of the standard composition and actual
composition of workers does not differ, the formula is:
Labour Mix variance= (Standard Cost of Standard Mix) - (Standard cost of
Actual Mix)
(ii) When the total hours i.e. time of the standard composition and actual
composition of workers differs, the formula is:
Labour Mix variance
Total Time of Actual mix ------------x Std cost of Std. mix) - (Std. cost of
Actual Mix) Total Time of Standard mix
If, on account of short availability of some category of workers, the
standard composition is itself revised, then Labour Mix Variance will be
calculated by taking revised standard mix in place of standard mix.
Labour Yield Variance (LYV)
It is just like Material Yield Variance. It is the difference between the
standard labour output and actual output of yield. It is calculated as below:
Labour Yield Variance
= Standard cost per unit {Standard production of Actual mix - Actual
Production}
7.2.4OVERHEAD VARIANCE
It is the difference between standard overheads for actual output i.e.
Recovered Overheads and Actual Overheads. It is the total of both fixed
and variable overhead variances. The variable overheads are those costs
75
Standard Costing and Budgeting which tend to vary directly in proportion to changes in the volume of
NOTES production. Fixed overheads consist of costs which are not subject to
change with the change in the volume of production. The variances under
overheads are analysed in two heads, viz Variable Overheads and Fixed
Overheads:
Overheads Cost Variance= Standard Total Overheads-Actual Total
Overheads
The term overhead includes indirect material, indirect labour and indirect
expenses and the variances relate to factory, office or selling and
distribution overheads. Overhead variances are divided into two broad
categories: (i) Variable overhead variances and (ii) Fixed overhead
variances. To compute overhead variances, the following terms must be
understood:
a) Standard overhead rate per unit
Budgeted overheads
#NAME?
Budgeted output
b) Standard overheads rate per hour
Budgeted overheads
#NAME?
Budgeted hours
c) Standard hours for actual output
Budgeted hours
……………………. x Actual output
Budgeted output
d) Standard output for actual time
Budgeted output
……………………. x Actual hours
Budgeted hours
e) Recovered or Absorbed overheads = Standard rate per unit x Actual

output f) Budgeted overheads = Standard rate per unit x budgeted output
g) Standard overheads = Standard rate per unit x Standard output for
actual time
h) Actual overheads = Actual rate per unit x Actual output
7.2.5 VARIABLE OVERHEAD VARIANCE
Variable cost varies in proportion to the level of output, while the cost is
fixed per unit. As such the standard cost per unit of these overheads
remains the same irrespective of the level of output attained. As the volume
does not affect the variable cost per unit or per hour, the only factors
leading to difference is price. It results due to the change in the expenditure
incurred.
(i) Variable Overhead Expenditure Variance: It is the difference
between actual variable overhead expenditure incurred and the standard
Self-Instructional Material variable overheads set in for a particular period. The formula is: -
76
{Actual Hours Worked X Standard Variable Overhead Rate per hour}-
Actual NOTES
(ii) Variable Overhead Efficiency Variance:

It shows the effect of change in labour efficiency on variable overheads
recovery. The formula is: - Standard Rate (Standard Quantity-
Actual Quantity)
Standard Overhead Rate= (Standard Time for Actual output- Actual Time)
(iii) Variable Overhead Variance
It is divided into two: Overhead Expenditure Variance and Overhead
Efficiency variance.
The formula is: -
Variable overhead Expenditure Variance + Variable overhead Efficiency
variance
7.2.6 FIXED OVERHEAD VARIANCE (FOV):
Fixed overhead variance depends on (a) fixed expenses incurred and (b)
the volume of production obtained. The volume of production depends
upon (i) efficiency (ii) the days for which the factory runs in a week
(calendar variance) (iii) capacity of plant for production.
FOV = Actual Output (Fixed Overhead Rate - Actual Fixed Overheads)
(a) Fixed Overhead Expenditure Variance. (Budgeted or cost Variance).
It is that portion of the fixed overhead which is incurred during a particular
period due to the difference between the budgeted fixed overheads and the
actual fixed overheads.
Fixed Overhead expenditure variance=Budgeted fixed overhead-Actual
fixed overhead
(b) Fixed Overhead Volume Variance. This variance is the difference
between the standard cost of overhead absorbed in actual output and the
standard allowance for that output. This variance measures the cover of
under recovery of fixed overheads due to deviation of actual output form
the budgeted output level.
(i) On the basis of units of output:
Fixed Overhead Volume Variance = Standard Rate (Budgeted Output-
Actual Output) OR
= (Budgeted Cost –Standard Cost) OR
= (Actual Output x Standard Rate)- Budgeted Fixed Overhead
(ii)On the basis of standard hours: Fixed Overhead Volume Variance =

Standard Rate per hour (Budgeted Hours-Standard Hours) Standard Hour =
Actual Output + Standard Output per hour
Example: 1
A manufacturing concern furnished the following information:
Standard: Material for 70kg, finished products:100kg; Price of materials:
Re.1 per kg
Actual: Output: 2,10,000 kg; Material used: 2,80,000; cost of material:
Rs.5,52,000.
Calculate: -
77
Standard Costing and Budgeting (a) Material Usage Variance (b) Material Price Variance (c) Material Cost
NOTES Variance
Solution:
Standard quantity:
For 70kg standard output
Standard quantity of material = 100 kg
210000 kg of finished products
= 210000 x 100
70 = 300000 kg
Actual Price per kg

= 252000
280000 = 0.90
A) Material usage or quantity variance

= SP (SQ – AQ)
1 (300000 – 280000)
1 X 20000
Rs. 20000 (Favourable)
B) Material price variance
= AQ (SP – AP)
280000 (1 – 0.90)
280000 X 0.10
Rs. 28000 (Favourable)
C) Material cost variance
= (SQ x SP) – (AQ x AP)
(300000 x 1) – (280000 x 0.90)
(300000) – (252000)
Rs 48000 (Favourable)
Exercise: 1
With the help of following information calculate:
a) Labour Cost variance
b) Labour rate variance
c) Labour Efficiency variance
Standard hours: 40 at Rs. 3 per hour.
Actual hours 50 at Rs. 4 per hour.
Exercise: 2
Vivek Ltd has furnished you the following for the month of Aug. 1994
Particulars Budget Actual
Output 30000 32500
Units (hour) 30000 33000
Fixed hours Rs. 45000 Rs. 50000
Variable OH Rs. 60000 Rs. 68000
Working days 25 26
Calculate the variances
78
NOTES
1. Define Standard cost.
2. What is labour rate variance?

1. “a pre-determined cost which is calculated from managements standards
of efficient operation and the relevant necessary expenditure. It may be
used as a basis for price fixing and for cost control through variance
analysis”.
2. “the difference between the standard and the actual direct Labour Rate
per hour for the total hours worked. If the standard rate is higher, the
variance is Favourable and vice versa.
Labour Rate Variance = Actual Time (Standard Wage Rate x Actual Wage
Rate)
=AT (SR-AR)

Short Questions:
1. What is standard costing
2. What is material cost variance?
3. What is fixed cost variance?
4. From the following information calculate:
a) Labour Cost variance
b) Labour rate variance
c) Labour Efficiency variance
Standard hours: 40 at Rs. 3 per hour.
Actual hours 50 at Rs. 4 per hour.
Further Reading:
1. Financial management: Panday, I.M. 9th ed Vikas
4. Financial Management: Text & Problems, Khan, M. Y Jain, P.K.
3rd ed, TMH
79
Budgets and Budgetary Control
NOTES
UNIT - VIII BUDGETS AND
BUDGETARY CONTROL
Structure
8.1 Introduction
8.2 Definition of Budget
8.3 Types of Budgeting
8.1 Introduction
To achieve the organizational objectives, an enterprise should be managed
effectively and efficiently. It is facilitated by chalking out the course of
action in advance. Planning, the primary function of management helps to
chalk out the course of actions in advance. But planning is to be followed
by continuous comparison of the actual performance with the planned
performance, i.e., controlling. One systematic approach in effective
follow up process is budgeting. Different budgets are prepared by the
enterprise for different purposes. Thus, budgeting is an integral part of
management.
8.2 Definition of Budget:
“A budget is a comprehensive and coordinated plan, expressed in financial
terms, for the operations and resources of an enterprise for some specific
period in the future”. (Fremgen, James M – Accounting for Managerial
Analysis)
“A budget is a predetermined detailed plan of action developed and
distributed as a guide to current operations and as a partial basis for the
subsequent evaluation of performance”. (Gordon and Shillinglaw)
“A budget is a financial and/or quantitative statement, prepared prior to a
defined period of time, of the policy to be pursued during the period for the
purpose of attaining a given objective”. (The Chartered Institute of
Management Accountants, London)
Definition of Budgetary Control:
CIMA, London defines budgetary control as, “the establishment of the
budgets relating to the responsibility of executives to the requirements of a
policy and the continuous comparison of actual with budgeted result either
to secure by individual action the objectives of that policy or to provide a
firm basis for its revision”
“Budgetary Control is a planning in advance of the various functions of a
business so that the business as a whole is controlled”. (Wheldon)
“Budgetary Control is a system of controlling costs which includes the
preparation of budgets, coordinating the department and establishing
responsibilities, comprising actual performance with the budgeted and
acting upon results to achieve maximum profitability”. (Brown and
Howard)
Budget, Budgeting and Budgetary Control:
A budget is a blueprint of a plan expressed in quantitative terms. Budgeting
is a technique for formulating budgets. Budgetary Control refers to the
80
principles, procedures and practices of achieving given objectives through
budgets. NOTES
According to Rowland and William, “Budgets are the individual objectives

of a department, whereas Budgeting may be the act of building budgets.
Budgetary control embraces all and in addition includes the science of
planning the budgets to effect an overall management tool for the business
planning and control”.
8.3 Types of Budgeting:
Budget can be classified into three categories from different points of view.
They are:
1. According to Function
2. According to Flexibility
3. According to Time
I. According to Function:
(a) Sales Budget:
The budget which estimates total sales in terms of items, quantity, value,
periods, areas, etc is called Sales Budget.
(b) Production Budget:
It estimates quantity of production in terms of items, periods, areas, etc. It
is prepared based on Sales Budget.
(c) Cost of Production Budget:
This budget forecasts the cost of production. Separate budgets may also be
prepared for each element of costs such as direct materials budgets, direct
labour budget, factory materials budgets, office overheads budget, selling
and distribution overheads budget, etc.
(d) Purchase Budget:
This budget forecasts the quantity and value of purchase required for
production. It gives quantity wise, money wise and period wise about the
materials to be purchased.
(e) Personnel Budget:
The budget that anticipates the quantity of personnel required during a
period for production activity is known as Personnel Budget.
(f) Research Budget:
The budget relates to the research work to be done for improvement in
quality of the products or research for new products.
(g) Capital Expenditure Budget:
The budget provides a guidance regarding the amount of capital that may
be required for procurement of capital assets during the budget period.
(h) Cash Budget:
This budget is a forecast of the cash position by time period for a specific
duration of time. It states the estimated amount of cash receipts and
estimation of cash payments and the likely balance of cash in hand at the
end of different periods.
(i) Master Budget:
81
Budgets and Budgetary Control It is a summary budget incorporating all functional budgets in a capsule
NOTES form. It interprets different functional budgets and covers within
its range the preparation of projected income statement and projected
balance sheet.
II. According to Flexibility:
On the basis of flexibility, budgets can be divided into two categories.
They are:
1. Fixed Budget
2. Flexible Budget
1. Fixed Budget:
Fixed Budget is one which is prepared on the basis of a standard or a fixed
level of activity. It does not change with the change in the level of activity.
2. Flexible Budget:
A budget prepared to give the budgeted cost of any level of activity is
termed as a flexible budget. According to CIMA, London, a Flexible
Budget is, “a budget designed to change in accordance with level of
activity attained”. It is prepared by taking into account the fixed and
variable elements of cost.
III. According to Time:
On the basis of time, the budget can be classified as follows:
1. Long term budget
2. Short term budget
3. Current budget
4. Rolling budget
1. Long-term Budget:
A budget prepared for considerably long period of time, viz., 5 to 10 years
is called Long-term Budget. It is concerned with the planning of operations
of the firm. It is generally prepared in terms of physical quantities.
2. Short-term Budget:
A budget prepared generally for a period not exceeding 5 years is called
Short - term Budget. It is generally prepared in terms of physical quantities
and in monetary units.
3. Current Budget:
It is a budget for a very short period, say, a month or a quarter. It is
adjusted to current conditions. Therefore, it is called current budget.
4. Rolling Budget:
It is also known as Progressive Budget. Under this method, a budget for a
year in advance is prepared. A new budget is prepared after the end of each
month/quarter for a full year ahead. The figures for the month/quarter
which has rolled down are dropped and the figures for the next
month/quarter are added. This practice continues whenever a
month/quarter ends and a new month/quarter begins.
I. SALES BUDGET:
Sales budget is the basis for the preparation of other budgets. It is the
Self-Instructional Material forecast of sales to be achieved in a budget period. The sales manager is
82
directly responsible for the preparation of this budget. The following
factors taken into consideration: NOTES
a. Past sales figures and trend b. Salesmen’s estimates

c. Plant capacity
d. General trade position e. Orders in hand
f. Proposed expansion g. Seasonal fluctuations h. Market demand
i. Availability of raw materials and other supplies j. Financial position
k. Nature of competition l. Cost of distribution
m. Government controls and regulations n. Political situation.
Example
1. The Royal Industries has prepared its annual sales forecast,
expecting to achieve sales of Rs.30,00,000 next year. The
Controller is uncertain about the pattern of sales to be expected by
month and asks you to prepare a monthly budget of sales. The
following sales data pertained to the year, which is considered
to be representative of a normal year:
Month Sales (Rs.) Month Sales (Rs.)

January 1,10,000 July 2,60,000
February 1,15,000 August 3,30,000
March 1,00,000 September 3,40,000
April 1,40,000 October 3,50,000
May 1,80,000 November 2,00,000
June 2,25,000 December 1,50,000
Prepare a monthly sales budget for the coming year based on the above
data.
Answer: Sales Budget
Month Sales Sales estimation based on cash sales ratio

(given) given
January 1,10,000 (1,10,000/25,00,000) x 30,00,000 = 1,32,000
February 1,15,000 (1,15,000/25,00,000) x 30,00,000 = 1,38,000
March 1,00,000 (1,00,000/25,00,000) x 30,00,000 = 1,20,000
April 1,40,000 (1,40,000/25,00,000) x 30,00,000 = 1,68,000
May 1,80,000 (1,80,000/25,00,000) x 30,00,000 = 2,16,000
June 2,25,000 (2,25,000/25,00,000) x 30,00,000 = 2,70,000
July 2,60,000 (2,60,000/25,00,000) x 30,00,000 = 3,12,000
August 3,30,000 (3,30,000/25,00,000) x 30,00,000 = 3,96,000

September 3,40,000 (3,40,000/25,00,000) x 30,00,000 = 4,08,000

83
NOTES
October 3,50,000 (3,50,000/25,00,000) x 30,00,000 = 4,20,000
November 2,00,000 (2,00,000/25,00,000) x 30,00,000 = 2,40,000
December 1,50,000 (1,50,000/25,00,000) x 30,00,000 = 1,80,000
Total 25,00,000 30,00,000
Example:
2. M/s. Alpha Manufacturing Company produces two types of products,
viz., Raja and Rani and sells them in Chennai and Mumbai markets. The
following information is made available for the current year:
Market Product Budgeted Sales Actual Sales
Chennai Raja 400 units @ Rs.9 each 500 units @ Rs.9 each
,, Rani 300 units @ Rs.21 each 200 units @ Rs.21 each
Mumbai Raja 600 units @ Rs.9 each 700 units @ Rs.9 each
Rani 500 units @ Rs.21 each 400 units @ Rs.21 each
Market studies reveal that Raja is popular as it is under-priced. It is
observed that if its price is increased by Re.1 it will find a readymade
market. On the other hand, Rani is overpriced, and market could absorb
more sales if its price is reduced to Rs.20. The management has agreed to
give effect to the above price changes.
On the above basis, the following estimates have been prepared by Sales
Manager:
% increase in sales over current budget
Product
Chennai Mumbai
Raja 10% 5%
Rani 20% 10%
With the help of an intensive advertisement campaign, the following
additional sales above the estimated sales of sales manager are possible:
Product Chennai Mumbai
Raja 60 units 70 units
Rani 40 units 50 units
You are required to prepare a budget for sales incorporating the above
estimates.
Answer:
Sales Budget
84
NOTES
Workings:
1. Budgeted sales for Chennai:
Raja Rani
Units Units
Budgeted Sales 400 300
Add: Increase (10%) 40 (20%) 60
440 360
Increase due to advertisement 60 40
Total 500 400
2. Budgeted sales for Mumbai:

Raja Rani
Units Units
Budgeted Sales 600 500
Add: Increase (5%) 30 (10%) 50
630 550
Increase due to advertisement 70 50
Total 700 600
II. PRODUCTION BUDGET:

Production = Sales + Closing Stock – Opening Stock
Example:
3. The sales of a concern for the next year is estimated at 50,000 units.
Each unit of the product requires 2 units of Material „A‟ and 3 units of
Material „B‟. The estimated opening balances at the commencement of the
next year are:
Finished Product : 10,000 units
Raw Material “A” : 12,000 units
Raw Material “B” : 15,000 units
The desirable closing balances at the end of the next year are:
Finished Product : 14,000 units
Raw Material “A” : 13,000 units
Raw Material “B” : 16,000 units
Prepare the materials purchase budget for the next year. Self-Instructional Material
Answer:
85
Budgets and Budgetary Control Production Budget
NOTES Estimated Sales 50,000 units
14,000 ,,
Add: Estimated Closing Finished Goods
64,000 ,,
10,000 ,,
Less: Estimated Opening Finished Goods
Production 54,000 ,,
Materials Purchase Budget
Material A Material B
Material Consumption 1,08,000 units 1,62,000 units
Add: Closing stock of materials 13,000 16,000
1,21,000 1,78,000
Less: Opening stock of materials 12,000 15,000
Materials to be purchased 1,09,000 1,63,000
Workings:
Materials consumption: Material A Material B
Material required per unit of production 2 units 3 units
For production of 54,000 units 1,08,000 1,62,000
1. Define budget.
2. What is sales budget?
1“A budget is a predetermined detailed plan of action developed and
distributed as a guide to current operations and as a partial basis for the
subsequent evaluation of performance”.
2. Sales budget is the basis for the preparation of other budgets. It is the
forecast of sales to be achieved in a budget period. The sales manager is
directly responsible for the preparation of this budget.
Short Questions:
1. What is cash budget?
2. What is zero budget?
3. What is flexible budget?
4. What is fixed budget?
5. What is master budget?
Long Questions:
1. What are the points to be considered while preparing material
purchase budget?
2. How do you prepare production budget?
Further Reading:
3rd ed, TMH
Self-Instructional Material 5. Cost and Management Accounting, Jain S.P. & Narang, K.L.
86
Budgets
UNIT - IX BUDGETS NOTES

Structure
9.1 Cash Budget
9.2. Procedure for Preparation of Cash Budget
9.3 Master Budget
9.4 Flexible Budget
9.5 Zero Base Budgeting (ZBB)
9.1 CASH BUDGET
It is an estimate of cash receipts and disbursements during a future period.
“The Cash Budget is an analysis of flow of cash in a business over a future,
short or long period of time. It is a forecast of expected cash intake and
outlay” (Soleman, Ezra – Handbook of Business administration).
9.2. PROCEDURE FOR PREPARATION OF CASH

BUDGET
1. First take into account the opening cash balance, if any, for the
beginning of the period for which the cash budget is to be prepared.
2. Then Cash receipts from various sources are estimated. It may be from
cash sales, cash collections from debtors/bills receivables, dividends,
interest on investments, sale of assets, etc.
3. The Cash payments for various disbursements are also estimated. It
may be for cash purchases, payment to creditors/bills payables, payment to
revenue and capital expenditure, creditors for expenses, etc.
4. The estimated cash receipts are added to the opening cash balance, if
any.
5. The estimated cash payments are deducted from the above proceeds.
6. The balance, if any, is the closing cash balance of the month concerned.
7. The closing cash balance is taken as the opening cash balance of the
following month.
8. Then the process is repeatedly performed.
9. If the closing balance of any month is negative i.e the estimated cash
payments exceed estimated cash receipts, then overdraft facility may also
be arranged suitably.
Example:
1. From the following budgeted figures prepare a Cash Budget in respect of
three months to June 30, 2006.
Month Sales Materials Wages Overheads
Rs. Rs. Rs. Rs.
January 60,000 40,000 11,000 6,200
February 56,000 48,000 11,600 6,600
March 64,000 50,000 12,000 6,800
April 80,000 56,000 12,400 7,200
May 84,000 62,000 13,000 8,600
June 76,000 50,000 14,000 8,000
Additional information:
1. Expected Cash balance on 1st April 2006 – Rs. 20,000
2. Materials and overheads are to be paid during the month following the
month of supply.
3. Wages are to be paid during the month in which they are incurred.
87
Budgets 4. All sales are on credit basis.
NOTES
5. The terms of credits are payment by the end of the month following the
month of sales: Half of credit sales are paid when due the other half to be
paid within the month following actual sales.
6. 5% sales commission is to be paid within in the month following sales
7. Preference Dividends for Rs. 30,000 is to be paid on 1st May.
8. Share call money of Rs. 25,000 is due on 1st April and 1st June.
9. Plant and machinery worth Rs. 10,000 is to be installed in the month of
January and the payment are to be made in the month of June.
Answer:
Cash Budget for three months from April to June 2006
Particulars April May June
Rs. Rs. Rs.
Opening Cash Balance 20,000 32,000 (-) 5,600
Add: Estimated Cash Receipts:
Sales Collection form debtors 60,000 72,000 82,000
Share call money 25,000 25,000
1,05,000 1,04,600 1,01,400
Less: Estimated Cash Payments:
Materials 50,000 56,000 62,000
Wages 12,400 13,000 14,000
Overheads 6,800 7,200 8,600
Sales Commission 3,200 4,000 42,000
Preference Dividend Nil 30,000 Nil
Plant and Machinery Nil Nil 10,000
72,400 1,10,200 98,800
Closing Cash Balance 32,600 (-)5,600 2,600
Workings:
1. Sales Collection:
Payment is due at the month following the sales. Half is paid on due and
another half is paid during the next month. Therefore, February sales Rs.
50,000 is due at the end of March. Half is given at the end of March and
another half is given in the next month i.e., in the month of April. Hence,
the sales collection for the month of April will be as follows:
For April – Half of February Sales (56,000 x ½) = 28,000

- Half of March Sales (64,000 x ½) = 32,000
Total Collection for April = 60,000
Similarly, the sales collection for the months of May and June may be
calculated.
2. Materials and overheads:
These are paid in the following month. That is March is paid in April, April
is paid in May and May is paid in June.
3. Sales Commission:
It is paid in the following month. Therefore,
For April – 5% of March Sales (64,000 x 5 /100) = 3,200
88
Budgets
For May – 5% of March Sales (80,000 x 5 /100) = 4,000
For April – 5% of March Sales (84,000 x 5 /100) = 4,200 NOTES
9.3 MASTER BUDGET

Master budget is a comprehensive plan which is prepared from and
summarizes the functional budgets. The master budget embraces both
operating decisions and financial decisions. When all budgets are ready,
they can finally produce budgeted profit and loss account or income
statement and budgeted balance sheet. Such results can be projected
monthly, quarterly, half-yearly and at year end. When the budgeted profit
falls short of target it may be reviewed and all budgets may be reworked to
reach the target or to achieve a revised target approved by the budget
committee.
9.4 FLEXIBLE BUDGET
A flexible budget consists of a series of budgets for different level of
activity. Therefore, it varies with the level of activity attained. According
to CIMA, London, A Flexible Budget is, „a budget designed to change in
accordance with level of activity attained‟. It is prepared by taking into
account the fixed and variable elements of cost. This budget is more
suitable when the forecasting of demand is uncertain.
Points to be remembered while preparing a flexible budget:
1. Cost can be classified into fixed and variable cost.
2. Total fixed cost remains constant at any level of activity.
3. Total Variable cost varies in the same proportion at which the level of
activity varies.
4. Fixed and variable portion of Semi-variable cost is to be segregated.
5. The following information at 50% capacity is given. Prepare a flexible
budget and forecast the profit or loss at 60%, 70% and 90% capacity.
Example
Fixed expenses: Expenses at 50% capacity (Rs.)
Salaries 5,000
Rent and taxes 4,000
Depreciation 6,000
Administrative expenses 7,000
Variable expenses:
Materials 20,000
Labour 25,000
Others 4,000
Semi-variable expenses:
Repairs 10,000
Indirect Labour 15,000
Others 9,000
It is estimated that fixed expenses will remain constant at all capacities.

Semi- variable expenses will not change between 45% and 60% capacity,
will rise by10% between 60% and 75% capacity, a further increase of 5%
when capacity crosses 75%.
89
Budgets Estimated sales at various levels of capacity are:
NOTES
Capacity Sales (Rs.)
60% 1,10,000
70% 1,30,000
90% 1,50,000
Answer: FLEXIBLE BUDGET (Showing Profit & Loss at various

capacities)
Capacities
Particulars 50% 60% 70% 90%
Rs. Rs. Rs. Rs.
Fixed Expenses:
Salaries 5,000 5,000 5,000 5,000
Rent and taxes 4,000 4,000 4,000 4,000
Depreciation 6,000 6,000 6,000 6,000
Administrative expenses 7,000 7,000 7,000 7,000
Variable expenses:
Materials 20,000 24,000 28,000 36,000
Labour 25,000 30,000 35,000 45,000
Others 4,000 4,800 5,600 7,200
Semi – Variable expenses:
Repairs 10,000 10,000 11,000 11,500
Indirect labour 15,000 15,000 16,500 17,250
Other 9,000 9,000 9,900 10,350
Total cost 1,05,000 1,14,800 1,28,000 1,49,300
Profit (+) or loss (-) (-) 4,800 (+)2,000 (+)700
Estimated sales 1,10,000 1,30,000 1,50,000
Example 2:
The following information relates to a flexible budget at 60% capacity.

Find out the overhead costs at 50% and 70% capacity and also determine
the overhead rates:
Particulars Expenses at 60% capacity

Variable overheads: Rs.
Indirect Materials 8,400
Semi-variable overheads:
Repair and Maintenance 7,000
(70% fixed; 30% variable)
Electricity 25,200
Self-Instructional Material (50% fixed; 50% variable)
Fixed overheads:
90
Budgets
Office expenses including salaries 70,000
Insurance 4,000 NOTES
Depreciation 20,000
Estimated direct labour hours 1,20,000 hours
Answer: FLEXIBLE BUDGET
50 % 60% 70%
Capacity Capacity Capacity
Rs. Rs. Rs.
Variable overheads:
Indirect Labour 8,750 10,500 12,250
Indirect Materials 7,000 8,400
Repair and Maintenance 6,650 7,000
(1)
Electricity 23,100 25,200
(2)
Fixed overheads:
Office expenses including 70,000 70,000 70,000
salaries
Insurance 4,000 4,000 4,000
Depreciation 20,000 20,000 20,000
Total overheads 1,39,500 1,45,100 1,50,700
Estimated direct labour hours 1,00,000 1,20,000 1,50,000
Overhead rate per hour (Rs.) 1.395 1.21 1.077
Workings:
1. The number of Repairs and maintenance at 60% Capacity is Rs.
7,000. Out of this, 70% (i.e Rs. 4,900) is fixed and remaining 30% (i.e Rs.
2,100) is variable. The fixed portion remains constant at all levels of
capacities. Only the variable portion will change according to change in the
level of activity. Therefore, the total amount of repairs and maintenance for
50% and 70% capacities are calculated as follows:
Repairs and maintenance 50% 60% 70%

Fixed (70%) 4,900 4,900 4,900
Variable (30%) 1,750 2,100 2,450
Total 6,650 7,000 7,350
9.5 ZERO BASE BUDGETING (ZBB)

It is a management technique aimed at cost reduction. It was introduced by
the U. S. Department of Agriculture in 1961. Peter A. Phyrr popularized it.
In 1979, president Jimmy Carter issued a mandate asking for the use of
ZBB by the Government.
91
Budgets 9.5.1 ZBB - Definition:
NOTES
“It is a planning and budgeting process which requires each manager to
justify his entire budget request in detail from scratch (Zero Base) and
shifts the burden of proof to each manager to justify why he should spend
money at all. The approach requires that all activities be analysed in
decision packages, which are evaluated by systematic analysis and ranked
in the order of importance”. – Peter A. Phyrr.
It implies that-
Every budget starts with a zero base
No previous figure is to be taken as a base for adjustments
Every activity is to be carefully examined afresh
Each budget allocation is to be justified on the basis of anticipated
circumstances
Alternatives are to be given due consideration
9.5.2 Advantages of ZBB:
1. Effective cost control can be achieved

2. Facilitates careful planning
3. Management by Objectives becomes a reality
4. Identifies uneconomical activities
5. Controls inefficiencies
6. Scarce resources are used beneficially
7. Examines each activity thoroughly
8. Controls wasteful expenditure
9. Integrates the management functions of planning and control
10. Reviews activities before allowing funds for them.
1. What is zero base budgeting?

2. Define flexible budget.
3. Prepare a Cost Sheet from the following information
Wages – Rs. 20,000
1. It is a management technique aimed at cost reduction. It was

introduced by the U. S. Department of Agriculture in 1961
2. A Flexible Budget is, „a budget designed to change in accordance
with level of activity attained‟.
Short Questions:
Self-Instructional Material 1. What cash budget?
2. What are the importance of preparing cash budget?
92
Budgets
3. What is master budget?
4. What is flexible budget? NOTES
Long Answer Questions:
1. What are the points to be considered while preparing cash budget?

2. What are the advantages and disadvantages of cash budget?
3. Why do you prepare flexible budget?
4. State the merits and demerits of zero-base budgeting.
5. From the following budgeted figures prepare a Cash Budget in

respect of three months to June 30, 2006.
Rs. Rs. Rs. Rs.
January 70,000 50,000 11,000 6,200
February 66,000 58,000 11,600 6,600
March 74,000 60,000 12,000 6,800
April 90,000 66,000 12,400 7,200
May 94,000 72,000 13,000 8,600
June 86,000 60,000 14,000 8,000
2. Materials and overheads are to be paid during the month
following the month of supply.
3. Wages are to be paid during the month in which they are
incurred.
4. All sales are on credit basis.
5. The terms of credits are payment by the end of the month
following the month of sales: Half of credit sales are paid when due
the other half to be paid within the month following actual sales.
6. 5% sales commission is to be paid within in the month following
sales
9. Plant and machinery worth Rs. 10,000 is to be installed in the
month of January and the payment are to be made in the month of
June.
6. The following information relates to a flexible budget at 50% capacity.

Find out the overhead costs at 60% and 70% capacity and determine the
overhead rates:
Particulars Expenses at 50% capacity

Variable overheads: Rs.
Indirect Materials 8,400
93
Budgets Repair and Maintenance 7,000
NOTES (70% fixed; 30% variable)
Electricity 25,200
(50% fixed; 50% variable)
Fixed overheads:
Office expenses including salaries 70,000
Insurance 4,000
Depreciation 20,000
Estimated direct labour hours 1,20,000 hours
Further Reading:
1. Financial management: Theory. Concepts and Problems, Rustagi,
R.P. 3rd revised ed, Galgotia
P.K. TMH
94
Financial Management
BLOCK - IV NOTES
UNIT – X FINANCIAL MANAGEMENT

Structure
10.1 Introduction
10.3 Scope of Financial Management
10.4Objectives of Financial Management:
10.5 Differences between Profit maximization &Wealth maximization
10.6 Other Objectives
10.8 Role of Finance Manager
10.9Financial Management and other Functional Areas
10.10 Significance of Financial Management
10.11 The changing scenario of Financial Management in India
10.1 Introduction
Finance is the life blood and nerve Centre of a business, just as
circulation of blood is essential in the human body for maintaining life;
finance is very essential for smooth running of the business. It has been
rightly termed as universal lubricant that keeps the firm dynamic. No
business, whether big, medium or small, can be started without an adequate
amount of finance. Right from the very beginning i.e . , conceiving an idea
to business, finance is needed to promote or establish the business, acquire
fixed assets, make investigations such as market surveys etc., develop
product, keep men and machines at work, encourage management to make
progress and create values. Even an existing firm may require further
finance for making improvement or expanding the business. Finance has
thus become an integral part of the firm. Unless the finance is managed in a
profitable manner, the firm cannot reach its full potentials for growth and
success. In order to manage finance, a new management discipline was
conceived. Such discipline is known as financial management. Financial
management was a branch of Economics till 1890. Later on its was
developed into a separate subject. The subject of financial management has
become utmost important both to the academicians and practicing
managers. The academicians find interested in the subject because the
subject is still in its developing stage and there are still certain areas where
controversies exist for which no unanimous solutions have been reached
yet. Practicing managers are interested in the subject because among the
most the most crucial decisions of the theory of financial management
provides them with conceptual and analytical insights to make those
decisions skilfully. This chapter is designed to give an overall view on the
concept of financial management.
Meaning of financial Management:
Financial management refers to the management of flow of funds
in the firm. It deals with the financial decision making of the firm. It is
mainly concerned with the timely procurement of adequate finance from Self-Instructional Material
various sources and its utmost effective utilization for the attainment of
95
Financial Management organizational objectives. Since raising of funds and their best utilization is
NOTES the key to the success of any firm, the financial management as a
functional area has got a place of prime relevance. It is mainly focusing on
overall managerial decision making in general and with the management of
economic resources in particular. All business decisions have financial
implications and therefore financial management is inevitably related to
almost every aspect of business operation. Broadly speaking, the financial
management includes any decision made by a firm that affects its finances.
The term financial management has been defined differently by
various authors. Some of the authoritative definitions are as follows:
(i) Solomon: Financial management is concerned with the efficient
use of an important economic resource, namely capital funds.
(ii) Phillioppatus: Financial management is concerned with the
managerial decisions that result in the acquisition and financing of short
term and long-term credits for the firm.
(iii) S.C. Kuchhal: Financial management deals with procurement
of funds and their effective utilization in the business.
(iv) J.F. Bradley: Financial management is the area of business
management devoted to a judicious use of capital and a careful selection of
sources of capital in order to enable a business firm to move in the
direction of reaching its goals.
(v) J.L. Massie: Financial management is the operational activity of
a business that is responsible for obtaining and effectively utilizing the
funds necessary for efficient operations.
(vi) Weston and Brigham: Financial management is an area of
financial decision making. Harmonizing individual motives and enterprise
goals.
(vii) Howard and Upton: Financial management is the area or set of
administrative functions in an organization which relate with arrangement
of cash and credit so that the organization may have the means to carry out
its objectives as satisfactorily as possible.
(viii) Archer and Ambrosio: Financial management is the
application of the planning and control function to the finance function.
10.3 Scope of Financial Management:
Financial management has undergone significant changes over the
years, in its scope and coverage. In order to have a better exposition of
these change, it will be appropriate to study both the traditional approach
and the modern approach to the function.
(i) Traditional Approach: The traditional approach to the scope of
financial management refers to its subject matter in the academic literature
in the initial stages of its evolution as a separate branch of study.
According to this approach, the scope of financial management is confined
to the raising of funds. Hence, the scope of finance was treated by the
traditional approach in the narrow sense of procurement of funds by
96
corporate enterprises to meet their financial needs. Since the main
emphasis of finance function at that period was on the procurement of NOTES
funds, the subject was called corporation finance till the mid-1950’s and
covered discussion on the financial instruments, institutions and practices
through which funds are obtained. Further, as the problem of raising funds
is more intensely felt at certain episodic events such as merger, liquidation,
consolidation, reorganization and so on. These are the broad features of the
subject matter of corporation finance which has no concern with the
decisions of allocating firm’s funds. But the scope of finance function in
the traditional approach has now been discarded due to the following
limitations:
(a) The emphasis in the traditional approach is on the procurement
of funds by the corporate enterprises which was woven around the
viewpoint of the suppliers of funds such as investors, financial institutions,
investment bankers, etc. i.e. outsiders. It implies that the traditional
approach was the “outsider-looking in” approach.
(b) Internal financial decision making was completely ignored.
(c) The scope of financial management was confined only to the
episodic events such as merger, acquisition, reorganization etc. The scope
of finance function in this approach was confined to a description of these
infrequent happenings in the life of a firm. Thus, it places over emphasis
on the topics of securities and its markets, without paying any attention on
the day to day financial aspects.
(d) The focus was on the long-term financial problem, thus
ignoring the importance of the working capital management. Thus, this
approach has failed to consider the routine managerial problems relating to
finance of the firm.
During the initial stages of development, financial management was
dominated by the traditional approach as is evident from the finance books
of early days. The traditional approach was found in the first manifestation
by Green’s book written in 1897, Medias on Corporation Finance, in 1910;
Dewing’s on Corporate Promotion and Reorganisation, in 1914 etc.
As mentioned earlier, in this approach all these writings
emphasized the financial problems from the outsiders’ point of view
instead of looking into the problems from management point of view. It
overemphasized long term financing, lacked in analytical content and
placed heavy emphasis on descriptive material. Thus, this approach has
completely ignored the important aspects like cost of capital, optimum
capital structure, valuation of firm etc. In the absence of these crucial
aspects in the finance function, this approach implied a very narrow scope
of financial management. The modern approach provides a solution to all
these aspects of financial management.
(ii) Modern Approach: After the 1950’s, the approach and utility
of financial management has started changing in a revolutionary manner.
The emphasis of financial management has been shifted from raising of
funds to the effective and judicious utilization of funds. The modern
97
Financial Management approach of the finance function focuses on ‘wise use of funds’. Since
NOTES financial decisions have a great impact on all other business activities, the
finance manager should be concerned about determining the size and
nature of technology, setting the direction and growth of the business,
shaping the profitability, amount of risk taking, selecting the mix of assets,
determination of optimum capital structure etc. The modern approach is
thus an analytical way of viewing the financial problems of a firm.
According to this approach, the financial management is concerned with
the solution for the major areas relating to the financial operations of a firm
viz., investment, financing and dividend decision. The modern finance
manager has to take financial decision in the most rational way. These
decisions have to be made in such a way that the funds of the firm are used
optimally. These decisions are referred to as managerial finance functions
since they require special care with extraordinary administrative ability,
management skills and decision-making techniques etc.
10.4 Objectives of Financial Management:
Efficient financial management requires the existence of some
objectives or goals because judgment as to whether or not a financial
decision is efficient must be made in the light of some objectives. The
objectives of financial management are broadly divided into two. i.e. (i)
Basic objectives and (ii) Other objectives.
(i) Basic objectives
The basic objectives of the financial management are:
(A) Profit Maximization
(B) Wealth Maximization
(A) Profit Maximization
Profit maximization is one of the basic objectives of
financial management. According to this concept, a firm should undertake
all those activities which add to its profits and eliminate all others which
reduce its profits. This objective highlights the fact that all decisions—
financing, dividend and investment, should result in profit maximization.
Following arguments are given in favour of profit maximization concept:
(a) Profit is a yardstick of efficiency on the basis of which
economic efficiency of a business can be evaluated.
(b) It helps in efficient allocation and utilization of scarce means
because only such resources are applied which maximize the profits.
(c) The rate of return on capital employed is considered as the best
measurement of the profits
(d) Profits act as motivator which helps the business organization to
be more efficient through hard work.
(e) By maximizing profits, social and economic welfare is also
maximized.
However, this objective has been criticized on various counts:
(a) Ambiguity: The term ‘profit maximization’ as a criterion for
Self-Instructional Material financial decision is vague and ambiguous concept. It lacks precise
98
connotation. The term ‘profit’ is amenable to different interpretations by
different people. For example, profit may be long term or short term. It NOTES
may be total profit or rate of profit. It may be not profit before tax or net
profit after tax. It may be return on total capital employed or total assets or
shareholders equity and so on.
(b) Time value of money: This concept ignores time value of
money. i.e. under this concept, income different years get equal weight.
But, in fact, the value of rupee today will be greater as compared to the
value of rupee receivable after one year. In this same manner, the value of
income received in the first year will be greater from that which will be
received in later years e.g. the profits of two different projects are as
follows:
Year Project X Project Y
Rs. Rs.
1 10,000 -
2 20,000 20,000
3 10,000 20,000
Both the projects have a total earnings of Rs. 40,000 in three years and
according to this concept, both will be considered equally profitable. But
project X has greater profits in the initial years of the project and therefore,
is more profitable in terms of value of income. The profits earned in initial
years can be reinvested and more profits can be earned.
(c) Risk factor: This concept ignores risk factor. The certainty or
uncertainty of income receivable in future can be high or less. High
uncertainty increases risk and less uncertainty reduces risk. Less income
with more certainty is considered better as compared to high income with
greater uncertainty.
Thus, the profit maximization concept was more significant for sale
trader and partnership firms because at that time when personal capital was
invested in business, they wanted to increase their assets by maximizing
profits. Companies are now managed by professional managers and capital
is provided by shareholders, debenture holders, financial institutions etc.
One of the major responsibilities of business management is to co-ordinate
the conflicting interest of all these parties. In such a situation, profit
maximization concept does not appear proper and practicable for financial
decisions.
(B) Wealth Maximization
Another basic objective of financial management is maximization
of shareholders’ wealth. This objective is also known as value
maximization or net present-worth maximization. According to this
concept, finance manager should take such decisions which increase net
present value of the firm and should not undertake any activity which
decrease net present value. This concept eliminates all the three basic
criticisms of the profit maximization concept.
As the value of an asset is considered from viewpoint of profits
accruing from it, in the same manner the evaluation of an activity depends
99
Financial Management on the profit arising from it. Therefore, all three main decisions of finance
NOTES manager – financing decision, investment decision, affect net present value
of the firm. The greater the amount of net present value, the greater will be
value of the greater the amount of net present value, the greater will be
value of firm and more it will be in the interest of shareholders. When the
value of firm increases, the market price of equity shares also increase.
Thus, to maximize net present worth means to maximize the market price
of shares.
The concept of wealth maximization is considered good for the
companies in present situation. This concept gives due consideration to the
time value of expected income receivable over different periods of time.
Under this concept, risk and uncertainty are analysed with the help of
interest rate. If uncertainty and time period are greater, higher rate of
interest will be used to calculate present value of expected future cash
benefits, whereas the interest rate will be lower for the projects with low
risk and uncertainty. Besides, this concept uses cash flows instead of
accounting profits which removes ambiguity associated with the term
‘profit’.
10.5 Differences between Profit maximization &Wealth
maximization:
The profit maximization concept measures the performance of a
firm by looking at its total profit. It does not take into account the risk
which the firm may undertake in maximization of profit. The profit
maximization concept does not consider the effect of earnings per share,
dividends paid or any other return to shareholders on the wealth of
shareholders. On the contrary, the objective of wealth maximization
considers all future cash flows, dividends, earnings per share, risk of a
decision etc. So, the wealth maximization concept is operational and
objective in its approach.
A firm, interested in maximizing its profits may not like to pay
dividend to its shareholders, whereas a firm interested in maximizing
wealth of shareholders, may pay regular dividends. The shareholders
would certainly prefer an increase in wealth against the generation of
increasing flow of profits to the firm. Moreover, the market price of a share
explicitly reflects the shareholders expected return, considers risk and
recognizes the importance of distribution of returns. Therefore, the
maximization of shareholders wealth as reflected in the market price of a
share is considered as a proper objective of financial management. The
profit maximization can be considered as a part of the wealth maximization
strategy but should never be permitted to overshadow the latter.
10.6 Other Objectives:
Besides basic objectives, the following are the other objectives of
financial management:
(i) Return maximization: The financial management is to safeguard the
economic interest of the persons who are directly or indirectly connected
100
with the firm i.e. shareholders, creditors and employees. All these
interested parties must get the maximum return for their contributions. But NOTES
this is possible only when the firm earns higher profits or sufficient profits
to discharge its obligation to them.
(ii) Provide support for decision making: Financial management is to
provide managers with the information and knowledge they need to
support operational decisions and to understand the financial implications
of decisions before they are made. It also enables managers to monitor
their decisions for any potential financial implications and for lessons to be
learnt from experience and to adapt or react as needed.
(iii) Mange risks: Financial management is to assist a firm in identifying
and assessing the financial consequence of events that could compromise
its ability to achieve its goals and objectives and/or result in significant loss
of resources. Financial management is an important component of risk
management needs to be considered with the full range of business risks
such as operational and strategic risk as well as social, legal, political and
environmental risks.
(iv) Use resources efficiently, effectively and economically: Financial
management is to ensure that a firm has enough resources to carry out its
operations and that it uses these resources with due regard to economy,
efficiency and effectiveness.
(iv) provide a supportive control environment: Financial management
is to contribute for promoting an organizational climate that fosters the
achievement of financial management objectives- a climate that includes
commitment from senior management, shared values and ethics,
communication and organizational learning.
(v) Comply with authorities and safeguard assets: Financial
management is to ensure that a firm carries out its transactions in
accordance with applicable legislation, regulations and executive orders;
that spending limits are observed; and that transactions are authorized. It
should also provide a firm with a system of controls for assets, liabilities,
revenues and expenditures. These controls help to protect against fraud,
financial negligence, violation of financial rules or principles and losses of
assets or public money.
In present organizations, financial management is treated as a
specialized activity and a separate department is created for finance
function.
The department is generally headed by an executive, popularly
known as “financial manager” has the responsibility of carrying out all the
functions expected of financial management. The finance manager has the
responsibility of carrying out all the functional management. The position
of finance department and finance manager in a firm can be illustrated as
follows:
101
Financial Management From the above, we can observe that the position of finance
NOTES manager is of the head of finance department of a firm. The position can be
explained as follows:
(a) Finance manager is generally head of finance department.
(b) The position of finance manager is of a line manager.
(c) The functions of finance manager are multiple.
(d) Finance manager is accountable to top level management.
10.8 Role of Finance Manager:

The finance manager is required to discharge all the
functions/activities envisaged by financial management. The important
functions of finance manager are as follows:
(i) Forecasting Financial Requirements:
The first function of finance manager is to forecast the required
funds in the firm. Certain funds are required for long term purposes i.e.
investment in fixed assets etc. A careful estimate of such funds, and of the
exact timing, when such funds are required must be made. Also, an
assessment has to be made regarding requirements of working capital
which involves estimating the amount of funds blocked in various current
assets and the amount of funds likely to be generated for short periods
through current liabilities. Forecasting the requirements of funds involves
the use of techniques of budgetary control and long-range planning.
Estimates of requirement of funds can be made only if all the physical
activities of a firm have been forecasted. They can then be translated into
monetary terms.
(ii) Financing Decision:
Once the requirements of funds have been estimated, the finance
manager has to take decision regarding various sources from where these
funds would be raised. A proper mix of various sources has to be worked
out. Each source of manager has to carefully look into the existing capital
structure and see how the various proposals of raising funds will affect it.
He has to maintain a proper balances between long term funds and short-
term funds. He has to ensure that he raises sufficient long-term funds in
order to finance fixed assets and other long-term investments and to
provide for the permanent needs of working capital. Within the total
volume of long-term loan funds, he must maintain a proper balance
between the loan funds and own funds. Long term funds raised from
outsiders have to be in a certain proportion with the funds procured from
the owners. There are various options available for procuring outside long
term funds also. The finance manager has to decide the ratio between
outside long-term funds and own funds. He has also to see that the overall
capitalization of the firm is such that the firm is able to procure funds at
minimum cost and is able to tolerate shocks of lean periods. All such kinds
of decisions are termed as ‘Financing Decisions’.
102
(iii) Investment Decision:
After having procured the funds from different sources, the finance NOTES
manager has to take investment decisions. Investment decisions relate to

selection of assets in which funds are to be invested by the firm.
Investment alternatives are numerous. Resources are scarce and limited.
They have to be rationed and discretely used. Investment decisions allocate
and ration the resources among the competing investment alternatives or
opportunities. The effort is to find out the projects, which are acceptable.
Investment decisions relate to the total amount of assets to be held
and their composition in the form of fixed and current assets. Both the
factors influence the risk the firm is exposed to take. The more important
aspect is how the investors perceive the risk.
The investment decision result in purchase of assets. Assets can be
classified under two broad categories:
(a) Long term investment decisions – Long term assets.
(b) Short term investment decisions – short term assets.
(a) Long term investment Decisions:
The long-term investment decisions are referred to as capital
budgeting decisions, which relate to fixed assets. The fixed assets are long
term in nature. Basically, fixed assets create earnings to the firm. They give
benefits in future. It is difficult to measure the benefits as future is
uncertain.
The investment decision is important not only for setting up new
units but also for expansions of existing units. Decisions related to them
are, generally, irreversible. Often reversal of decision result in substantial
loss. When a brand-new car is sold, even a day after its purchase, buyer
treats the vehicle as a second-hand car. The transaction, invariably, results
in heavy loss for a short period of owning. So, the finance manager has to
evaluate profitability of every investment proposal carefully before funds
are committed to them.
(b) Short term Investment Decisions:
The short-term investment decisions are, generally referred as
working capital management. The finance manager has to allocate among
cash and cash equivalent, receivables and inventories. Though these
current assets do not, directly, contribute to the earnings, their existence is
necessary for proper, efficient and optimum utilization of fixed assets.
(iv) Dividend Decision:
The finance manager is also concerned with the decision to pay or
declare a dividend. He has to assist the top management in deciding as to
what amount of dividend should be paid to the shareholders and what
amount should be retained in the business itself. Generally, firms distribute
certain amount of profit in the form of dividend, in a stable manner, to
meet the expectations of shareholders and balance is retained within the
firm for expansion. If dividend is not distributed, there would be great
dissatisfaction to the shareholders. Non- declaration of dividend affects the
market price of equity share severely. One significant element in the
103
Financial Management dividend decision is, therefore, the dividend pay-out ratio i.e. What
NOTES proportion of dividend is to be paid to the shareholders? The dividend
decision depends on the preference of the equity shareholders and
investment opportunities available within the firm. A higher rate of
dividend, beyond the market expectations, increases the market price of
shares. However, it leaves a small amount in the form of retained earnings
for expansion. The business that reinvests less will tend to grow slower.
The other alternative is to raise funds in the market for expansion. It is not
a desirable decision to retain all the profit for expansion, without
distributing any amount in the form of dividend.
There is no ready-made answer, how much is to be distributed and
what portion is to be retained. Retention of profit is related to:
(a) Re investment opportunities available to the firm.
(b) Alternative rate of return available to equity shareholders, if
they invest themselves.
The principal function of a finance manager relates to decisions
regarding procurement, investment and dividends. However, the finance
manager also undertakes the following subsidiary functions:
(v) Deciding over all objectives:
The finance manager needs to be guided by some objectives. As a
head of finance department, the finance manager, therefore, he has to
determine the overall goals of finance department. The goals help in
effective financial planning and decision making.
(vi) Supply of funds to all parts of the organization:
The finance manager has also to ensure that all sections i.e.
branches, factories, departments and units of the organization are supplied
with adequate funds. Sections which have an excess of funds have to
contribute to the central pool for use in other sections which need funds.
An adequate supply of cash at all points of time is absolutely essential for
the smooth flow of business operations. Even if one of the 200 retail
branches do not have sufficient funds, the whole business may be in
danger. Hence the need for laying down cash management and cash
disbursement policies with a view to supplying adequate funds at all times
and at all points in an organization is an important function of finance
manager. Cash management should also ensure that there is no excessive
cash.
(vii) Evaluating financial performance:
Management control system are often based upon financial
analysis. One prominent example is the ROI (Return on Investment)
system of divisional control. The finance manager has to constantly review
the financial performance of the various units of the organization. The ROI
chart is extremely useful in this regard. Analysis of the financial
performance helps the management for assessing how the funds have been
utilized in various divisions and what can be done to improve it.
104
(viii) Financial negotiation:
A major portion of the time of finance manager is utilized in NOTES
carrying out negotiations with the financial institutions, banks and public
depositors. He has to furnish a lot of information to these institutions and
persons and have to ensure that raising of funds is within the statutes the
Companies Act etc. Negotiations for outside financing often required
specialized skills.
(ix) Keeping touch with stock exchange quotations and behaviour of
share prices:
This involves analysis of major trends in the stock market and
judging their impact on the prices of the shares of the firm.
Liquidity Vs Profitability (Risk – Return Trade off)
As a principal function, the finance manager takes various types of
financial decisions- finance decision, investment decision and dividend
decision- as discussed above, from time to time. In every area of financial
management, the finance manager is always faced with the dilemma of
liquidity Vs profitability. He has to strike a balance between the two.
Liquidity means that the firm has (a) adequate cash to pay bills as
and when they fall due, and (b) sufficient cash reserves to meet
emergencies and unforeseen demands, at all time.
Profitability goal, on the other hand, requires that the funds of the
firm be so utilized as to yield the highest return.
Liquidity and profitability are conflicting decisions. When one
increases, the other decreases. More liquidity results in less profitability
and vice versa. This conflict, finance manager has to face as all the
financial decisions involve both liquidity and profitability.
Example: Firm may borrow more, beyond the risk-free limit, to
take advantage of cheap interest rate. This decision increases the liquidity
to meet the requirements of firm. Firm has to pay committed fixed rate of
interest at fixed time irrespective of the return the liquidity (funds) gives.
Profitability suffers, in this process of decision, if the expected return does
not materialize. This is the risk the firm faces by this financial decision.
Risk: Risk is defined as the variability of the expected return from
the investment.
Return: Return is measured as a gain or profit expected to be made,
over a period, at the time of making the investment.
Example: If an investor makes a deposit in a nationalized bank,
carrying an interest of 8% p.a., virtually, the investment is risk free for
repayment, both principal and interest. However, if a similar amount is
invested in the equity shares, there is no certainty for the amount of
dividend or even for getting back initial investment as market price may
fall, subsequently, at the time of sale. The expected dividend may or may
not materialize. In other words, the dividend amount may vary, or the firm
may not declare dividend at all. A bank deposit is a safe investment, while
equity share is not so, risk is associated with the quality of investment.
105
Financial Management The relationship between risk and return can be expressed as
NOTES follows:
Return: Risk free rate+ Risk premium
Risk free rate is a compensation or reward for time and risk
premium for risk. Risk and return go hand in hand. Higher the risk, higher
the required return expected. It is only an expectation at the time of
investment. There is no guarantee that the return would be, definitely,
higher. If one wants to make an investment, without risk, the return is
always lower. For this reason, only, deposit in a bank or post office carry
lower returns, compared to equity shares.
So, every financial decision involves liquidity and profitability
implications, which carries risk as well as return. However, the quantum of
risk differs from one decision to another. Equally, the return from all the
decision is not uniform and also varies, even from time to time.
Relationship between liquidity & Profitability and Risk Return:
Example: If higher inventories are built, in anticipation of an
increase in price, more funds are locked in inventories. So, firm can
experience problems in making other payments in time. If the expected
price increase materials, firm enjoys a boost in profit due to the windfall
return the decision yields. The expected increase in price is a contingent
event. In other words, the increase in price may or may not happen. But
firm suffers liquidity problems immediately. This is the price firm has to
pay, which otherwise is the risk the firm carries.
It may be emphasized that risk and return always go together, hand
in hand. More risk, chances of higher return exist. One thing must be
remembered, there is no guarantee of higher return, with higher risk. The
classical example is lottery. There is a great risk, if one invests amount in a
lottery. There is no guarantee that you would win the lottery. However,
liquidity and profitability are conflicting decisions. There is a direct
relationship between higher risk and higher return. In the above example,
building higher inventories, more than required, is a higher risk decision.
This higher risk has created liquidity problem. But the benefit of higher
return is also available. Higher risk, on one hand, endangers liquidity and
higher returns, on the other hand, increases profitability. Liquidity and
profitability are conflicting, while risk and return go together. The pictorial
presentation is as under:
Conflicting Go together Role of finance Manager – Relationship between
liquidity and profitability and risk and return
The finance manager cannot avoid the risk altogether in this
decision making. At the same time, he should not take decision,
considering the return aspect only. At the time of taking any financial
decision, the finance manager has to weigh both the risk and return in the
proposed decision and optimize the risk and return at the same time. A
proper balance between risk and return has to be maintained by the finance
Self-Instructional Material manager to maximize the market value of shares. A particular combination
where both risk and return are optimized is termed as Risk-Return Trade
106
off. In other words, Risk and Return Trade to the level of operations at
which shareholders’ wealth can be maximized. Every finance manager NOTES
should take efforts to achieve that trade off in every finance decision. At
this level, the market value of the firm’s shares would be maximum. To
achieve maximum return, funds flowing in and out of the firm are to be
constantly monitored to ensure their safety and proper utilization.
10.9 Financial Management and other Functional Areas:
Financial management is one of the important parts of overall
management, which is directly related with other functional areas such as
production, material, personnel, marketing, accounting etc. The
relationship between financial management and other functional areas has
been explained briefly in the pages to come.
(i) Financial Management and Production Management:
Production management is the operational part of the business concern,
which helps to multiply the money into profit. Profit of the firm depends
upon the production performance. Production performance needs finance,
because production department requires raw materials, machinery, etc.
These expenditures are decided and estimated by the finance department
and the finance manager allocates the appropriate finance to production
department. The finance manager must be aware of the operational process
and finance required for each process of production activities.
(ii) Financial Management and Material Management: The
financial management and the material department are also interrelated.
Material department covers the areas such as storage, maintenance and
supply of material and stores, procurement etc. The finance manager and
material manager in a firm may come together while determining economic
order quantity, safety level, storing place requirement, stores personnel
requirement, etc. The costs of all these aspects are to be evaluated so that
the finance manager may come forward to help the material manager.
(iii) Financial Management and Personnel Management: The
personnel department is entrusted with the responsibility of recruitment,
training and placement of the staff. This department is also concerned with
the welfare of the employees and their families. This department works
with finance manager to evaluate employee’s welfare, revision of their pay
scale, incentive schemes, etc.
(iv) Financial Management and Marketing Management: The
marketing department is concerned with the selling of goods and services
to the customers. It is entrusted with framing marketing, selling,
advertising and other related policies to achieve the sales target. It is also
required to frame policies to maintain and increase the market share, to
create a brand name etc. For all this, finance is required. So, the finance
manager has to play an active role for interacting with the marketing
department.
(v) Financial Management and Accounting: Accounting records
include the financial information of the firm. Hence, we can easily
107
Financial Management understand the relationship between the financial management and
NOTES accounting. In the olden periods, both financial management and
accounting are treated as a same discipline and then it has been merged as
management accounting, because this part is very much helpful to finance
manager to take decision. But now a day’s financial management and
accounting discipline are separate and interrelated.
(vi) Financial Management and Mathematics: Modern
approaches of the financial management apply large number of
mathematical and statistical tools and techniques. They are also called
Econometrics. Economic order quantity, discount factor, time value of
money, present value of money, cost of capital, ratio analysis and working
capital analysis are used as mathematical and statistical tools and
techniques in the field of financial management.
(vii) Financial Management and Economics: Economics
concepts like Micro and Macroeconomics are directly applied with the
financial management approaches. Investment decisions, micro and macro
environmental factors are closely associated with the functions of finance
manager. Financial management also uses the economic equations like
money value discount factor, economic order quantity etc. Financial
economics is one of the emerging areas, which provides immense
opportunities to finance and economical areas.
Methods and Tools of Financial Management:
The finance manager has to employ various methods and
techniques at the time of taking various financial decision such as finance
decision, investment decision and dividend decision. In the area of
financing, there are various methods to procure funds. Funds may be
obtained from long term sources as well as from short term sources. Long
term funds may be made available by owners i.e. shareholders, lenders by
issuing debentures, from financial institutions, banks and public at large.
Short term funds may be procured from commercial banks. Suppliers of
goods, public deposits, etc. The finance manager has to decide an optimum
capital structure to maximise shareholders’ wealth. For this, judicious use
of financial leverage or trading on equity is important to increase the return
to shareholders. In planning the capital structure, the aim is to have proper
mix of debt and equity. EBIT-EPS analysis, PE Ratios and mathematical
models are used to determine the proper debt-equity mix to derive
advantage to the owners and firm.
In the area of investment decisions, Payback period, Average rate
of return, Net present value, Profitability Index and Internal Rate of Return
are some of the methods applied in evaluating capital expenditure
proposals.
In the area of working capital management, certain techniques are
adopted such as ABC analysis, Economics order Quantity, Cash
management models etc. to improve liquidity and to maintain adequate
Self-Instructional Material circulating capital. For evaluation of firm’s performance, Ratio analysis is
pressed into service. With the help of ratios, an investor can decide whether
108
to invest in a firm or not. Funds flow statement, cash flow statement and
projected financial statements help a lot to the finance manager in NOTES
ascertaining required funds at the right time.

10.10 Significance of Financial Management:
The significance of financial management is summarized as given
below:
(i) Financial management is essential wherever funds are involved
– in a centrally planned economy and also in a capitalist set up. It attempts
to use funds in the most productive manner i.e. optimizing the output from
the given inputs of funds. It focuses on effective utilization of the most
important resource in any activity i.e. money.
(ii) Financial management helps in ascertaining how the firm would
perform in future. It helps in including whether the firm will generate
enough funds to meet its various obligations like repayment of the various
instalments due on loans, redemption of other liabilities etc.
(iii) Financial management provides complete coordination
between various functional areas marketing, production, etc. to achieve the
organizational goals. If financial management is defective, the efficiency of
all other departments can, in no way, be maintained. For example, it is very
necessary for the finance department to provide finance for the purchase of
raw materials and meeting the other day- to- day expenses for the smooth
running of the production unit. If finance department fails in its
obligations, the production and the sales will suffer and consequently the
income of the firm and rate of profit on investment will also suffer. Thus,
financial management occupies a central place in the business organization
which controls and co-ordinates all the other activities in the firm.
(iv) Almost, every decision in the business is taken in the light of its
profitability. Financial management provides scientific analysis of all facts
and figures through various financial tools, such as different financial
statements, budgets etc, which help in evaluating the profitability of the
given circumstances, so that a proper decision can be taken to minimize the
risk involved in the plan.
(v) Saving are possible only when the firm makes substantial profits
and maximizes its wealth. Effective financial management helps in
promoting and mobilizing individual and corporate savings.
(vi) Financial management also helps in profit planning, capital
spending, measuring costs, controlling inventories, accounts receivables
etc.
10.11 The changing scenario of Financial Management in
India:
Modern financial management has come a long way from the
traditional corporate finance. As the economy is opening up and global
resources are being tapped, the opportunities available to finance managers
virtually have no limits. The finance manager is now responsible for Self-Instructional Material
109
Financial Management shaping the fortunes of the firm and is involved in the most vital decisions
NOTES of the allocation of capital.
Due to the changes in the global environment, the finance manager
needs to have a broader and far- sighted outlook, and must realize that his
actions would have far- reaching consequences for the firm because they
influence the size, profitability, growth, risk and survival of the firm, and
as a consequence, affect the overall value of the firm.
Some of the important changes in the environment are:
(a) Interesting rates have been freed from regulation. Treasury
operations therefore have to be more sophisticated as the interest rates are
fluctuating. Minimum cost of capital necessitates anticipating interest rate
movements.
(b) The rupee has become fully convertible on current account.
(c) Optimum debt-equity mix is possible. The firms have to take
advantage of the financial leverage to increase the shareholders’ wealth.
However, using financial leverage necessarily makes a business vulnerable
to financial risk. Finding a correct trade-off between the risk and the
improved return to shareholders is a challenging task for the finance
manager.
(d) With free pricing of issues, optimum price determination of new
issues is a daunting task as overpricing results in under subscription and
loss of investor confidence while under-pricing leads to unwanted increase
in number of shares there by reducing the earnings per share (EPS).
(e) Ensuring management control is vital especially in the light of
foreign participation in equity which is backed by huge resources making
the firm an easy takeover target. Existing management may lose control in
the eventuality of being unable to take up the share entitlements. Financial
strategies to prevent this are vital to the present management.
1. Define financial management.
2. Write short note on profit maximization.
1 Financial management is concerned with the efficient use of an important
economic resource, namely capital funds.
2. Profit maximization is one of the basic objectives of financial
management. According to this concept, a firm should undertake all those
activities which add to its profits and eliminate all others which reduce its
profits.
Short Questions:
1. What is wealth maximization?
2. Write short on dividend decision.
3. Explain the current scenario of financial management in India
4. What are the significances of financial management?
5. What are the roles of financial manager?
110
Further Reading:
1. Financial Management, Khan & Jain – Tata McGraw Hill NOTES
3. Financial management: Panday, I.M. 9th ed Vikas
3rd ed, TMH
111
Capital Budgeting
NOTES
UNIT – XI CAPITAL BUDGETING
Structure
11.1 Introduction
11. 8 Procedure for computation of ARR
11.1 Introduction
As mentioned in chapter 1, the finance manager of a firm is
responsible to procure the required quantum of funds from different
sources and invest the raised funds in various assets in the most profitable
way. The investment of funds requires a number of decisions to be taken in
a situation in which funds are invested and benefits are expected over a
long period. The finance manager is to determine the compositions of
assets of the firm. The assets of the firm are of two types i.e., fixed assets
and current assets. The aspect of taking the financial decision with regard
to fixed assets of taking the financial decision with regard to fixed assets is
called capital budgeting.
Capital budgeting means planning the capital expenditure in
acquisition of fixed (capital) assets such as land, building, plant or new
projects as a whole. It includes replacing and modernising a process.
Introduction a new product and expansion of the business. It involves the
preparation of Detailed Project Report (DPR) and cost and revenue
statements indication the profitability. The project which gives the highest
return on investment is to be selected and then investment is to be made in
such a project as to maximize the profitability of the firm.
The term capital budgeting is formally defined as follows:
I. Charles T. Horngren: capital budgeting is the long term planning
for making and financing proposed capital outlays.
II. GC.Philoppatos: capital budgeting is concerned with the allocation
of the firm’s scarce financial resources among the available market
opportunities. The consideration of investment opportunities
involves the comparison of the expected future streams of earnings
from a project, with the immediate and subsequent streams of
expenditure for it.
III. Milton H.Spencer: capital budgeting involves the planning for
assets. The returns from which will be realised in future time
periods.
IV. Keller and Ferrara: The capital expenditure budget represents the
plans for the appropriations and expenditures for fixed assets during
the budget period.
112
V. R.M. Lynch: Capital budgeting consists in planning for Capital Budgeting
development of available capital for the purpose of Maximising the
NOTES
long term profitability (return on investment) of the firm.
Capital budgeting is thus, broader term and includes not only
investment decisions but also the exploration of profitable
investment opportunities, marketing and engineering investigation
of these opportunities and financial analysis as to their future
profitability. However, the terms “Investment Decisions”, “Capital
expenditure decisions”, “Capital Expenditure Management”, “Long
term Investment Decision” and “Management of Fixed Assets” are
generally used interchangeably.
The following basic features of capital budgeting may be deduced
from the preceding discussion:
I. Investments: Capital expenditure plans involve a huge investment
in fixed assets.
II. Long-term: Capital expenditure, once approved, represents long
term investment that cannot be reversed or withdrawn without
sustaining a loss.
III. Forecasting: preparation of capital budget plans involves
forecasting of several years profits in advance in order to judge the
profitability of projects.
IV. Serious consequences: In view of the investment of large amount
for a fairly long period of time, any error in the evaluation of
investment projects may lead to serious consequences, financially
and otherwise and may adversely affect the other future plans of the
organization.
The objectives of capital budgeting are summarized as given below:
I. Capital budget aims at deciding the most profitable among the
numerous investment proposals available.
II. It decides the most suitable among different sources of finance on
the basis of capital market constraints.
III. The growth and expansion of the firm and modernization can be
taken care of.
Need and significance of Capital Budgeting
Capital buffeting decision is of paramount importance in financial
decision making. Special care should be taken in making these decisions on
account of the following reasons:
I. Substantial expenditure: Capital budgeting decisions involve the
investment of substantial amount of funds. It is therefore necessary
for a firm to make such decisions after a thoughtful consideration
so as to result in the profitable use of its scarce resources. The hasty
and incorrect decision would not only result in huge losses but may
also account for the failure of the firm.
II. Long term implications: The capital budgeting decisions has its
effect over a long period of time. These decisions not only affect
the future benefits and cost of the firm but also influence the rate
and direction of growth of the firm.
113
Capital Budgeting III. Irreversible decisions: The capital budgeting decisions are
NOTES irreversible and the heavy amount invested cannot be taken back
without causing a substantial loss because it is very difficult to find
a market for the second hand capital goods and their conversion
into other uses may not be financially feasible.
IV. Complexity: The capital budgeting decisions are based on

forecasting of future events and inflows. Quantification of future
events involves applications of statistical and probabilistic
techniques, careful judgment and application of mind is necessary.
V. Risk: The longer the time period of returns, greater is the

risk/uncertainty associated with cash flows. Hence capital
budgeting decisions should be taken after a careful review of all
available information.
VI. Surplus: Funds are raised by the firm at a certain cost (i.e.,WACC).
Even internally generated funds have an implicit cost. Hence, there
is a need to obtain a surplus over and above the cost of funds. Only
then, the investment is justified.
Advantages of Capital Budgeting

The main advantages of capital budgeting are as under:
I. At any given time, numerous in investment proposals may be
available. Capital budgeting evaluates them and ranks them as
per merit. This enables management to decide on implementing
appropriate proposals.
II. The limited funds available can be most effectively utilised.
III. The timing and actual execution of each project can be adjusted to
changes in capital market.
IV. Different sources of finance can be considered, and judicious
selection of sources can reduce overall cost of capital.
V. Capital budgeting can take care of the proportion of debt and equity
in the capital structure and the resulting capital gearing.
VI. In tight money situations, capital rationing van be followed not to
waste scarce funds available.
Capital investment decisions are the part of the capital budgeting
process, which is concerned with determining (a) which specific project
a firm should accept, (b)the total amount of capital expenditure which
the fir should undertake, and(c) how the total amount of capital
expenditure should be financed generally.
The following stages are involved in the capital budgeting process:

I. Identification of investment proposals: The capital budgeting
process begins with the identification of investment proposals.
The proposals may come from a rank and file worker of any
department or from any line officer. The department head
collects all the investment proposals and reviews them in the
light of financial and risk policies of the organization in order
to send them in the capital expenditure planning committee for
consideration.
114
II. Screening the proposals: after getting the proposals, the Capital Budgeting
expenditure planning committee analyses all the proposals
NOTES
from various angles to ensure that these are in accordance with
the corporate strategies or selection criterion of the firm and
also do not lead to departmental imbalance.
III. Evaluation of proposals: Evaluation of different proposals in
terms of cost of capital, expected returns from alternative
investment opportunities and life of the assets is the next step
in the capital budgeting process. Various methods such as
payback period, average rate of return method, NPV method,
IRR method etc., which are discussed later in the chapter, are
employed to evaluate the proposals.
IV. Fixing priorities: Once the evaluation process is over, only
economic and profitable proposals are given green signal to go
ahead. But it is not possible to take up all the proposals
simultaneously due to fund constraints. In view of this, all the
accepted proposals are ranked and priorities are given in the
following order:
(a) Current and incomplete projects are given first priority.
(b) Safety projects and projects necessary to carry on the
legislative requirements.
(c) Projects for maintaining present efficiency of the firm.
(d) Projects for supplementing the income, and
(e) Projects for the expansion of product line.
V. Final approval: projects finally recommended by the committee

are sent to the top management along with the detailed report,
both of the capital expenditure and of sources of funds to meet
them. The management affirms its final seal to proposals taking
in view urgency, profitability of the projects and the available
financial resources.
VI. Implementing proposals: When the proposals are finally
selected, funds are allocated for them. Such formal plan for the
allocation of funds is called capital budget. It is the duty on the
part of the top management to ensure that funds are spent in
accordance with the allocation made in the capital budget. A
control over such capital expenditure is very much essential
and for that purpose, a monthly report showing the amount
allocated, amount spent, amount approved but not spent should
be prepared and submitted to the controller.
VII. Follow up: Finally, a system of following up the results of
completed projects should be established. Such follow up
comparison of actual performance with budgeted data will
ensure better forecasting and will also help in sharpening the
technique of forecasting.
There are many ways to classify the capital budgeting decision.
Generally capital investment decisions are classified in two ways. One way
is to classify them on the basis of firm’s existence. Another way is to
classify them on the basis of decision situation.
I. On the basis of firm’s existence: The capital budgeting
decisions are taken by both newly incorporated firms as well as
115
Capital Budgeting by existing firms. The new firms may be required to take
NOTES decision in respect of selection of a plant to be installed. The
existing firm may be required to take decisions to meet the
requirement of new environment or to face the challenges of
competition. These decisions may be classified into:
(i) Replacement and modernization decisions: All types of
plant and machinery eventually requires
replacement. If the existing plant is to be replaced
because the economic life of the plant is over, then
the decision may be known as a replacement
decision. However, if an existing plant is to be
replaced because it has become technologically
outdated (though the economic life is not over), the
decision may be known as a modernization
decision. These two decisions are also known as
cost reduction decisions.
(ii) Expansion decisions: Existing successful firms may
experience growth in demand of their product line.
If such firms experience shortage or delay in the
delivery of their products due to inadequate
production facilities, they may consider proposal to
add capacity to existing product line.
(iii) Diversification decisions: Sometimes, the firms may
be interested to diversify into new product lines,
new markets, production of spare parts etc. In such
a case, the finance manager is required to evaluate
not only the marginal cost and benefits, but also the
effect of diversification on the existing market share
and profitability. Both the expansion and
diversification decision may also be known as
revenue increasing decisions.
II. On the basis of decision situation: The capital budgeting

decisions on the basis of decision situation are classified as
follows:
(i) Mutual exclusive decisions: Decisions are said to be
mutually exclusive if two or more alternative
proposals are such that the acceptance of one
proposal will exclude acceptance of the other
alternative proposals. For example, a firm may be
considering proposal to buy either a low cost
economy model asset or a high cost super model
asset. If the economy model is purchased, it means
that the super model need not be purchased and vice
versa.
(ii) Accept – Reject decisions: The accept – reject
decisions occur when proposals are independent
and do not compete with each other. The firm may
accept or reject a proposal on the basis of a
minimum return on the required investment. All
those proposals which give a higher return than
116
certain desired rate of return is accepted and the rest Capital Budgeting
are rejected.
NOTES
(iii) Contingent decisions: These are independent
proposals. The investment in one proposal requires
investment in one or more other proposals. For
example, if a company accepts a proposal to set up
a factory in a remote area, it may have to invest in
infrastructure also e.g. building of roads, houses for
employees etc.
11.7.1 Factors influencing Capital Budgeting Decisions
The following factors are generally taken into account while
making capital budgeting decisions:
I. Initial investment: This equals the cash outflow at the initial

stage, net of salvage value of old assets if any. Initial
investment = Cost of new assets purchased+ Investment
in working capital – Salvage value of old assets, if any
II. Cash flows after taxes (CFAT): It indicates income
generated by the projects at various points of time.
Generally, CFAT= Profit before depreciation, after tax.
III. Terminal cash inflows: There may be some terminal cash
inflows at the end of the project like recovery of working
capital investment in the project, salvage value of fixed
assets etc.
IV. Time value of money: The value of money differs at
different points of time. So, the present value of future
cash inflow will have to be ascertained by discounting the
same at the appropriate discount rate.
V. Discount rate: It is a cut off rate for capital investment
evaluation A project which does not earn at least the cut
off rate should be rejected. Generally, the rate used for
discounting is the Weighted Average Cost of Capital
(WACC).
VI. PV factor and Annuity factor tables: These two tables are
used for calculation of present value of future cash
inflows. In case of uniform cash inflows during the
project life, PV annuity factor table can be used. If the
cash inflows are not uniform, the PV factor table can be
used.
11.7.2 Evaluation of Capital Budgeting Proposals
As discussed earlier in the chapter, the capital budgeting decision
requires a current investment, the benefits of which are received in
future/after one year i.e., it involves a long term commitment. This
decision actually is a very significant one since the future development and
the competitive power of the firm depends on it which, in other words, has
a direct impact on the future earning and growth of the firm. For this
purpose, a sound appraisal method should be adopted in order to measure
the economic worth of each investment proposal. In practice, several
methods are used to evaluate and select an investment proposal. These
methods can be grouped into two categories as given below:
1. Traditional (or) Non-discounting Method
2. Improvement in traditional approach to payback period
117
Capital Budgeting
I. Traditional (or) Non-discounting Method
NOTES As the name itself suggests, these methods do not discount cash
flows to find out their present worth. There are two such methods
available i.e., (i) payback period method, and (ii) the accounting or
average rate of return method. These are essentially rules of thumb
that intuitively grapple with the trade-off between net investment
and operating cash inflows. Both these traditional evaluation
criteria are discussed below:
1. Payback Period Method: This method, sometimes called the
payout or pay off or replacement period method, determines the
length of time required to recover the initial outlay of a project.
In other words, it is the period within which the total cash
inflows from the project equals the cost of investment in the
project. The lower the payback period, the better it is since
initial investment is recouped faster.
Example: Suppose a project with an initial investment of Rs. 5 lakh,
yields profit of Rs.1 lakh, after writing off depreciation of Rs. 25,000 per
annum. In this case, the payback period is computed as given below:
= 1,00,000 + 25,000 = Rs. 1,25,000
Procedure for computation of payback period

(i) Ascertain the initial investment (cash outflow) of the project.
(ii) Ascertain the cash inflows (CFAT)from the project for various
years.
(iii)Calculate the payback period as under:
(a) In case of uniform CFAT p.a.
(b) In case of differential CFAT for various years.

(i) Compute cumulative CFAT at the end of each year.
(ii) Find out the year in which cumulative CFAT exceeds
initial investment (calculated on time proportion basis).
(iii)Accept if the payback period is less than maximum or
benchmark period, else reject the project.
11.7.3 Merits of Payback Period Method
(i) It is very easy to apply, calculate and interpret.

(ii) It is most useful when cost is not high, and the capital project is
completed in a short period.
(iii)It focuses on early return heavily and ignores distant returns. It,
thus, contains a built-in edge against economic depreciation or
obsolescence.
(iv) It is useful in evaluating those projects which involve high
uncertainty.
(v) It gives an indication to a company facing shortage of funds to
invest in projects with small payback period. This is particularly
118
useful when funds are difficult to obtain, and a quick return is Capital Budgeting
essential for rapid repayment.
NOTES
11.7.4 Limitations of Payback Period Method
(i) This method fails to take into account the time value of
money. All cash flow is treated and weighed equally regardless
of the time period of their occurrence.
(ii) It does not measure the profitability of a project. It ignores
the cash inflows beyond the payback period. Thus, it is a biased
indicator of economic value.
(iii) It does not differentiate between projects requiring different
cash investments and thus it does not provide a meaningful and
comparable criterion.
(iv) It does not indicate any cut-off period for the purpose of
investment decision.
(v) A slight change in operation cost will affect the cash inflows
and as such payback period shall also be affected.
(vi) Neither allowance is made for taxation nor is nay capital
allowance made.
11.7.5 Improvement in traditional approach to payback period
(a) Discounted Payback Period Method: The payback period method

discussed above can be reworked, taking into consideration the time
value of money and the firms required rate of return, thereby
overcoming one of the limitations of the undiscounted payback
period method. When payback period is calculated by taking into
account the discount or interest factor, it is known as discounted
payback period.
Procedure for calculation of discounted payback period
(i) Ascertain the initial investment (cash outflow)

(ii) Ascertain CFAT (profit before depreciation and after tax) for
each year.
(iii) Ascertain the PV factor for each year and compute discounted
CFAT (CFAT ×PV factor) for each year.
(iv) Ascertain cumulative discounted CFAT at the end of each year.
(v) Calculate discounted payback period at the tie at which
cumulative discounted CFAT exceeds initial investment.
(vi) Accept if discounted payback period is less than
maximum/benchmark period, else reject the project.
(b) Post pay-back Profitability: One of the major limitations of
payback period method is that it neglects the profitability of
investment during the excess of economic life period over the
payback of that investment. Hence, an improvement over this
method can be made by taking into account the returns receivables
beyond the payback period. These returns are called post pay-back
profits. If other things remain equal, the project which has highest
post pay-back profits is to be preferred. The formula for calculating
post pay-back profitability index is as follows:
119
Capital Budgeting
NOTES
(c) Payback reciprocal: as the name indicates, it is the reciprocal of
payback period. A major limitation of payback period method is
that it does not indicate any cut off period for the purpose of
investment decision. It is, however, argued that the reciprocal of the
payback period and the project generated equal amount of the
annual cash inflow. In practice, the payback reciprocal is a helpful
tool for quickly estimating the rate of return of the project provided
its life is at least twice the payback period. The payback reciprocal
can be ascertained by using the formula given below:
(Or)
2. Accounting or Average Rate of Return (ARR) Method
ARR is the annualised net income earned on the average funds

invested in a project. It is a measure based on the accounting
profit (profit after depreciation and tax) rather than the cash
flows and is very similar to the measure of rate of return on
capital employed, which is generally used to measure the
overall profitability of the firm. The alternative formula for
calculating the ARR is as follows:
a) Annual return on original investment method
Where, Annual average net earnings = Average of the

earning (savings) after depreciation and tax over the whole of the
economic life of the project.
Investment = Capital cost of the equipment minus

salvage value of the old equipment
b) Annual return on average investment method
The amount of ‘Average investment’ can be

computed in any of the following methods:
(i) Average investment
(ii) Average investment
120
(iii) Average investment Capital Budgeting
NOTES
11. 8 Procedure for computation of ARR

(i) Determine the average investment as given above.
(ii) Determine the profit after tax for each year: PAT = CFAT less
depreciation.
(iii) Calculate the total PAT for N years, where N = project life.
(iv) Calculate average PAT per annum (Total PAT of all years / N
years)
(v)
Merits of ARR Method
(i) It is very simple and easy to understand and to use.
(ii) It takes into consideration the total earnings from the project
during its lifetime.
(iii) It places emphasis on the profitability of the project, rather
than on liquidity as in the case of payback period
method.
(iv) It can be calculated by using the accounting data without
another set of workings like cash flow etc.
Demerits of ARR Method
(i) It ignores the time value of money and considers the profit
earned in the 1st year as equal to the profits earned in
later years. It does not discount the future profits.
(ii) It does not consider the length of project life
(iii) It ignores salvage value of the proposal. In real sense, the
salvage value is also a return from the proposal and
should be considered.
(iv) It also fails to recognize the size of investment required for
the project particularly, in case of mutually exclusive
proposals, the two projects having significantly different
initial costs, may have same ARR.
II. Discounted Cash Flow (DCF) Methods (or)
Time Adjusted Methods (or)
Present Value Methods
The payback period and ARR methods discussed above did not
recognise the time value money i.e., a rupee today is considered more
valuable than the one receivable after a year or two. Discounted cash flow
methods take into account the time value of money. The basic feature of
discounted cash inflows and cash outflows are discounted at a
predetermined discounting rate to ascertain their present values. Usually,
the discounting rate is the cost of capital rate of the firm. But it can be any
other rate also. Discounting factors can be obtained from present value
tables. They can also be ascertained by using the following formula:
Where, r = Discount rate

n = No. of years Self-Instructional Material
121
Capital Budgeting The second commendable feature of DCF methods is that they take into
NOTES account all benefits and costs during the entire life of the project.
Moreover, they use cash flows (i.e, CFAT) and not the accounting concept
of profit (i.e., PAT).
The DCF methods are becoming increasingly popular day
by day. Following are the discounted cash flow methods:
1. Net Present Value (NPV) Method
2. Internal Rate of Return (IRR) Method
3. Profitability Index (PI)
1. Net Present Value (NPV) Method: It is one of DCF methods in which

both future cash inflows and outflows from a project are discounted at a
cost of capital rate. This gives present value of cash inflows and
outflows. The difference between present value of cash inflows and
outflows is called Net Present Value (NPV)

(i) Ascertain the total cash inflows of the project and the time
periods in which they arise.
(ii) Calculate the present value of cash inflows i.e., CFAT × PV
factor
(iii) Ascertain the total cash outflows of the project and the time
periods in which they occur.
(iv) Calculate the present value of cash outflows i.e., cash
outflows × PV factor.
(v) Calculate NPV = Present value of cash inflows – Present
value of cash outflows
(vi) Accept project if NPV is positive, else reject. If two projects
are mutually exclusive, the project with higher NPV
should be preferred.
Merits of NPV Method

(i) It recognizes the time value of money.
(i) It uses the discount rate which is the firm’s cost of capital.
(ii) It considers all cash flows over the entire life of the project.
(iii) NPV constitutes addition to the wealth of shareholders and
thus focuses on the basic objective of financial
management.
(iv) Since all cash flows are converted into present value
(current rupees), different projects can be compared on
NPV basis, thus, each project can be evaluated
independent of others on its own merit.
Limitations of NPV Method
(i) This method assumes that the discount rate i.e., firm’s cost
of capital is known. But the cost of capital is difficult to
understand and measure in practice.
(ii) It may not give reliable answers while dealing with
alternative projects under the conditions of unequal lives
of projects.
(iii) Decisions arrived at may not be satisfactory when projects
being compared involve different amounts of
investment.
122
Capital Budgeting
2. Internal Rate of Return (IRR) Method
NOTES
IRR is the rate of return at which the sum of discounted cash
inflows equals the sum of discounted cash outflows. It is the
rate at which the NPV of the investment is zero. It is called
internal rate because it depends mainly on the outlay and
proceeds associated with the project and not on any rate
determined outside the investment. This method is also
known as marginal rate of return method or time adjusted
rate of return method. This method is generally employed
when cost of investment and annual cash inflows are
known, while the unknown rate of return (i.e., rate of cost of
capital) is to be ascertained.

IRR is calculated according to two methods on the basis tabular
values.
(a) When cash inflows are uniform for all the years: In this
case, the IRR is determined with the help of annuity table
showing the present value of Re. 1 received annually over
‘n’ years by adopting the following two steps:
Step (i): The factors to be located in the relevant annuity table is
calculated by using the following simple equation:
Where, F = Factors to be located

I = Initial investment
C = Cash inflow per year
Step (ii): The factor, thus, calculated is located in annuity table on
the line representing number of year corresponding to the estimated
useful life of the assets and the relevant percentage of the discount
which represents IRR.
(b) When cash inflows are not uniform: In this case, IRR is to
be ascertained by trial and error process. In this process,
cash inflows are to be discounted by a number of trial rates.
Just to start, the average cash inflows of different years are
to be found. Original investment is to be divided by this
average cash inflow. This may be taken as present value
factor. The rate can be ascertained from PV table for this
factor and at this rate, the PV of case inflows of several
years are to be calculated, then total PV of cash inflows are
compared with the original investment. If the calculated PV
of cash inflows is less than the original investment, the
further interpolation be carried on at lower rate. On the
other hand, a higher rate should be tried if the PV of cash
inflows is higher than the original investment. This process
continues till the PV of cash inflows and the original
investment are equal or nearly equal. However, the exact
rate of return can be ascertained with the help of the
following formula:
123
Capital Budgeting
NOTES
Accept or reject criterion
Accept the project if the IRR is higher than or equal to minimum
required rate of return. The minimum required rate of return is also known
as cut off rate or firm’s cost of capital. While evaluating two or more
projects, project giving a higher IRR should be preferred.
Merits of IRR Method
(i) All cash inflows of the project arising at a different point of
time are considered.
(ii) Time value of money I taken into account.
(iii) Decision are immediately taken by comparing IRR with the
cost of capital.
(iv) It helps in achieving the basic objective of maximization of
shareholders wealth. All projects having IRR above the
cost of capital will be automatically accepted.
Limitations of IRR Method
(i) Computation of IRR is quite tedious, and it is difficult to
understand.
(ii) Both NPV and IRR assume that the cash inflows can be
reinvested the discounting rate in the new projects.
However, reinvestment of funds at the cut-off rate is
more appropriate than at the IRR. Hence, NPV method
is more reliable than IRR for ranking two or more
projects.
(iii) It may give results inconsistent with NPV method, this is
especially true in case of mutually exclusive projects
i.e., projects where acceptance of one would result in the
rejection of the other. Such conflict of results arises due
to the following:
(a) Differences in cash outlays
(b) Unequal lives of projects
(c) Different pattern of cash flows
3. Profitability Index (PI) Method

This method is a variant of the NPV method. It is also known as
benefit cost ratio or present value index. It is also based on the basic
concept of discounting the future cash flows and is ascertained by
comparing the present value of cash inflows with the present value
of cash outflows. It is calculated dividing the former by the latter.
Significance of PI
The PI represents the amount obtained at the end of the
project life, for every rupee invested in the project life, for every rupee
invested in the project at the initial stage. The higher the PI, the better it is,
since the greater is the return for every rupee of investment in the project.
Accept or Reject Criterion

Accept the project if its PI is more than 1 and reject the
project if the PI is less than 1. However, if the PI is equal to 1, then the
firm may be indifferent because the present value of inflows is expected to
Self-Instructional Material be just equal to the present value of the outflows. In case of mutual
124
exclusive projects, project with highest PI should be given top priority, Capital Budgeting
while the project with the lowest PI should be assigned lowest priority. The
NOTES
projects having PI of less than 1 are likely to be out rightly rejected.
Merits of PI Method
(i) It considers the time value of money.
(ii) It is a better project evaluation technique than NPV and
helps in ranking projects where NPV is positive.
(iii) It focuses on maximum return per rupee of investment and
hence is useful in case of investment in divisible
projects, when funds are not fully available.
Limitations of PI Method
(i) The PI as a guide in resolving capital rationing fails where
projects are indivisible. Once a single large project with
high NPV is selected, possibility of accepting several
small projects which together may have higher NPV
than the single project is excluded.
(ii) Situations may arise where a project with a lower PI
selected may generate cash flows in such case being
more than the one with a project with highest PI.
The PI approach thus cannot be used indiscriminately but all types of
combinations of projects will have to be worked out.
Profitability Index Vs NPV Method Vs IRR Method of Ranking of

Projects
In case, a firm has two or more projects competing for the same funds at its
disposal, the question of raking the projects arises. For a given project, PI
and NPV methods give the same accept and reject signals. However, if we
have to select one project out of two mutually exclusive projects, the NPV
method should be preferred. It is because of the fact that the NPV indicated
the economic contribution of the project in absolute terms. As such a
project which gives higher economic contribution should be preferred.
As regard NPV method versus IRR method, one has to consider the
basic presumption behind the two. In the case of IRR method, the
resumption is that intermediate cash inflows will be reinvested at the same
rate i.e., IRR, whereas the case of NPV method, intermediate cash inflows
are presumed to be reinvested at the cut off rate. It is obvious that re-
investment of funds at the cut off rate is more possible than at the IRR
which at times may be very high. Hence, the NPVs being obtained from
discounting at a fixed cut off rate more reliable in ranking two or more
projects than the IRR.
Capital Rationing
Generally, firm fix up maximum amount that can be invested in
capital projects, during a given period of time, say a year. The firm then
attempts to select a combination of investment proposals, that will be
within the specific limits providing maximum profitability and put them in
descending order according to their rate of return, such a situation is then
considered to be capital rationing.
A firm should accept all investment projects with positive NPV,
with an objective to maximise the wealth of shareholders. However, there
may be resource constraints due to which a firm may have to select from
125
Capital Budgeting among various projects with positive NPVs. Thus, there may arise a
NOTES situation of capital rationing where there may be internal or external
constraints on procurement of necessary funds to invest in all investment
proposals with positive NPVs.
The capital rationing can be experienced due to external factors,
mainly imperfections in capital markets which can be attributed to non-
availability market information, investors attitude etc. internal capital
rationing is due to the self-imposed restrictions imposed by management
like not to raise additional debt or laying down a specified minimum rate of
return on each project.
There are various ways of resorting to capital rationing. For
instance, a firm may affect capital rationing through budgets. It may also
put up a ceiling when it has been financing investment proposals only by
way of retained earnings (ploughing back of profits).
Since the amount of capital expenditure in that situation cannot exceed the
amount of retained earnings, it is said to be an example of capital rationing.
Capital rationing may also be introduced by following the concept
of “Responsibility Accounting”, whereby management may introduce
capital rationing by Authorising a particular department to make
investment only up to a specified limit, beyond which the investment
decisions are to be taken by higher ups.
Selection of projects under Capital Rationing

The selection of projects under capital rationing involves two steps:
(i) Identify the projects which can be accepted by using

methods of evaluation discussed above.
(ii) To select the combination of projects.
In capital rationing, it may also be more desirable to accept several

small investment proposals than few large investment proposals so
that there may be full utilisation of budgeted amount. This may
result in accepting relatively less profitable investment proposals if
full utilisation of budget I a prime consideration. Similarly, capital
rationing may also mean that the firm forgoes that next most
profitable investment following after the budget ceiling even
though it is estimated to yield a rate of return much higher than the
required rate of return. Thus, capital rationing does not always lead
to optimum results.
Inflation in capital Budgeting
Inflation has become almost a way of life. It causes erosion in the

purchasing power of money. It should be incorporated in capital budgeting
analysis. It can be incorporated in the capital budgeting evaluation
procedure by adjusting the cash flows or the discount rate. But care must
be taken that the treatment of inflation must be consistent. If inflation is
included in the cash flows (i.e., money cash flow), then it should be
included in discount rate also or in other words, both the cash flows as well
as the discount rate may be stated in real terms as if there has been no
inflation. The consequences of a mismatch can be dire. If money cash
flows are discounted at real discount rate, the resultant NPV will be
overestimated. Further, if real cash flows are discounted at money
126
(nominal) discount rate, the resultant NPV will be understated. If Capital Budgeting
adjustment for inflation is done consistently, however, the NPV will be
NOTES
identical (i.e., either money cash flows are discounted at money discount
rate or the real cash flows are discounted at real discount rate). An example
will make this concept more clear.
Example: A firm usually forecast cash flows in nominal terms and

discounts at a 10.25% nominal rate. The firm is considering a project at
present involving an immediate cash flow of Rs. 20,000 and has forecasted
cash flows in real terms i.e., in terms of current purchasing power of rupees
as follows:
Year 1 2 3
Cash inflow (Rs.) 10000 16000 12000
The firm expects inflation to be at the rate of 5% p.a Calculate NPA
Solution:
I. Computation of NPV by discounting money cash flows at money

discount rate:
(i)Calculation of Money Cash flows
Since the future cash inflows are given in current price and the
inflation rate is 5%, the future cash inflows in money term would be as
follows:
Year CFAT Inflation factor Money cash
Rs. inflow
Rs.
1 10,000 (1.05)1 10,500
2 16,000 (1.05)2 17,640
3
3 12,000 (1.05) 13,892
(ii) Calculation of PV factor @ 10.25%
Where, r = 10.25 %, n = 5 years
= 0.907
= 0.823
= 0.746
(iii) Calculation of NPV
Year Money cash PVF 10.25% Present value
inflow (Rs.) (Inflation Rs.
adjusted)
1 10,500 0.907 9,524
2 17,640 0.823 14,518
3 13,892 0.746 10,363
P.V. of money cash inflows 34,405
Less: P.V. of cash outflow (20,000 x1) 20,000
NPV 14,405
127
Capital Budgeting
NOTES
II. Computation of NPV by discounting real cash flows at real
discount rate
(i) Calculation of real discount rate
(ii) Calculation of NPV

Year CFAT PVF 5% Present value
(Real cash inflows) Rs. Rs.
1 10,000 0.9524 9,524
2 16,000 0.9070 14,512
3 12,000 0.8638 10,366
P.V. of real cash inflows 34,402
Less: P.V. of cash outflow (20,000 x1) 20,000
NPV 14,402
From the above example, it is to be noted that the real discount rate is
approximately equal to the difference between the nominal discount rate of
10.25% and the inflation rate of 5% discounted at 5.25% (difference
between the two factors i.e., nominal rate inflation = 4.9875(i.e., 5.25 ×
95%) as compared with 5% as calculated earlier – not exactly right, but
close. The message of all this is quite simple. Discount nominal cash flows
at a nominal discount rate. Discount real cash flows at real discount rate.
Risk Analysis in Capital Budgeting
So far, our analysis of investment decisions has been based on

condition of certainty regarding the future and the proposed investment do
not carry any risk. The assumptions of certainty and no risk were made
simply to facilitate the understanding of capital investment decisions. But
in practice, all investment decisions are undertaken under conditions of risk
and uncertainty. Since investment decisions involve projecting the future
cash inflows and outflows, uncertainty inevitably creeps in. neither rupee
amounts not the dates of cash flows can be known with precision. The
amount and timing of the long-term future cash flows could vary
significantly from those predicted. It is, therefore, essential to consider risk
factor at the time of determining cash flows from a project for the purpose
of capital budgeting decisions. However, incorporation of risk factor in
capital budgeting decisions is a difficult task. Some of the popular methods
used for this purpose are as follows:
1. Risk adjusted discount rate method

2. Certainty – equivalent method
3. Sensitivity analysis
4. Probability assignment
128
5. Standard deviation and coefficient of variation. Capital Budgeting
6. Decision tree analysis.
NOTES
These methods are discussed one by one in detail in the pages to come.
1. Risk adjusted Discount Rate Method: This method is also known

as varying discount rate method. It is based on the presumption that
investors expect a higher rate of return on risky projects as
compared to less risky projects. The rate requires determination of
(a) risk free rate and (b) risk premium rate. Risk free rate is the rate
at which the future cash inflows should be discounted has there
been no risk. Risk premium rate is the extra return expected by the
investors over the normal rate (i.e., the risk-free rate), on account of
the project being risky. Thus, Risk adjusted discount rate is a
composite discount rate that takes into account both the time and
risk factors. A higher discount rate will be applied for projects
which are considered more risky, conversely, lower discount rate is
applied for less risky projects.
2. Certainty-Equivalent method: Under this method, risk element is

compensated by adjusting cash inflows rather than adjusting the
discount rate. Expected cash flows are converted into certain cash
flows by applying certainty-equivalent co-efficient, depending upon
the degree of risk inherent in cash flows. To the cash flows having
higher degree of certainty, higher certainty – equivalent co-efficient
is applied and foe cash flows having low degree of certainty, lower
certainty equivalent co-efficient is used. For evaluation of various
projects, cash flows so adjusted are discounted by a risk-free rate.
3. Sensitivity Analysis: In the methods discussed above, only one

figure of cash flow for each year is considered. However, there are
chances of making estimation errors. The sensitivity analysis
approach takes care of this aspect by giving more than one estimate
of the future cash flow of a project. It is thus superior to one figure
forecast as it provides a more clear idea about the variability of the
return. Generally, sensitivity analysis gives information about cash
inflows under three assumptions i.e., ‘Optimistic’, ‘Most likely’ and
“Pessimistic” outcomes associated with the project; it explains how
sensitive the cash flows are under these three situations. Further
cash inflows under these three situations are discounted to
determine net present values. The larger the difference between the
pessimistic and optimistic cash flows, the more risky is the project
and vice versa.
4. Probability assignment: Although sensitivity analysis approach

provides different cash flow estimated under three assumption, it
does not provide chances of occurrence of each of these estimates.
The chances of occurrence can be ascertained by assigning
appropriate probabilities to each of these estimates. In most of the
capital budgeting situations, the probabilities are usually assigned
by the decision maker on the basis of some relevant facts and
figures and his subjective considerations. If the decision maker
foresees a risk in the proposal, then he has to prepare a separate
129
Capital Budgeting probability distribution to summaries the possible cash flow for
NOTES each year through the economic life of the proposal. Thereafter he
has to find out the expected value of probability distribution for
each year.
To determine the expected value, each cash flow of the probability

distribution is multiplied by the respective probability of the cash
flow and then adding the resulting products. This procedure is to be
adopted for the probability distribution for all the years and the
expected value of cash inflows are discounted at an appropriate
discount rate to determine the NPV of the proposal.
5. Standard Deviation and Co-efficient of variation:
The probability assignment discussed above does not give a

precise value indicating about the variability of cash flows and
therefore the risk. This limitation can be overcome by following
standard deviation approach. Standard deviation (SD) is a measure
of dispersion. It is defined as the square root of squared deviation
calculated from the mean. In case of capital budgeting, SD is
applied to compare the variability of possible cash flows of
different projects from their respective mean or expected value. A
project having a larger SD will be more risky as compared to a
project having smaller SD. The SD is calculated by using following
formula:
Co-efficient of variation is a relative measure of dispersion and can be

applied in capital budgeting decision process to measure the risk of a
project particularly in case when the alternative projects are of different
size. It is defined as the standard deviation of the probability distribution
divided by its expected value. The formula for calculation of CV is as
follows:
6. Decision Tree Analysis: This is a useful alternative for evaluating risky

investment proposals. It takes into account the impact of all probabilistic
estimates of potential outcomes. Every possible outcome is weighed in
probabilistic terms and then evaluated. A decision tree is a pictorial
representation in tree form which indicates the magnitude probability and
inter-relationship of all possible outcomes. The format of the problem of
the investment decision has an appearance of a tree with branches and
therefore this analysis is termed as decision tree analysis. The decision tree
shows the sequential cash flows and NPV of the proposed project under
different circumstances.
ILLUSTRATIONS
i. Payback Period Method

130
1. A project has initial investment of Rs. 200000. It will produce cash Capital Budgeting
flows after tax of Rs. 50,000 per annum for six years. Compute the
NOTES
payback period for the project.
Solution:
Computation of Payback period (Uniform CFAT)
2. Project Y has an initial investment of Rs 500000.its cash flows for 5

years are Rs.150000, Rs.180000, Rs.150000, Rs.132000 and Rs.120000.
Determine the payback period.
Solution:
Computation of payback period (differential CFAT)
Since the cash inflows are not uniform, accumulation cash inflows have to
be ascertained to calculate payback period.
Statement showing cumulative cash inflow
Year CFAT Rs. Cumulative CFAT

Rs.
1 150000 150000
2 180000 330000
3 150000 480000
4 132000 612000
5 120000 732000
Initial investment is Rs. 500000.Rs.480000 can be recovered in three years.

The remaining amount of Rs.20000 is to be recovered in the fourth year.
Time required for earning Rs.132000 in the fourth year =12 months.
Time required to earn Rs. 20,000 in the fourth year =
(or) 2
months
Payback period = 3 years, 2 months.

3. A company has to choose one of the following two mutually exclusive
projects. Investment required for each project is Rs 150000. Both the
projects have to be depreciated on straight line basis. The tax rate is 50%.
Calculate payback period.
Year Profit before depreciation

Profit X (Rs.) Profit Y (Rs.)
131
Capital Budgeting
1 42,000 42,000
NOTES 2 48,000 45,000
3 70,000 40,000
4 70,000 50,000
5 20,000 1,00,000
Solution:
In this problem, profit before depreciation is given. For calculation of
payback period, CFAT (profit before depreciation, after tax) is needed.
Project x
Statement showing CFAT & Cumulative CFAT
Year Profit Dep. PBT PAT CFAT Cum.
before (1,50,000/5) CFAT
dep. &
tax
(1) (2) (3) (4) (5) (6) (7)
Rs. Rs. Rs. Rs. Rs. Rs.
1 42,000 30,000 12,000 6,000 36,000 36,000
2 48,000 30,000 18,000 9,000 39,000 75,000
3 70,000 30,000 40,000 20,000 50,000 1,25,000
4 70,000 30,000 40,000 20,000 50,000 1,75,000
5 20,000 30,000 (-) (-) 20,000 1,95,000
10,000 10,000
The above table shows that is 3 years, Rs. 1,25,000 has been
recovered, Rs. 25,000 is left out of initial investment. In the 4th Year, the
CFAT is Rs. 50,000. It means the payback period is between third and
fourth years.
= 3 years, 6 months
Project x
Statement showing CFAT & Cumulative CFAT
Year Profit Dep. PBT PAT CFAT Cum.
before (1,50,000/5) CFAT
dep. &
tax
(1) (2) (3) (4) (5) (6) (7)
Rs. Rs. Rs. Rs. Rs. Rs.
1 42,000 30,000 12,000 6,000 36,000 36,000
2 45,000 30,000 15,000 7,500 37,500 73,500
3 40,000 30,000 10,000 5,000 35,000 1,08,500
4 50,000 30,000 20,000 10,000 40,000 1,48,500
5 1,00,000 30,000 70,000 35,000 65,000 2,13,500
The above statement reveals that Rs. 1,48,500 has been recovered
in 4 years’ time. Rs. 1,500 is left out of initial investment. In the 5 th year,
the CFAT is Rs. 65,000. It means the payback period is between 4th and 5th
year.
= 4 years, 9 days
II. Discounted Payback Period Method
1. Project M has an initial investment of RS.3 lakh. Its cash flows for five
years are RS. 90000 RS. 108000 RS.90000 RS 79200 and RS 72000.
132
Determine the discounted payback period assuming a discount rate of 10% Capital Budgeting
p.a.
NOTES
Solution:
Statement showing Discounted CFAT & Cumulative Discount CFAT
Year CFAT P.V factor DCFAT Cum.
Rs. AT 10% Rs. DCFAT
Rs.
1 90,000 0.909 81,810 81,810
2 1,08,000 0.826 89,208 1,71,018
3 90,000 0.751 67,590 2,38,608
4 79,200 0.683 54,094 2,92,702
5 72,000 0.621 44,712 3,37,414
The above table reveals that in 4-year, RS. 292702 has been recovered,
Rs.7298 is left out of initial investment. In the 5 th year, the CAFT is
44712.It means the payback period is between fourth and fifty years.
= 4 years, 2 months
Note: In case of different CFAT, use P.V. factors.
III. Accounting (or) Average Rate of Return (ARR) Method

1. Project k required an investment of RS 20 lakh and yields profits after
tax and depreciation as follows:
Year 1 2 3 4 5
Profits after 1,00,000 1,50,000 2,50,000 2,60,000 1,60,000
tax &
depreciation
(Rs.)
At the end of 5th year, the plant can be sold for Rs. 1,60,000. You are
required to calculated ARR.
Solution:
Average profit =
= 20%
2. X Ltd. is considering the purchase of a new machine to replace a
machine which has been in operating in the factory for the lest 5 year.
Ignoring interest but considering tax at 50% of net earnings, suggest which
of the two alternatives should be preferred. The following are the details: Self-Instructional Material
133
Capital Budgeting
Old machine New machine
NOTES Purchase price Re. 40,000 Re. 60,000
Estimated life on 10 years 10 Years
machine
Machine running hours 2,000 2,000
p.a
Units per hour 24 36
Wages per running 3 5.25
Power per annum 2,000 4,500
Consumable stores p.a 6,000 7,500
All other charges p.a 8,000 9,000
Material cost per unit 0.50 0,50
Selling price per unit 1.25 1.25
You may assume that the above information regarding sales and cost of
sales will hold good throughout the economic life of each of the machines.
Depreciation has to be charged according to straight line method. Calculate
accounting rate of return.
Solution:
Profitability statement
Particulars Old Machine New machine
Rs. Rs.
Sales (48,000 x 1.25) 60,000 (72,000 x 1.25) 90,000
Less: Cost of
sales: (48,000 x 0.50) 24,000 36,000
Direct materials (2,000 x 3) 6,000 10,500
Wages 2,000 4,500
Power 6,000 7,500
Consumable 8,000 9,000
stores 40,000/10 4,000 6,000
Other charges
Depreciation
Profit before tax 10,000 16,500
Less: Tax @ 5,000 8,250
50%
Profit after tax 5,000 8,250
Working note: Calculate of No. of units produced
Output = Units per hour x Running hours
Old machine = 24 x 2,000 = 48,000 units
New machine = 36 x 2,000 = 72,000 units
Calculation of Accounting Rate of Return (ARR)
ARR =
Old machine =
New machine =
Analysis: As the accounting rate of return of new machine (13.75%) is
higher than that of old machine (12.5%), the old machine can be replaced
by the new machine.
134
IV. Net present value (NPV) Capital Budgeting
1. An investment of Rs. 10,000 (having scrap value of Rs. 500) yields the
NOTES
following returns:
Year 1 2 3 4 5
CFAT 4,000 4,000 3,000 3,000 2,500
The cost of capital is 10%. Is the investment desirable? Discuss it
according to NPV method assuming the P.V. factors for 1 st , 2nd , 3rd, 4th
and 5th year. 0.909, 0.826, 0.751, 0.683 and 0.620 respectively.
Solution:
Statement showing Net Present Value
Year CFAT P.V factor @ Present value
Rs. 10% Rs.
(1) (2) (3) (4) = (2) x(3)
1 4,000 0.909 3,636
2 4,000 0.826 3,304
3 3,000 0.751 2,253
4 3,000 0.683 2,049
5 2,500 0.620 1,550
500 (scrap) 0.620 310
Total present value of cash inflows 13,102
Less: Present value of cash outflow(10,000x 1) 10,000
Net present value (NPV) 3,102
Note: (i) The scrap value is taken as an additional inflow at the end of fifth
year.
(ii) In case of differential CFAT, use P.V factors.
Analysis: Since NPV is positive, the investment is desirable.
V. Internal Rate of Return (IRR) Method
1. (Uniform CFAT)
Initial outlay RS 100000
Life of the assets 6 year
Estimated cash inflow RS 20000
You are required to calculate internal rate of return.
Solution:
Computation of internal Rate of Return (IRR)
Present value factor = initial investment/CFAT = 100000/20000= 5
The present value factor is to be found out in the present value
annuity table in the column of 6 year (life of the assets). The figure 4.917
(nearer to 5) is found in the row of 6%. Therefore, the IRR is 6%.
11.11 Check Your Progress
1. What is capital budging?

2. What are the features of capital budgeting?
135
Capital Budgeting 1. Capital budgeting means planning the capital expenditure in acquisition
NOTES of fixed (capital) assets such as land, building, plant or new projects as a
whole. It includes replacing and modernising a process.
2. Investments: Capital expenditure plans involve a huge investment in

fixed assets. Long-term: Capital expenditure, once approved, represents
long term investment that cannot be reversed or withdrawn without
sustaining a loss. Forecasting: preparation of capital budget plans involves
forecasting of several years’ profits in advance in order to judge the
profitability of projects.

1. What are the advantages of capital budgeting?
2. What are the capital budgeting decisions?
3. Calculate the pay-back period for a project which requires a cash outlay
of Rs.100000 and generates cash inflows Rs.25000 Rs.35000, Rs.30000,
and Rs.25000 in the first, second, third and fourth years respectively.
5. Calculate discount payback period from the details given below:
Cost of project: Rs. 6,00,000; Life of the project: 5 years; Annual cash
inflow; Rs. 2,00,000; Cut off rate: 10%
Year 1 2 3 4 5
Discount 0.909 0.826 0.751 0.683 0.621
factor
6. A project requires an investment of RS.500000 and has a scrap value of

Rs.20000 after 5 year. It is expected to yield profile after taxes and
depreciation during the five years amounting to RS.40000, Rs.60000,
Rs.70000, Rs.50000 and Rs.20000. calculate the Average rate of return on
investment.
7. An investment of Rs. 10,000 (having scrap value of Rs. 500) yields the
following returns:
Year 1 2 3 4 5
CFAT 4,000 4,000 3,000 3,000 2,500
The cost of capital is 10%. Is the investment desirable? Discuss it
according to NPV method assuming the P.V. factors for 1 st , 2nd , 3rd, 4th
and 5th year. 0.909, 0.826, 0.751, 0.683 and 0.620 respectively.
Further Reading:
• Financial management: Panday, I.M. 9th ed Vikas
• Principles of financial management: Inamdar, S.M. Everest
• Fundamentals of Advanced Accounting, R.S.N. Pillai Bagavathi,
• Financial Management: Text & Problems, Khan, M. Y Jain, P.K.
3rd ed, TMH
• Financial Management, Khan & Jain – Tata McGraw Hill
• Cost and Management Accounting, Jain S.P. & Narang, K.L.
136
Working Capital Management
UNIT - XII WORKING CAPITAL
MANAGEMENT NOTES
Structure
12.1 Introduction
12.1 Introduction
It is common knowledge that a firm’s value cannot be Maximised
in the long run unless it survives the short run. Firms fail most often
because they are unable to meet their working capital needs. Consequently,
sound working capital management is a requisite for firm’s survival.
Working capital management is requisite for firm’s survival. Working
capital management is the functional area of finance that covers all the
current assets of the firm. It is concerned with management of the level of
individual current assets as well as the management of total working
capital. In chapter 1, it is mentioned that financial management means
procurement of funds and effective utilization of these procured funds.
Procurement of funds is firstly concerned for financing working capital
requirement of the firm and secondly for financing fixed assets. In this
chapter, we are going to deal with various issue relating to financing and
management of working capital.
Working capital is the amount of funds required for meeting day-to-
day expenses of the business. The firm starts with cash. It buys raw
materials, employs workers and spends on expenditures like advertising
etc. Even then it may not receive cash immediately if sold on credit. The
firm will have to use its own cash before it gets back sales revenue and
then the cycle can go on. So, the money or funds required to meet the
expenditure until it gets back through sales revenue is called working
capital and this much funds it has to keep. In simple words, working capital
refers to that part of the firm’s capital which is required for financing short
term or current assets such as cash, marketable securities, debtors and
137
Working Capital Management inventories. Funds, thus, invested in current assets keep revolving fast and
are being constantly converted into cash and this cash flows out again in
exchange for other current assets. Hence, it is also known as revolving or
NOTES
circulating or short-term capital.
(i) ICAI: Working capital means the funds available for day-to –day
operation of an enterprise.
(ii) Shubin: Working capital is a part of capital which is required for
purchase of raw materials and for meeting day-to-day
expenditure on salaries, wages, rent and advertising etc.
(iii)J.M. Mill: The sum of the current assets is the working capital of
the business.
(iv) C.W. Gerstenberg: Working capital is the excess of current assets
over current liabilities.
(v) Annual survey of Industries (1961) : Working capital is defined to
include “stocks of materials, fuels, semi-finished goods
including work-in-progress and finished goods and by-
products; cash in hand and at bank and the algebraic sum of
sundry creditors as represented by (a) outstanding factory
payments i.e., rent, wages, interest and dividend; (b)
purchase of goods and services; (c) short term loans and
advances and sundry debtors comprising amounts due to the
factory on account of sale of goods and services and
advances due to the factory on account of sale of goods and
services and advances towards tax payments.
From the above definitions, it is observed that there are two concepts of
working capital. They are: (i) Gross concept and (ii) Net concept.
i) Gross concept: According to this concept, the term working capital
refers to the amount of funds invested in current assets that are employed
in the firm. The amount of current liabilities is not subtracted from the total
current assets. This concept views working capital and aggregate of current
assets as two interchangeable terms. To understand this concept, it is
essential to know the meaning of current. Current assets are such assets as
in the orderly and natural course of business move onward through the
various process of production, distribution and payment of goods, until
they become cash or its equivalent by which debts may be readily and
immediately paid. In other words, correct assets refer to those assets which
can be converted into cash in hand and with banks, stock-finished, in-
process and raw materials, receivables for sale of merchandise, marketable
securities held as temporary investment, prepaid expensed and accrued
income.
Those gross concept is also known as “current capital” or “circulating
capital”. This concept is sometime preferred due to the following reasons:
a) Earnings in each firm are the outcome of both fixed as well as
current assets. Individually these assets have no significance. The points of
138
similarity in these assets are that both are borrowed, and they yield profit Working Capital Management
much more than the interest cost. But the distinction in the two lies in the
fact that fixed assets constitute the fixed capital of a firm, whereas current
assets are of a circulating nature. Hence, logic demands that current assets NOTES
should be considered as the working capital of the firm.

(b) This concept takes into consideration the fact that there would
be an automatic increase in the working capital with every increase in the
funds of the firm; but it is not so according to the net concept of working
capital.(c) Every management is interested in the total current assets out of
which the operation of a firm is made possible, rather than in the sources
from where the capital is procured; (d) This concept is also useful in
determining the rate of return on investment in working capital.
Net concept: According to this concept, working capital is the excess of
current assets over currents liabilities, or say, Net working capital =
Current Assets-Current liabilities. The term “Current liabilities” refers to
those claims of outsiders which are expected to mature for payment within
an accounting year and includes sundry creditors, bill payable, bank
overdraft, outstanding expensed, short term loans, advances and deposits,
provision for tax if it does not amount to appropriation of profit. The net
working capital can be positive or negative. When current assets exceed
current assets, the net working capital becomes negative. The Net concept
lays emphasis upon the qualitative aspect of the working capital. It is an
accounting concept. It deals with the management of “Net working capital
flows” in the long run. It is concerned with the management of each current
asset as well as each current liability. It is more widely accepted and is
used in the analysis of fund flow, ratio analysis and also in the structured
decisions and management of working capital. Accounting Standard Board
has used the term ‘working capital’ and not ‘net working capital’ and says
it refers to excess of current assets over current liabilities, thus, implicitly
accepted the “net concept”.
The net working capital concept is useful in the following ways:
a) It is a qualitative concept, which indicates the firm’s ability to meet its
operating expenses and short-term liabilities.
b) It indicates the margin of protection available to the short-term creditors.
(a) It is an indicator of the financial soundness of the firm.
(b) It suggests the need of financing a part of working capital
requirement out of the permanent sources of funds.
Generally speaking, the amount of funds required for operating
needs varies from time to time in every business. A certain amount of
assets in the form of working capital is always required, if a business has to
carry out its functions efficiently and without a break. But a certain amount
is needed for meeting day-to-day expenditures of business which varies
from time to time. These two types of requirements – permanent and
variable are the basis for a convenient classification of working capital.
(i) Permanent working capital: It is the amount of funds which is required to

produce good and service necessary to satisfy demand at its lowest point.
139
Working Capital Management Such capital is constantly changing from one assets to another without
leaving the business process until the business ceases to exist. Tandon
committee has named it as “Core current assets”. This capital can again be
NOTES subdivided into (1) Regular working capital and (2) Reserve margin or
cushion Working capital.
Regular working capital is the minimum amount of liquid capital needed to
keep up the circulation of the capital from cash to inventories to receivables
and back again to cash .This would include a sufficient cash balance in the
bank to pay all bills, maintain an adequate supply of raw materials for
processing, carry a sufficient stock of finished goods to give prompt delivery
and effect the lowest manufacturing costs and enough cash to carry the
necessary accounts receivables for the type of business engaged in.
Reserve margin or cushion working capital is the excess over the need for
regular working capital that should be provided for contingencies that arise
at unstated period. The contingencies include (a) rising prices, which may
make it necessary to have more money to carry inventories and receivables
or may make it advisable to increase inventories;
(b)business depressions ,which may raise the amount of cash required to
ride out usually stagnant periods;(c)strikes ,fires and unexpectedly severe
competition ,which use up extra supplies of cash ,and (d)Special operations
such as experiments with new products or with new method of distribution
,war contracts, contracts to supply new businesses and the like, which can
be undertaken only if sufficient funds are available and which in many
cases mean the survival of a business.
The permanent working capital has the following characteristics:
a) It is classified on the basis of time factor;
b) It constantly changes from one asset to another and continues to
remain in the business process;
c) Its size increases with the growth of business operation;
d) It should be financed out of long-term funds
(ii) Temporary working capital:
It represents working capital requirements over and above permanent
working capital and is dependent on factors like peak season, trade
cycle, boom etc. It is also called fluctuating or variable working capital.
It can further be classified as seasonal working capital and special
working capital.
Seasonal working capital is the additional amount of current assets-
particularly cash, receivable and inventory which is required during the
more active business seasons of the year.
Special working capital is the part of temporary working capital which
is required for financing special operations such as extensive marketing
campaigns, experiments with product or methods of production,
carrying of special jobs etc.
Features: The temporary working capital possesses the following

characteristics:
a) It is not always gainfully employed, though it may change from
one assets to another, as permanent working capital does.
b) It is particularly suited to businesses of a seasonal or cyclical
nature.
140
The distinction between permanent and temporary working capital Working Capital Management
is of great significance particularly in arranging the finance for a
firm. The Permanent working capital should be raised in the same
way as fixed capital is procured, through a permanent investment of NOTES
the owner or through long term borrowing. As business expands,
this regular capital will necessarily expand. if the cash realized
from sales includes a large enough profit to take care of expanding
operations and growing inventories, the necessary additional
working capital may be provided by the earning surplus of the
business. Temporary working capital needs can, however, be
financed out of short-term borrowings from the bank or from public
in the form of deposits.
The position with regard to the “permanent working capital” and
“Temporary working capital” can be shown with the help of
following figure:
Form the above figure, it is crystal clear that the amount of
permanent working capital remains the same over all periods of
time.e.g.,Rs.5 lakh at all times, irrespective of the amount of sales,
activity etc .But it cannot be presumed that the permanent working
capital will always remain fixed throughout the life of the firm. As
the size of the business grows, permanent working capital too is
bound to grow. This position can be depicted with the help of the
following figure:
The above figure made it clear that the permanent working capital
increases in amount (rupee value) based on the activity level of the firm.
For example, working capital of Rs.5 lakh may be sufficient for a turnover
level of 25 lakh. But when the turnover increased to Rs.50 crore, after a
certain time period, the amount of working capital should rise and hence,
should be an amount higher than Rs.5 lakh.
Every business firm requires some amount of working capital .Even a fully
equipped manufacturing firm is sure to collapse without(a)an adequate
supply of raw materials to process;(b)cash to meet the wage bill;(c)The
capacity to wait for the market for its finished product(d)the ability to grant
credit to its customers. similarly, a commercial enterprise is virtually good
for nothing without customers. Similarly, a commercial enterprise is
virtually good for nothing without merchandise to sell. Working capital,
thus ,is the backbone of a business. As a matter of fact, any organization,
whether profit oriented or otherwise will not be able to carry on production
and distribution activities smoothly without adequate working capital.
As indicated above, every firm is supposed to have adequate working
capital i.e., as much as needed by the firm. It should neither be excessive
nor inadequate .Both inadequate and redundant working capital situations
are dangerous. Excess working capital means idle funds lying with the firm
and not earning any profit for it. Whereas inadequate working capital
means that the firm does not have sufficient funds for financing its daily
141
Working Capital Management business activities, which ultimately result in stoppage of production and
reduced productivity .It is rightly said, “Inadequate working capital is
dangerous; whereas redundant working capital is a criminal waste”.
NOTES
(i) Cash discount: The business can avail the advantage of cash discount
by paying cash for the purchase of raw materials and merchandise. If
proper cash balance is maintained, this will reduce the cost of
production.
(ii) Sense of security and confidence: Adequate working capital creates a
sense of security and confidence not only among the business
executives but also among the customers, creditors and business
associates.
(iii)Credit worthiness: prompt payment of dues results in establishing
credit worthiness of the business. This facilitates commanding
Favourable terms for further borrowings.
(iv) Continuous supply of raw materials: A firm with adequate working
capital is assured of regular supply of required raw materials on the
basis of prompt payment.
(v) Exploitation of good opportunities: Good opportunities can be
exploited in case of adequacy of capital in a concern. For Example, a
firm may make off-season purchases resulting in substantial savings or
it can fetch big supply orders resulting in good profits.
(i) Inefficient management: Excessive working capital indicates
inefficient management of the firm. It show that the management is not
interested in expanding the business, otherwise the excessive working
capital might have been utilized for this purpose.
(ii) Increased capital expenditure: As enough fund is available, there may
be boost up in acquiring plant and machinery to enhance production. In
case there is not enough sales potentiality with adequate margin of
profit, such fixed investment may not be worthwhile for fund
employment.
(iii)Over capitalization: Excessive working capital gives birth to over
capitalization with all its evils. Over capitalization is not only
disastrous to the smooth survival of the firm but also affects the
interests of those associated with the firm.
(iv) Lower return on capital employed: A firm with excessive working
capital cannot earn a proper rate of return on its total investments, as
profit are distributed on the whole of its capital. This brings down the
rate of return to the shareholders. In turn, lower dividend reduces the
market value of share and causes capital loss to the shareholders
The following factors are considered for a proper assessment of the
quantum of working capital requirements:
(a) Nature of business: working capital is very limited in public sector
undertakings such as electricity, water supply and railways
because they offer cash sales only and supply services, not
Self-Instructional Material products and no funds are tied up in inventories and receivables.
142
On the other hand, the trading and financial firms require less Working Capital Management
investment in fixed assets but have to invest large amount of
working capital along with fixed investment.
NOTES
(b) Length of production cycle: The longer the manufacturing time, the
raw materials and other supplies have a be carried for a longer
time in the process with progressive increment of labour and
service costs before the final product is obtained. so working
capital is directly proportional to the length of the
manufacturing process.
(c) Rate of stock turnover: There is an inverse co-relationship between

the question of working capital and the velocity or speed with
which the sale is affected. A firm having a high rate of stock
turnover will need lower amount of working capital as
compared to a firm having a low rate of turnover.
(d) Business cycle: In period of boom, when the business is prosperous,

there is need for larger amount of working capital due to rise in
sales, rise in prices, optimistic expansion of business etc. On the
contrary, in times of depression, the business contracts, sales
decline, difficulties are faced in collection from debtors and the
firm may have a large amount of working capital.
(e) Earning capacity and dividend policy: some firms have more
earning capacity then others due to quality of their products,
monopoly condition, etc. such firm may generate cash profits
from operations and contribute to their working capital. The
dividend policy also affects the requirement of working capital.
A firm maintaining a steady high rate of cash dividend
irrespective of its profits, need working capital than the firm
that retains larger part of its profits and does not pay so high
rate of cash dividend.
(f) Operating cycle: The speed with which the operating cycle
completes its round
(i.e., cash raw materials finished product accounts
receivables cash) plays a decisive role in influencing the
working capital needs.
(g) Operating efficiency: operating efficiency means optimum
utilization of resources. The firm can minimize its need for
working capital by efficiently controlling its operation costs.
With increased operating efficiency, the use of working capital
is improved, and pace of cash cycle is accelerated. Better
utilization of resources improves profitability and helps in
relieving the pressure on working capital.
(h) Price level changes: Generally, rising price level requires a higher
investment in working capital. With increasing prices, the same
levels of current assets need enhanced investment. However,
firms which can immediately revise prices of their products
upwards may not face a severe working capital problem in
143
Working Capital Management periods of rising levels. The effects of increasing price level
may, however, be felt differently by different firms due to
variations in individual prices. It is possible that some
NOTES companies may not be affected by rising prices, whereas others
may be badly hit by it.
(i) Degree of mechanization: In a highly mechanized concern having a

low degree of dependence on labour, working capital
requirement gets reduced. Conversely, in labour intensive
industries, greater sums shall be required to pay for wages and
related facilities.
(j) Growth and expansion of business: In the business, the working

capital requirements of a firm are low. However, with the
gradual growth and expansion, its working capital needs also
increase. Discernibly, larger amount of working capital in a
growing concern is required for its expansion programmes.
(k) Seasonal variations: some industries manufacture and sell goods

only during certain seasons. For example, sugar, oil, timber, and
textile industries have either seasonal supplies of raw materials
or make their sales in a particular season. Hence, the working
capital requirements of such industries will be higher during a
certain season as compared to any other period.
(l) Capital structure of the firm: If shareholders have provided some

funds towards the working capital needs (at least to satisfy the
permanent working capital needs), the management will find it
relatively easy to manage working capital. If the firm has to
depend entirely upon outside sources for both permanent and
temporary working capital needs, it faces an uphill task under
dear money conditions.
(m) Credit policy: A firm making purchases on credit and sales on cash
will always require lower amount of working capital. On the
contrary, a firm which is compelled to sell on credit and at the
same time having no credit facilities may find itself in a tight
corner. Prevailing trade practices and changing economic
conditions do generally exert greater influence on the credit
policy of the concern.
(n) Size of the business: The size of business has also an important
impact on its working capital needs. Size may be measured in
terms of scale of operation. A firm with larger scale of
operation will need more working capital than a small firm.
(o) Production policy: The production policies pursued by the

management have a significant effect on the requirement of
working capital of the business. The production schedule has a
great influence on the level of inventories. The decisions of the
management regarding automation, etc. Will also have effect on
working capital requirements. In case of labour-intensive
144
industries, the working capital requirements will be more. Working Capital Management
While in case of a highly automatic plant, the requirement of
long-term funds will be more.
NOTES
(p) Profit margin: Firm differ in their capacity to generate profit from
business operation. Some firm enjoy a dominant position, due
to quality product or good marketing management or monopoly
power in the market and earn a high profit margin. Some other
firms may have to operate in an environment of intense
competition and may earn a low margin of profit. A high net
profit margin contributes to wards the working capital pool. In
fact, the net profit is a source of working capital to the extent it
has been earned in cash.
(q) Liquidity and profitability: In case, a firm desires to take a greater

risk for bigger gains, it reduces the size of its working capital in
relation to its sales. If it is interested in improving its liquidity,
it increases the level of its working capital. However, this policy
is likely to result in a reduction of the sales volume, and
therefore, of profitability. A firm, therefore, should choose
between liquidity and profitability and decide about its working
capital requirements accordingly.
(r) Capacity to repay: A firm’s ability to repay determines level of its

working capital. The usual practice of a firm is to prepare cash
flow projections according to its plans of repayment and fix the
working capital levels accordingly.
(s) Value of current assets: A decrease in the real value of current

assets as compared to their book value reduces the size of the
working capital. If the real value of current assets increases,
there is an increase in working capital.
(t) Means of transport and communication: Working capital needs also

depend upon the means of transport and communication. If they
are not well developed, the industries will have to keep huge
stocks of raw materials, spares, finished goods, etc., at places of
production as well as distribution outlets.

Working capital management is best described as the administration of all
aspects of current assets and current liabilities. It is concerned with the
problems that arise in the management of current assets, current liabilities
and the interrelationships that exist between them.
The primary objective of working capital management is to manage
the firm’s current assets and current liabilities in such a way that the
satisfactory amount of working capital is maintained i.e., it is neither
inadequate nor excessive. Both inadequate and excessive working capital
are dangerous. Inadequate working capital may lead to stoppage of
production. Excessive working capital may lead to carelessness about costs
and therefore, to inefficiency of operations. If a firm invests more in
current assets, it increases liquidity, reduces the risk and profitability. The
145
Working Capital Management reason is the opportunity cost of earning from excess investment in current
assets is lost. On the other hand, less investment in current assets reduces
liquidity, but increases the risk and profitability. Thus, the amount of
NOTES investment made in current assets has a bearing on liquidity and
profitability. In fact, liquidity and profitability are inversely related. When
one increases, the other decreases. Therefore, the finance manager has to
frame a suitable working capital management policies to strike a balance
between the liquidity and profitability.
Working capital management policies also have a great impact on
the structural health of the organization. If different components of
working capital are not balanced, then in spite of the fact that current ratio
and liquid ratio may indicate satisfactory financial position in respect of the
liquidity of the firm, it may not in fact be as liquid as indication by the
current and liquid ratios. For example, if the proportion of inventory is very
high in the total current assets or greater proportion is appropriated by slow
moving or obsolete inventory, then this cannot provide the cushion of
liquidity. Similarly, high investment in accounts receivable and failure to
collect them on time will also adversely affect the real liquidity of the firm,
thereby adversely affecting the structural health of the organization. In
case, a firm maintains more cash and bank balances, it means that the firm
is not making profitable use of its resources.
It is, therefore, important that the finance manager has to frame
proper working capital management policies for the various constituents of
working capital i.e., cash account receivables, inventories etc., so as to
ensure higher profitability, proper liquidity and sound structural health of
the organization.
In order to achieve the objective of maintaining satisfactory level of
working capital in a firm, the finance manager has to perform the following
two functions:
1. Forecasting the working capital requirements
2. Finding the sources of working capital
I. Forecasting the working capital requirements

As stated earlier, an adequate amount of working capital is essential
for the smooth running of a firm. The finance manager should
forecast working capital requirements carefully to determine the
optimum level of investment in working capital. While forecasting
working capital requirements, it should be borne in mind that
working capital requirements are to be determined on an average
basis and not at any specific point of time. The following two
methods are generally adopted to forecast the working capital
requirements:
1. operating cycle method
2. Estimation of components of working capital method
1. operating cycle method: one of the methods for forecasting
working capital requirements is based on the concept of
operating cycle. As discussed at the beginning of this chapter,
when goods are sold on credit as is the normal practice of
business firms today to cope with increased competition, the
sale of goods cannot be converted into cash instantly because of
time lag between sales and realization of cash.
146
As there is a time lag between sales and realization of Working Capital Management
receivables, there is a need for sufficient working capital to deal
with the problem which arises due to lack of immediate
realization of cash against goods sold. The operating cycle is NOTES
the length of time required for conversion of non-cash assets
into cash. This operating cycle refers to the time taken for the
conversion of cash into raw materials, raw materials into work-
in-progress, work-in-progress into finished goods, finished
goods into receivables, receivables into cash and this cycle
repeats. This cycle is also known as working capital cycle or
cash cycle.
The operating cycle length differs from firm to firm. If a firm
has lengthy production process or a firm has liberal credit
policy, the length of operating cycle will be more. On the other
hand, if a firm is a trading concern, then the length of operating
cycle will be reduced to a greater extent. The following
diagrams will make this concept more clear:
Operating cycle of manufacturing firm operating
cycle of Trading firm

(a) Surplus generation: It represents the activity cycle of business i.e.,
purchases, manufacture, sales and collection thereof. Hence, the
operating cycle stands for the process that creates surplus or profit
for the business.
(b) Funds rotation: It indication the total time required for rotation of
funds. The faster the funds rotate, the better it is for the firm.
(c) Going concern: It lends meaning to the going concern concept. If
the cycle stops in between, the going concern assumption may be
violated. Hence, operating cycle should be on par with the industry
147
Working Capital Management average. A long cycle indicates overstocking of inventories or
delayed collection of receivables and is considered unsatisfactory.
Computation of operating cycle
NOTES The operating cycle can be determined as given below:
Days
Raw material storage period xxx
Add: Work-in-progress holding xxx
period xxx
Finished goods storage period xxx
Debtors collected period
xxx
Less: Creditors payment period xxx
Operating cycle period xxx
The various components of operating cycle can be calculated by using
following formula given below:
(i) Raw material storage period:
(ii) Work-in-progress holding period:
(iii) Finished goods storage period:
(iv) Debtors collection period:
(v) Creditors payment period:
Computation of working capital required

After ascertaining the various constituents of working capital as
discussed above, the difference between total current assets and total
current liabilities is to be taken as required working capital. It may be
prudent to add a certain percentage to cover contingencies. The following
is the proforma for estimation of working capital requirements:
Statement showing working capital requirements
Particular Rs. Rs.
Current assets:
(i) Stock:
Raw material xxx
Work-in-progress:
148
Raw materials (100%) xxx Working Capital Management
Labour (50%) xxx
Overheads (50%) xxx xxx
Finished goods xxx xxx NOTES
(i) Trade debtors xxx
(ii) Cash balance xxx
xxx
Less: Current liabilities:
Trade creditors xxx
Outstanding wages xxx
Outstanding overheads xxx xxx
Net working capital (CA- CL) xxx
Add: Provision for contingencies xxx
working capital required xxx

After determining the working capital requirements of the firm, the next
function of finance manager is to find an assortment of appropriate source
of working capital to finance for its current assets. A firm has various
sources to meet its financial requirements. The sources of working capital
are of two types i.e., long term and short-term sources. The financing of
current assets through long term sources is generally costlier than that of
short-term sources. However, financing of current assets from long term
sources provides stability, reduces risk of repayments and increases
liquidity of the firm. The following is a snapshot of various sources of
working capital available to a firm.
(i) Long term sources
(ii) Short term sources
(i) long term sources
(a) Issue of equity shares
(b) Issue of preference shares
(c) Issue of debentures or shares
(d) Retained earnings
(e) Loans from financial institutions
(ii) Short term sources

Internal
(a) Depreciation fund
(b) Provision for taxation
(c) Outstanding expenses
External
(a) Trade credit
(b) Commercial paper
(c) Advances from customers
(d) Bank credit
I. Long term sources
a) issue of equity shares:
A firm may raise funds from promoters or from the investing
public by way of owners’ capital or equity capital by issue of
149
Working Capital Management ordinary shares. Ordinary shareholders are owners of the firm. Since
equity shares can be paid off only in the event of liquidation, this
source has the least risk involved. Further, the dividend payable on
NOTES
shares is an appropriation of profits and not a charge against profits.
This means that it has to be paid only out of profits after tax.
1. It is a permanent source of finance.
2. The issue of new equity shares increases flexibility of the firm.
3. The firm can raise further share capital by making a rights issue.
4. There is no mandatory payments to shareholders of equity shares.
b) Issue of preference shares:
These are a special kind of shares, the holders of such shares
enjoy priority, both as regards the payment of a fixed amount of
dividend and repayment of capital on winding up of the firm.
Preference share capital is a hybrid from of financing which
partakes some characteristics of equity capital and some attributes
of debt capital. It is similar to equity because preference dividend,
like equity dividend is not a tax-deductible payment. It resembles
debt capital because the rate of preference dividend is fixed.
Typically, when preference dividend is skipped, it is payable in
future because of the cumulative feature associated with most of
preference shares.
Cumulative convertible preference share may also be
offered, under which the shares would carry a cumulative
dividend of specified limit for a period of say there years after
which the shares are converted into equity shares. These shares
are attractive for projects with a long gestation period. For normal
preference shares, the maximum permissible rate of dividend is
14%. preference share capital can be redeemed at a Pre decided
future date or at an earlier stage inter alia out of profits of firm.
This enables the promoters to withdraw their capital from the firm
which in now self-sufficient and the withdrawn capital may be
reinvested in other profitable ventures. It may be mentioned that
irredeemable preference shares cannot be issued by any firm.
The advantages of taking the preference share capital route
are:
(i) No dilution in EPS on enlarged capital base-if equity
is issued, it reduces EPS, thus affecting the
market perception about the firm.
(ii) There is leveraging advantage as it bears a fixed
charge.
(iii)There is no risk of takeover.
(iv) There is no dilution of managerial control.
(v) Preference share capital can be redeemed after a
specified period.
c) Issue of debentures or bonds:
150
Loans can be raised from public by issuing debentures or Working Capital Management
bonds by the firm. Debentures are normally issued in different
denominations ranging from Rs.100 to Rs. 1000 and carry
NOTES
different rates of interest. By issuing debentures, a firm can
raise long term loans from public. Normally, debentures are
issued on the basis of a debenture trust deed which list the
terms and conditions on which the debentures are floated.
Debentures are normally secured against the assets of the firm.
As compared with preference shares, debentures provide
a more convenient mode of long-term funds. The cost of
capital raised through debentures is quite low since the interest
payable on debentures can be charged as an expense before
tax. From the investors’ point of view, debentures offer a more
attractive prospect then the preference shares since interest on
debentures is payable whether or not the firm makes profits.

1) The cost of debentures is much lower than the cost of preference
or equity capital as the interest is tax deductible. Also, investors
consider debenture investment safer than equity or preference
investment and, hence may require a lower return on debentures
investment.
2) Debenture financing does not result in dilution of control.
3) In a period of rising prices, debenture issue is advantageous. The
fixed monetary outgo decrease in real terms as the price level
increases.
The disadvantages of debentures financing are:
1) Debentures interest and capital repayment are obligatory payment
2) The protection covenants associated with a debenture issue may be
restrictive
3) Debentures financing enhances the financial risk associated with
the firm.
d) Retained earnings:
It represents undistributed profits of the firm commonly used by
the established firm for financing their permanent working capital
requirements known as “ploughing back of profit”. It is a regular
and cheapest source of working capital. It makes the firm
financially strong and increases credit worthiness. It can be used
not only for the development, expansion and modernization of the
firm but also for redeeming debt and stabilizing the rate of
dividend.
e) Loans from financial institutions:
In India, specialized institutions provide long term finance to
firms. Thus, IFCI, SFC, LIC of India. ICICI, IDBI etc. provide
term loans to firm. Such loans are available at different rates of
interest under different schemes of financial institutions and are to
be repaid according to a stipulated repayment schedule. The loans
151
Working Capital Management in many cases stipulate a number of conditions regarding the
management and certain other financial policies of the firm.
II. Short term sources
NOTES
The temporary working capital requirements can be met through
two major short-term sources i.e., Internal sources and external
sources.
(A) Internal sources
(1) Depreciation fund: The depreciation funds created out of firm’s
profits provide a reliable source of working capital so long as they are not
invested in assets or distributed as dividends.
(2) Provision for taxation: There remains a time lag between creating
provision for taxes and their actual payment. Thus, the funds appropriated
for taxation can be used for the short-term working capital requirements of
the firm during the intermittent period.
(3) Outstanding expenses: Sometimes, the firm postpones the payment
of certain expenses due on the date of finalization of accounts.
Outstanding expenses like unpaid wages, salaries, rent, etc. also constitute
an important source of short-term working capital.
(B) External sources
(a) Trade credit: It represents credit extended by the suppliers of
goods in the normal course of business. The usual duration of credit is 15
to 90 days. It is granted to the firm on open “account”, without any
security except that of the goodwill and financial standing of purchaser.
No interest is expressly charged for this, only the price is a little higher
than the cash price. This source of working capital has the following
advantages:
(1) Ready availability: There is no need to arrange financing formally.
(2) Flexible means of financing: Trade credit is a more flexible means
of financing. The firm does not have to sign a promissory note, pledge
collateral or adhere to a strict payment schedule on the note.
(3) Economic means of financing: Generally during periods of tight
money, large firms obtain credit more easily then small firms do.
However, trade credit as a source of financing is still more accessible by
small firms even during the periods of tight money.
(b) Commercial paper (CP): CP is a “since promissory note” issued
by a firm, approved by RBI, negotiable by endorsement and delivery,
issued at such discount on the face value as may be determined by the
issuing firm. Each CP will bear a certificate from the banker verifying
signature of the executors. These are issued by a firm to raise funds for a
short period, generally verging from a few days to few months. The CP
may be issued in multiples of Rs.5 lakh.
Eligibility: The following conditions are to be fulfilled by the firm for
issuing CP:
(a) The issuing firm should have a tangible net worth of not less than
Rs. 4 core as per the latest balance sheet.
(b) The firm should have working capital limit of not less than Rs. 4
core.
152
(c) The current ratio should be minimum 1.33 as per the latest balance Working Capital Management
sheet.
(d) The firm should have minimum P2/A2 rating from
CRISIL/ICRA/CARE or any other credit Rating Agency for the purpose. NOTES
The rating should not be more than two months old from the date of issue
of the CP.
(e) The borrowing account of the firm is classified as standard assets
by financing banking company/companies.
No CP can be issued for period less than 15 days from the date of its
issue. There is no grace period for payment of CPs. The RBI has increased
the maturity period of the CPs from a maximum of 6 months to a
maximum of less than 1-year period from the date of its issue.
There is, however, reluctance on the part of investors, especially banks

to invest in less than 1-year CP because of the absence of a secondary
market.
CP may be issued to any person including individuals, banks and other
corporate bodies registered/incorporated in India and unincorporated
bodies. It cannot, however, be issued to NRI’s
A firm issuing CP may request the banker to provide standby facility for
an amount not exceeding the amount of issue for meeting the liability of
CP on maturity. The financing banker shall correspondingly reduce the
working capital limits of every firm issuing the CP.
Issuing Norms: As per the guidelines issued by RBI, a firm will issue
CP’s through same bank/consortium of banks from whom it has a line of
credit. In other words, instead of making loans and advances, the bank will
deal in the issue.
Another underlying issue is the time dimension. The firms applying for
issue of CP to RBI have to obtain credit rating, which should not be more
than two months old. This implies that firm intending to issue CP has to
obtain a fresh rating if time lapses.
Besides, once the RBI approves a firm’s application, it has to make
arrangement within 15 days for placing the CP privately.
Advantage: The advantages of commercial paper lie in its simplicity
involving hardly any documentation between the issuer and the investor
and its flexibility with regard to short-term maturity. A well rated firm can
diversify its sources of finance from banks to the short-term money
markets at a somewhat cheaper cost, especially in a situation of easy
money market. The CP provides investors with higher returns than they
could obtain from the banking system. They have to pay off their debts
semi-annually I.e., for instance eight instalments over a period of year.
(c)Advances from customers: Firms engaged in producing or
constructing costly goods involving considerable length of manufacturing
or construction time usually demand advance money from their customers
at the time of accepting their orders for executing their contracts or
supplying the goods. This is a cost-free source of working capital and
really useful.
(d) Bank credit: Commercial banks provide working capital to the
firm in the form of cash credit, overdraft, bills discounting, bills
acceptance, line of credit, letter of credit and bank guarantee. Banks do not
sanction loans on a long-term basis beyond a small proportion of their
demand and time liabilities. Loans are granted against tangible securities Self-Instructional Material
153
Working Capital Management such as goods, shares, promissory notes, bills, etc. All forms of loans given
by the banks are explained briefly as given below:
(i) Cash credit: This facility will be given by the banker to the
NOTES customers by giving certain amount of credit facility against security of
inventory on continuous basis. The borrower will not be allowed to
exceed the limits sanctioned by the bank.
(ii) Bank overdraft: It is a short-term borrowing facility made available
to the firms in case of urgent need of funds. The banks will impose limits
on the amount they can lend. When the borrowed funds are no longer
required, they can quickly and easily be repaid. The banks provide
overdrafts with a right to call them in at short notice.
(iii) Bills discounting: The firm which sells goods on credit, will
normally draw a bill on the buyer who will accept it and sent it to the seller
of goods.
The seller, in turn discounts the bill with his banker. The banker will
generally earmark the discounting bill limit.
(iv) Bills acceptance: To obtain finance under this type of arrangement,
a firm draws a bill of exchange on bank. The bank accepts the bill
thereby promising to pay out the amount of the bill at some specified
future date.
(v) Line of credit: It is a commitment by bank to lend a certain amount
of funds on demand specifying the maximum amount.
(vi) Letter of credit: It is an arrangement by which the issuing bank on
the instruction of a customer or on its own behalf undertakes to pay or
accept or negotiate or authorize another bank to do so against stipulated
documents subject to compliance with specified terms and conditions.
(vii) Bank guarantees: Bank guarantee is one of the facilities that the
commercial banks extend on behalf of their clients in favorer of third
parties who will be the beneficiaries of the guarantees.
A study group was appointed by the RBI in July 1974, under the
chairmanship of shri Prakash Tandon to suggest guidelines for the rational
allocation and optimum use of bank credit in view of the number of
weaknesses in the bank lending at that time.
Recommendation
(a)Inventory and receivable norms: The study group recommended
norms for inventory/receivable for 15 major industries. The banker should
finance only the genuine production needs of the borrower. The borrower
should maintain the reasonable levels of inventory and receivable. He
should hold just enough inventory to carry on target production. Efficient
management of resources should be ensured to eliminate slow moving and
flabby inventories. Flabby, profit-making or excessive inventory should not
be permitted under any circumstances. Similarly, the banker should finance
only those receivable which are in tune with the practices of the borrower’s
firm and industry. Initially, the norms for inventory and receivables were
intended to be applied to all borrowers with aggregate credit limit of Rs. 10
154
lakh or more from the banking system but were to be gradually extended to Working Capital Management
all borrowers.
(b) Lending norms: The Tandon committee has introduced the concept of
maximum permissible bank finance (MPBF) and suggested that bank NOTES
should attempt to supplement the borrower’s resources in financing the

current assets. It has recommended that the banker should finance only a
part of working capital gap, the other part to be financed by the borrower
from the long-term resources. The working capital gap is defined as current
assets minus current liabilities excluding bank borrowings.
In this connection, the committee suggested three methods of determining
MPBF:
(i) First method: The borrower will contribute 25% of the
working capital gap, the remaining 75% can be financed from
bank borrowings. This method will give a minimum current
ratio of 1:1 and maximum current ratio of 1.17:1
(ii) Second method: The borrower will contribute 25% of the total
current assets. The remaining working capital gap can be bridged from
the bank borrowings. This method will give a current ratio of 1.33:1
(iii) Third method: The borrower will contribute 100% of core current
assets representing the irreducible technological minimum of assets and
25% of the balance of current assets. The remaining working capital gap
can be met from the borrowings. This method will further strengthen the
current ratio.
The methods discussed above for determining the MPBF may be
described as given below:
First method: MPBF = 75% of (Current assets – Current liabilities)
Second method: MPBF = 75% of (Current assets – Current liabilities)
Third method: MPBF = 75% of (Current assets – Core Current assets) –
Current liabilities.
Working capital ratios
As indicated earlier, the finance manager has to maintain an adequate
working capital at every time so as to carry on the operations successfully
and maximize the return on investment. He has to be vigilant about the
trends in the items that make up the working capital. This requires a
careful inquiry into the current assets and current liabilities in order to
control the working capital and to conserve it properly. Ratio analysis is
the most common tool of financial analysis of working capital. It is used
by financial executives to check upon the efficiency with which working
capital is being used in the firm. The following are the most useful ratios
in diagnosing the working capital position of a firm:
(i) Current ratio: It is also known as ‘working capital ratio’. It shows
whether the short-term obligations are sufficiently covered by the current
assets. The formula is as follows:
Current ratio
Here,
155
Working Capital Management Current Assets = Stock + Debtors + Cash in hand + Cash at bank + Bills
Receivable + Prepaid expenses + Accrued income
NOTES Current Liabilities: Creditors + Bills payable + Bank overdraft +

Outstanding expenses + Income received in advance etc.
(i) Quick ratio: It is the ratio between quick assets of the firm
and current liabilities, also known as acid- test ratio, or
liquid ratio. It deposits the immediate liquid position of the
firm. It is calculated as follows:
Quick ratio =
Current liabilities
Here,
Liquid Assets = Current assets – Stock - Prepaid expenses
Cash ratio: Cash ratio is the preferred measure of liquidity. It is also known
as absolute liquidity ratio. It is the ratio of cash and equivalent assets to
current liabilities. As per formula:
Cash ratio =
(iv) Debtors turnover ratio: It expresses the relationship between net credit
sales and average accounts receivable. It measures the number of times the
receivable is rotated in a year in terms of sales. It also indicates the
efficiency of credit collection and efficiency of credit policy. It is
calculated by applying the following formula:
Debtors turnover ratio =

Here,
Accounts receivable = Debtors +B/R
(v) Stock turnover ratio: It establishes relationship between average stock
at cost and cost of goods sold. It is employed to measure how quickly stock
is converted into sales. It is calculated by using the following formula:
Stock turnover ratio =

Here,
Average stock =
156
Cost of goods sold = Sales – Gross profit (or) Operating stock + Working Capital Management
Purchases + Direct expenses – Closing stock
(vi) Creditors turnover ratio: It expresses relationship between credit NOTES
purchases and average accounts payable. It is calculated to find out
whether the firm is making payments to creditors on time. It is calculated
as under:
Creditors turnover ratio =

Here,
Accounts payable = Creditors + Bills payable
(vii) Working capital turnover ratio: It indicates the number of times the
working capital is converted into sales. It is calculated as given below:
Working capital turnover ratio =

(viii) Current assets turnover ratio: It is a ratio of sales revenue to total
current assets. It measures how effective; management is in controlling the
current assets. It shows the over or under trading position in relation to the
quantum of working capital. As per formula:
Current assets turnover ratio =
Illustration
1. From the following information extracted from the books of a
manufacturing company, compute the operating cycle in days:
Period covered: 365 days
Average period of credit allowed by suppliers: 16 days
Rs.
Average total of debtors outstanding 4,80,000
Raw materials consumption 44,00,000
Total production cost 1,00,00,000
Total cost of sales 1,05,00,000
Sales for the year 1,60,00,000
Value of Average stock maintained:
Raw materials 3,20,000
Work-in-progress 3,50,000
Finished goods 2,60,000
Solution:
Statement showing operating cycle
Particulars Rs
(a) Raw material held in stock:
157
Working Capital Management 27
(b) Work – in – progress:

NOTES 13
(c) Finished goods held in stock:

9
(d) Credit period allowed to debtors:

11
60
Less: Average credit period allowed by creditors 16
Net operating cycle period 44
2. Determine the working capital requirements of a company from the

information given below:
Operating cycle components:
Raw materials =60 days
W.I.P =45 days
Finished goods =15 days
Debtors = 30 days
Creditors = 60 days
Annual turnover =73 lakh; Cost structure (as % of sale price) is Materials
50%, Labour 30%, Overheads 10 % and Profit 10%. Of the overheads,
30% constitute depreciation.
Desired cash balance to be held at all times: Rs. 3 lakh.
Solution:
Working notes:
(i) Calculation of % of WIP cost under Total Approach
WIP cost %. =Materials+50% of Labour and OH
=50%+50% of (30% +10 %) = 70%
(ii) Calculation of % of WIP cost under Cash cost Approach
WIP cost % =Materials +50% of Labour and OH minus

depreciation
=50%+50% of (30% +7%)- 68.5%
Statement showing calculation of Effective days of operating cycle
Particulars Gross Total Approach Cash cost
days Approach
Cost % Effective Cost % Effective
days days
Current Assets:
Raw material 60 50% 30.00 50% 30.00
WIP 45 70% 31.50 68.5% 30.825
Finished goods 15 90% 13.50 87% 13.05
Debtors 30 100% 30.00 87% 26.10
Total 150 105 99.975
Less: Current liability:
158
Creditors 60 50% 30 50% 30.000 Working Capital Management
Operating cycle 90 75 69.975
Statement showing working capital Requirements
NOTES
Particulars Total Approach Cash cost Approach
working capital 73,00,000 = 75/365 73,00,000x69.975/365
(Based on sales) = 15,00,000 = 13,99,500
Add: Minimum cash
balance required = 3,00,000 = 3,00,000
Required working 18,00,000 16,99,500
capital
NOTE: In order to determine working capital requirements, two
conceptual approaches are followed i.e. Total approach and cash cost
approach. Under total approach, all expenses and profit margin are
considered. Under cash cost approach, only cash expenses (excluding
depreciation) are considered.
1. Define working capital.
2. What are the types of working capital
3. What are the sources of working capital
1. Working capital is the excess of current assets over current liabilities.
C.W. Gerstenberg:
2. Permanent working capital and Temporary working capital
3. Long term sources, Short term sources

Short Questions:
1. What is working capital?
2. What are the significances of working capital?
3. Explain the term working capital ratio.
4. Briefly explain the term concepts of working capital.
5. What are the disadvantages of maintaining insufficient working
capital?
6. State the disadvantages of maintaining excessive working capital in a
company.
7. Calculate the operating cycle of a company which gives the
following details relating to its operating:
Raw materials consumption per annum
Annual cost of production
Annul cost of sales
Annual sales
Average value of current assets held:
Raw materials
Work-in-progress
Finished goods
Debtors
The company gets 30 days credit from its suppliers. All sales made
by the firm are on credit only. You may take one year as equal to
365 days.
159
Working Capital Management [Ans: operating cycle: 120 days]
8. From the following estimates, calculate the average amount of

NOTES working capital required:
(a)Average amount locked-up in stock: P.A. (Rs.)

Stock of finished goods &W.I.P 10000
Stock of stores, materials, etc. 8000
(b)Average credit given:
Local sales:2 weeks credit 104000
Sales outside the state: 6 weeks credit 312000
(c)Time available for payment:
For purchases:4 weeks 78000
For Wages:2 weeks 260000
Add10% to allow for contingencies
[Ans: Net working capital Rs.46200]
9. From the following estimates of RLG Ltd., You are required to

prepare a forecast of working capital requirements:
Expected level of production for the year: 15600 units.
Cost per unit: Raw materials Rs.90, Direct labour Rs.40, overheads
Rs.75.
Selling price per unit Rs.265
Raw materials in stock on an average for one month.
Materials are in process on an average for 2 week.
Finished goods in stock on an average for one months.
Credit allowed by suppliers is one months.
Time lag in payment from debtors is 2 months.
Lag in payments of Wages 1 ½ weeks.
Lag in payment of overheads is one month. All sales are on credit.
Cash in hand and at bank is expected to be Rs.60000
It is assumed that production is carried on evenly throughout the
year. Wages and over heads accrued evenly and a period of 4 week
is equivalent to a month.
[Ans: Net working capital required Rs.778500]
10. You are required to prepare a statement of working capital

needed to finance a level of activity of 5200 units of output. You are
given the following information:
Elements of cost Amount per unit
Rs.
Raw materials 8
Direct labour 2
Overheads 6
Total cost 16
Profit 4
Selling price 20
Raw materials are in stock on an average – one months. Materials

are in process on an average – half-a-month. Finished goods are in
stock on an average -6 weeks. Credit allowed by creditors is one
month. Lag in payment of Wages is 1.5 weeks. Cash in hand and at
160
bank is expected to be Rs.7300. Credit allowed to debtors is two Working Capital Management
months.
You are information that production is carried on evenly during the
year and wages and overheads accrue similarly. NOTES
[Ans: Net working capital required Rs.31800]
Further Reading:

P.K. TMH
3rd ed, TMH
161
Cost of Capital
UNIT - XIII COST OF CAPITAL
Structure
NOTES 13.1 Introduction
13.2 Meaning of Cost of Capital
13.3 Definition of Cost of Capital
13.4 Components of Cost of Capital
13.5 Factors determining the Cost of Capital
13.6 Types of Cost of Capital
13.7 Computation of cost of capital
13.9 Benefits of book value approach
13.1 Introduction
In order to evaluate investment proposals, different methods have been used in
chapter 3 on capital budgeting. All those methods, their application, evaluation
criteria etc. depend upon two basis inputs i.e., cash flows emanating from
projects and the discount rate. The discount rate is actually the ‘cost of capital’.
The cost of capital is also known as cut-off rate, minimum required rate of
return, rate of interest, hurdle rate, target rate etc. The concept of cost of capital
has two applications. First in capital budgeting, it is used to find the present
value of future cash flows and it is also used in optimization of the financial
plan or capital stricter of a firm. The second aspect of concept of cost of capital
will be taken up in chapter 5. In this chapter, an attempt has been made to
measure the cost of capital of each source of finance so as to find the total cost
of capital of a firm.
13.2 Meaning of Cost of Capital:
For financing its operations, a firm can raise long term funds
through a combination of (i) Debt, (ii) Preference share capital, and (iii) Equity
share capital. The firm has to service these funds by paying interest, preference
dividend and equity dividend respectively. The payment made by the firm
constitutes the cost of obtaining/utilising that source of finance.
13.3 Definition of Cost of Capital:
(i) Milton H. Spencer: Cost of capital is the minimum rate of return
which a firm requires as a condition for undertaking an investment.
(ii) G.C. Phillioppatus: The cost of capital is the minimum required
rate of return, the hurdle or handle or target rate, the cut-off rate or the financial
standard of performance of a project.
(iii) James C. VanHorne: The cost of capital represents a cut-off
rate for the allocation of capital to investment of projects. It is the rate of return
on a project that will leave unchanged the market price of the stock.
(iv) Hamplon John J: Cost of capital is the rate of return the firm
requires from investment in order to increase the value of the firm in the market
rate.
(v) Haley and Schall: In general sense, the cost of capital is any
discount rate used to value cash streams.
(vi) Solomon Ezra: The cost of capital is the minimum rate of
return or cut-off rate for capital expenditures.
(vii) Hunt William and Donaldson: Cost of capital is the rate that
must be earned on the net proceeds to provide the cost elements of the burden at
the time they are due.
162
We can, thus, define cost of capital as a minimum rate of return which a Cost of Capital
firm is expected to earn from a proposed project so as to make no reduction in
the earnings per share to equity shareholders and its market price.
13.4 Components of Cost of Capital: NOTES
The cost of capital of a firm consists of the following three

components:
(i) Return at Zero risk: This includes the projected rate of return on
investment when the project does not involve any business of financial risk.
(ii) Premium for business risk: The cost of capital includes
premium for business risk. Business risk refers to the changes in operating
profit on account of charges in sales. The projects involving higher risk than the
average risk can be financed at a higher rate of return than the normal rate. The
suppliers of funds for such project will expect a premium for increased business
risk. The business risk is generally determined while taking capital budgeting
decisions.
(iii) Premium for financial risk: The cost of capital includes
premium for financial risk arising on account of higher debt content in capital
structure, requiring higher operating profit to cover periodic payment of interest
and repayment of principal amount on maturity. As the chances of cash
insolvency of a firm with higher debt content in its capital structure are greater,
the suppliers of funds would expect a higher rate of return as a premium for
higher risk.
13.4.1 Importance of Cost of Capital:
Prior to the development of the concept of cost of capital, the
problem was ignored or by-passed. The progressive management always takes
notice of the cost of capital while taking a financial decision. This concept is
quite relevant in the following managerial decision:
(i) Capital Budgeting decision: Cost of Capital is used as a
‘measuring rod’ for evaluating investment proposals. The firm, naturally, will
choose the project which gives a satisfactory return on investment which would
be in no case less than the cost of capital incurred for its financing. In various
methods of capital budgeting, cost of capital is the key factor in deciding the
project out of various proposals pending before the management. It measures
the financial performance and determines the acceptability of all investment
opportunities.
(ii) Designing the capital structure: The cost of capital is
significant in designing the firm’s capital structure. The cost of capital is
influenced by the changes in capital structure. A capable financial executive
always keeps an eye on capital market fluctuations and tries to achieve the
sound and economical structure for the firm. He may try to substitute the
various sources of finance in an attempt to minimize the cost of capital so as to
increase the market price and the earning per share.
(iii) Deciding about the method of financing: A capable financial
executive must have knowledge of the fluctuations in the capital market and
should analyse the rate of interest on loans and normal dividend rates in the
market from time to time. Whenever firm requires additional finance, he may
have a better choice of the sources of finance which bears the minimum cost of
capital. Although cost of capital is an important factor in such decision, equally
important are the considerations of relating control and of avoiding risk.
(iv) Performance of top management: The cost of capital can be
used to evaluate the financial performance of the top executives. Evaluation of
the financial performance will involve a comparison of actual profitability of
163
Cost of Capital the projects undertaken with the projected overall cost of capital and an
appraisal of the actual costs incurred in raising the required funds.
(v) Other areas of decisions making: The concept of cost of
NOTES capital is also used in many other areas of decision making, such as leasing,
bond refunding, dividend policy decision, working capital management
policies, etc. In social accounting, this concept is used in selecting the best
investment opportunities which would maximise the social and minimize the
social costs.
13.5 Factors determining the Cost of Capital:
Following are some of the factors which are relevant for the determination
of cost of capital of the firm:
(i) General economic conditions: General economic conditions
determine the demand and supply of capital within the economy as well as the
level of expected inflation. This economic variable is reflected in the risk less
rate of return. This economic variable is reflected in the risk less rate of return.
This rate represents the rate of return on risk-free investment such as the interest
rate on short term government securities, in principle, as the demand for money
in the economy changes relative to the supply, investors alter their required rate
of return. For example, if the demand for money increases without an
equivalent increase in the supply, lenders will raise their required interest rate.
At the same time, if inflation is expected to deteriorate the purchasing power of
the rupee, investors require a higher rate of return to compensate for this
anticipated loss.
(ii) Market Conditions: When an investor purchases a security
with significant risk, an opportunity for additional return is necessary to make
the investment attractive. Essentially, as risk increases, the investor requires a
higher rate of return. This increase is called premium. When investors increase
their required rate of return, the cost of capital rises simultaneously. If the
security is not readily marketable, when the investor wants to sell or even if a
continuous demand for the security exists, but the price varies significantly, an
investor will require a relatively high rate of return. Conversely, if a security is
readily marketable and its price is reasonable stable, the investor will require a
lower rate of return and the firm’s cost of capital will be lower.
(iii) Operating and financing decision: Risk or the variability of
returns, also results from decisions made with in the firm. Risk resulting from
these decisions is generally divided into two type: business risk and financial
risk. Business risk is the variability in returns on assets and is affected by the
firm’s investment decisions. Financial risk is the increased variability in returns
to equity shareholders as a result of financing with debt or preferred stock. As
business risk and financial risk increase or decrease, the investor’s required rate
of return (and the cost of capital) will move in the same direction.
(iv) Amount of financing: The last factor determining the firm’s
cost of funds is the level of financing that the firm requires. As the financing
requirements of the firm become larger, the overall cost of capital increases for
several reasons. For instance, as more securities are issued, additional floatation
cost or the cost incurred by the firm for issuing securities, will affect the
percentage cost of the funds to the firm. Also, as management approaches the
market for large amounts of capital relative to the firm’s size, the investors’
required rate of return of return may rise, supplier of capital become hesitant to
grant relatively large sums without evidence of management’s capability to
absorb this capital into the business, This is typically “too much too soon”.
Also, as the size of the issue increases, there is greater difficulty in placing it in
164
the market without replacing the price of the security, which also increases the Cost of Capital
firm’s cost of capital.
13.6 Types of Cost of Capital:
NOTES
Cost of Capital can broadly be classified as under:
(i) Historical cost and Future cost: Historical cost refers to the cost
refers to the cost which has already been incurred in order to finance a
particular project. It is useful for projecting future cost. Future cost is the
expected cost of funds for financing a particular project. It is applied for taking
financial decision. For example, at the time of taking a capital budgeting
decision, a comparison is to be made between the expected IRR and the
expected cost of funds for financing the same i.e., the relevant cost here is the
future cost.
(ii) Explicit cost and Implicit Cost: The explicit cost is the discount
rate that equates the present value of cash flows that are incremental to the
taking of the financing opportunity with the present value of its incremental
cash flows. It is the internal rate of the cash flows of financing opportunity.
Implicit cost is also known as opportunity cost. It is a rate of
return associated with the best investment opportunity for the firm and its
shareholders that will be foregone if the project is accepted. The cost of
retained earnings is an opportunity cost of because a shareholder is deprived of
the opportunity to invest the retained earnings elsewhere.
(iii) Specific cost and composite cost: It refer to the cost of each
component of capital viz., equity share capital, preference share capital, debt
etc. It is particularly useful where the profitability of the project is evaluated on
the basis of specific source of funds taken for financing the said project. For
example, if the estimated cost of equity capital becomes 10% that project which
is financed by equity shareholders’ funds, will be accepted provided the same
will yield at least a return of 10%.
The composite cost refers to the combined cost of equity capital,
preference capital, debt etc. It is also known as weighted average cost of capital
or overall cost of capital. This cost is used for evaluating capital structure
decisions.
(iv) Average cost and Marginal cost: Average cost is the weighted
average cost of each component of funds invested by the firm for a particular
project i.e., percentage or proportionate cost of each element in total
investment.
Marginal cost is the cost of obtaining another rupee of new capital.
Generally, a firm raises a certain amount of fund for fixed capital investment.
But marginal cost reveals the cost of additional amount of capital which is
raised by a firm for current or fixed capital investment. When a firm raises
additional capital from one particular source only i.e., equity shares, the
marginal cost in that case is known as specific or explicit cost of capital.
13.7 Computation of cost of capital:
1. Cost of Debt:
Cost of debt may be defined as the returns expected by the potential
investors of debt securities of a firm. It measures the current cost to the firm of
borrowing funds to finance the projects. It is generally determined by the
following variables:
(i) The current level of interest rates: As the level of interest rates
increases, the cost of debt will also increase;
165
Cost of Capital (ii) The default risk of the firm: As the default risk of the firm
increase, the cost of debt will also increase. One way of measuring the default
risk is to use the bond rating for the firm; higher interest rates.
NOTES (iii) The tax advantages associated with the debt: Since the interest
is tax deductible, the after-tax cost of debt is a function of tax-rate. The tax
benefit that accrues from paying interest makes the after-tax cost of debt lower
than the pre-tax cost.
The cost of debt is of two types i.e., cost of irredeemable debt and
cost of redeemable debt.
1. Cost of Irredeemable Debt: Irredeemable debt also known as perpetual debt
refers to the debt which is not redeemable during the lifetime of the firm.
Interest payable on such debt is called cost of irredeemable debt. It is calculated
by using the following formula:
A. Cost of debt before tax (K db)
Kdb =
(a) Interest on debt should be calculated only on the face value of debt
irrespective of issue price.
(b) Net proceeds (NP) is to be ascertained as gives below:
(i) Debt issued at par:
NP= Face value - Issue expenses
(ii) Debt issued at premium:
NP= Face value + Securities premium – Issue expenses
(iii) Debt issued at discount:
NP = Face value – Discount - Issue expenses.
B. Cost of debt after tax (K da)
As the interest on debt is tax deductible, the firm gets a saving in its tax
liability. The interest works as a tax liability of the firm is reduced. Thus, the
effective cost of debt is lower than the interest paid to debt investors. The cost
of debt is determined as given below:
Cost of debt after tax (Kda)=

The after-tax cost of debt may also be determined by applying the formula
given below:
Kda= Kdb(1- Tax rate)
2. Cost of Redeemable Debt:
Redeemable debt refers to the debt which is repayable after a stipulated
period, say 5 or 7 or 10 years. The cost of this debt is determined as given
below:
(A) Cost of debt before tax (Kdb)
Kdb=
(a) Computation of Annual cost before tax
Rs.
Interest on debt p.a. xxx
Add: Issue expenses, amortised p.a. xxx
Add: Discount on issue, amortised p.a. xxx
Add: Premium on redemption of debt,
amortised p.a.
(In case of redemption at premium) xxx
——
xxx
166
Less: Premium on issue of debt, amortised p.a. Cost of Capital
(In case of issue at premium) xxx
——
Annual cost before tax xxx NOTES
——
Note: (i) While calculating annual cost, the issue expenses, discount on issue,
premium on redemption and premium on issue are amortised over the tenure of
debt.
(ii) Issue expenses (floatation costs) are to be calculated at face the issue
price whichever is higher.
(b) Computation of average value of debt (AV):
The average value of debt is the average of net proceeds (NP) and
redemption value (RV) of debt.
AV=
(B) Cost of debt after tax (K da):
The cost of redeemable debt after tax is calculated as given bellow:
Kda=
The cost of redeemable debt after tax can be ascertained by using the following
formula:
Kda= Kdb(1-Tax rate)
II Cost f Preference share capital

Dividend paid to the preference shareholders is the cost of preference
share capital. The cost of preference share capital is based on the rate of return
required by the firm’s preference shareholders, which is determined by the
market price of the preference shares. Since preference dividend is not tax
deductible, there is no need for tax adjustment in calculating the effective cost
of preference share capital. Like debt capital, preference shares are divided into
two categories i.e., irredeemable and redeemable. In India, Companies
Amendment Act, 1988 prohibits issue of irredeemable preference shares.
A. Cost of Irredeemable Preference Share capital:
In case of irredeemable preference shares, the dividend at the fixed rate will
be payable to the preference shareholders perpetually. The cost of irredeemable
preference share capital can be calculated with the help of the following
formula:
Cost of Preference share capital (Kp ) =
The net proceeds indicate the net amount realized from the issue of
preference shares which can be determined as follows:
(a) Issued at par:
NP=Face value - Issue expenses
(b) Issued at premium:
NP = Face value + Security premium – Issues expenses
(c) Issued at discount:
NP= Face value – Discount – issue expenses
(B) Cost of Redeemable Preferences Share capital (RPS)
If the preferences shares are redeemable at the end of a specified period, then
the cost of preference share capital can be calculated by applying the formula
given under:
167
Cost of Capital Cost of Redeemable preferences share capital =
NOTES
(a) Computation of Annual Cost:

Rs.
Annual preference dividend xxx
Add: Issue expenses, amortised p.a. xxx
Discount on issue, amortised p.a. (In xxx
case of issue at discount)
Premium on redemption amortised
p.a. xxx
(In case of redemption at premium)
Less: Premium on issue amortised xxx
p.a. xxx
(In case of issue at premium)
Annual cost xxx
Note: The issue expenses, discount on issue, premium on redemption and

premium on issue are to be amortised over the tenure of the preference shares to
determine the annual cost.
(b) Computation of average value of RPS:
The average value of redeemable preference shares is the average of net
proceeds (NP) of the issue and the redemption value (RV)
Average value of RPS =

The Net Proceeds (NP) is to be ascertained as given below:
(i) Issued at par:
NP=Face value - Issue expenses
(ii) Issued at premium:
NP = Face value + Security premium – Issues expenses
(iii) Issued at discount:
NP= Face value – Discount – issue expenses
III. Cost of Equity Capital:
Computation of cost of equity is quite complex. Some people argue that
the equity capital is cost free as the firm is not legally bound to pay dividend to
equity shareholders. But this is not true. Shareholders invest their funds with the
expectation of dividends. The market value of equity share depends on the
dividends expected by shareholders, the book value of firm and the growth in
the value of firm. Thus, the required rate of return which equates the present
value of the expected dividends with the market value of equity share is the cost
of equity capital. The cost of equity capital may be expressed as the minimum
rate of return that must be earned on new equity share capital financed
investment in order to keep the earnings available to the existing equity
shareholders of the firm unchanged. The following are the different methods on
the basis of which the cost of equity capital may be computed:
(i) Dividend yield (or) Dividend price method
According to this method, the cost of equity is calculated on the basis of a
required rate of return in terms of future dividend to be paid on equity shares for
maintaining their present market price. The cost of new equity share can be
Self-Instructional Material determined according to the following formula:
168
Cost of Capital
Cost of equity (Ke)=

Where: = Expected dividend per share
NOTES
NP = Net proceeds per share
Note: In case of new issue, the firm will have to incur some floatation costs
such as fees to investment bankers, brokerage, underwriting commission and
commission to agents etc. So, the net proceeds per share (Face value –
Floatation Costs) is considered for calculating cost of equity.
In case of existing equity shares, the cost of equity should be calculated on
the basis of market price of firm’s equity share according to the following
formula:
Cost of equity (Ke) =

Where = Expected dividend per share
MP = Market Price per share
This method is simple and rightly emphasises the importance of dividend,
but it suffers from two serious limitations: (i) It ignores the earning on retained
earning which increases the rate of dividend on equity shares and (ii) It ignores
growth in dividends, capital gains and future earnings. This method is suitable
only when the firm has stable dividend policy over a reasonable length of time.
(ii) Dividend price plus growth (D/p+g) method
Under this method, the cost of equity is determined on the basis of the
expected dividend rate plus the rate of growth in dividend. The growth rate in
dividend is assumed to be equal to the growth rate in earnings per share and
market prices per share. The cost of equity, under this method, is determined by
using the following formula: as the variability of returns inherent, in the type of
security, while the return is defined as the total economic return obtained from
it including interest, dividends and market appreciations.
The CAPM divides the total risk associated with a security/assets into
two classes i.e., (i) The diversifiable/unsystematic risk and (ii) non –
diversifiable systematic risk. The risk refers to that risk which can be eliminated
by more and more diversification. On the other hand, non – diversifiable risk is
that risk which affects all the firms at a particular point of time and hence
cannot be eliminated e.g., risk of political uncertainties, risk of government
policies etc.
The CAPM further states that the investor can eliminate the diversifiable
risk by diversifying into more and more securities, however, the non-
diversifiable risk is the point where the investor’s attention is required. This
non-diversifiable risk of a security is measured in relation to the market
portfolio and is denote by the beta coefficient ᵝ. In order to estimate the
required rate of return of the equity investors, the risk associated with the shares
(as represented by beta factor) and risk – return relationship in the securities
market need to be estimated. The CAPM as applied to find out the cost of
equity can be presented as follows:
Ke =Rf + ᵦ (Rm - Rf)
Where, Ke= Cost of equity capital
Rf = Risk free return (Risk free interest rate)
ᵦ = The beta factor i.e., the measure of non-diversifiable risk
Rm= The expected cost of capital of market portfolio or average rate of
return on all assets or market return.
169
Cost of Capital For example, a firm having beta coefficient of 1.6 finds that the risk-free
rate to be 9% and the market cost of capital at 12%. The cost of equity of the
firm will be:
NOTES Ke =Rf + ᵦ (Rm - Rf)
= 0.09 + 1.6 (0.12 – 0.09)
= 0.138 or 13.8%
IV. Cost of Retained Earnings:
Retained earnings are the accumulated amount of undistributed profits
belonging to the equity shareholders. They provide a major source of financing,
expansion and diversification of projects. Their cost is the opportunity cost of
the funds. If these were distributed to the shareholders, they would have
reinvested them in the same firm by purchasing its equity and earned on the
additional shares the same rate of return as they are earning on their existing
shares. Thus, the cost of retained earnings is the same as the cost of equity
capital. However, unlike issue of equity shares, retained earnings do not involve
the payment of personal income tax as well as any floatation cost. This makes
their cost slightly lower than the cost of equity capital. The cost of retained
earnings may be calculated as follows:
(i) Cost of equity (Ke) xxx
(ii) Less: Tax on cost of equity xxx
xxx
(iii) Less: Brokerage (% on (i) –(ii)) xxx
Cost of retained earning xxx
Alternatively, the cost of retained earnings can be ascertained by using the

following formula:
Cost of retained earnings (Kᵧ) = Ke (1 – t) (1 – b)
Where, Ke= Cost of equity capital
t = tax rate
b = brokerage
v. Weighted Average Cost of Capital (WACC):
After having ascertained the cost of each component of capital as
explained above, the average or composite cost of all the sources of
capital is to be determined. The cost of each component of the capital
weighted by the relative proportion of that type of funds in the capital
structure. Them it is called Weighted Average Cost of Capital (WACC).
WACC is defined as the average of the costs of each source of funds
employed by the firm, properly weighted by the proportion they hold in the
capital structure of the firm. It is denoted by k o. The proportion or
percentage or weight of each component may be determined based on
either book value or market value of capital.
As the cost of capital is used as a cut-off rate for investment projects,
the market value approach is considered better due to the following
reasons:
(a) It evaluates profitability as well as the long-term financial position
of the firm.
(b) Investors always consider the committing of his funds to a firm and
an adequate return on his investment. In such cases, book values are of
little significance.
(c) It considers price level changes.
Self-Instructional Material 13.9 Benefits of book value approach:
170
However, as the market value fluctuates widely and frequently, the use of Cost of Capital
book value weights is preferred in practice due to following reasons:
(a) The firms set their targets in terms of book value.
(b) It can easily be calculated from published accounts. NOTES
(c) The investors generally use the debt-equity ratio on the basis of
published figures to analyse the riskiness of the firm.
Computation of weighted average cost of capital:
The following steps are to be taken to calculate WACC:
Step 1: Calculate the cost of specific sources of funds, for example, cost of
debt, cost of equity etc.
Step 2: Multiple the cost of each source by its proportion in capital
structure.
Step 3: Add the weighted component costs to get the firm’s WACC.
The following format may be adopted for computation of WACC:
Sources of funds Amt. Proportion After tax Weighted
to total cost cost
Debt xx w1 k da k da x w1
Preference share xx w2 kp k p x w2
capital xx w3 kr k r x w3
Retained earnings xx w4 ke k e x w4
Equity share capital
Total xx WACC xxx
13.10 Significance of weighted average cost of capital:

(i) In capital budgeting, WACC is used as a cut off rate (or Hurdle
rate) against which projects can be evaluated. A project can be considered
viable only if the returns from the project are higher than the cost there of
i.e., WACC.
(ii) WACC represents the minimum rate of return at which a firm
can produce value for its investors (Debt and equity). If a firm’s return on
capital employed is less than its WACC, it means the firm is losing its
value/wealth. Such a situation is most disadvantageous to equity
shareholders.
(iii) WACC is useful in making economic value added
(EVA)calculations.
VI. Marginal Cost of Capital (MCC)
The MCC is defined as the cost of raising an additional rupee of capital.
Since the capital is raised in substantial amount in practice, marginal cost is
referred to as the cost incurred in raising new funds. MCC is derived when
we calculate the average cost of capital using the marginal weights. The
marginal weights represent the proportion of funds the firm intends to
employ. Thus, the problem of choosing between the book value weights
and the market value weights does not arise in the case of MCC
computation. To calculate MCC, the intended financing proportion should
be applied as weights to marginal component costs. The MCC should,
therefore, be calculated in the composite sense. When a firm raises funds in
proportional manner and the component’s cost remain unchanged, there
will be no difference between average cost of capital (of the total funds)
and the marginal cost of capital. The component costs may remain constant
up to certain level of funds raised and then start increasing with amount of
funds raised. For example, the cost of debt may remain 8% (after tax) till
Rs. 20 lakh of debt is raised, between Rs. 20 lakh and Rs. 30 lakh, the cost
171
Cost of Capital may be 10% and so on. Similarly, if the firm has to use the external equity
when the retained profits are not sufficient, the cost of equity will be higher
because of the floatation costs. When the components cost start rising, the
NOTES average cost of capital will rise and the MCC will, however rise at a faster
rate.
ILLUSTRATIONS
Illustration: 1(Cost of irredeemable debt)
Sakthi Ltd. Issued 20,000 8% debentures of Rs. 100 each on 1 st
April 2009. The cost of issue was Rs. 50,000. The company’s tax rate is
35%. Determine the cost of debentures (before as well as after tax) if they
were issued, (a) at par; (b) at a premium of 10% and (c) at a discount of
10%.
Solution:
a) Debentures issued at par:
Rs.
(i) Interest: (20,00,000 x 8%) 1,60,000
Less: Tax (1,60,000 x 35%) 56,000
Interest after tax 1,04,000
Rs.
(ii) Gross proceeds: (20,000 x 100) 20,00,000
Less: Cost of issue 50,000
Net proceeds 19,50,000
Cost of debentures before tax (kdb) =
= X100 = 8.21%
Cost of debentures after tax (kda) =
= X100 = 5.33%
(b) Debentures issued at a premium of 10%
Gross proceeds (20,000 x 110) 22,00,000
Cost of debentures before tax (kdb) = = 7.44%
Cost of debentures after tax (kda) = = 4.84%

(c) Debentures issued at a discount of 10%
Gross proceeds (20,000 x 90) 18,00,000
Cost of debentures before tax (kdb) = = 9.14%

172
Cost of Capital
Cost of debentures after tax (kda) = = 5.94%
Note: Whether the debentures are issued at par (or) at par at premium (or)
at discount, interest on debentures should be calculated only on the face NOTES
value of debentures.

1. What do you mean by cost of capital
2. What are the importance of cost of capital?
3. What is meant by cost of retained earning?

1. The cost of capital is the minimum required rate of return, the hurdle or
handle or target rate, the cut-off rate or the financial standard of
performance of a project.
2. Capital Budgeting decision, Designing the capital structure, deciding
about the method of financing, Performance of top management: Other
areas of decisions making.
3. Retained earnings are the accumulated amount of undistributed profits
belonging to the equity shareholders. They provide a major source of
financing, expansion and diversification of projects.

Short Questions:
1. What are the significances of weighted average of cost of capital?
2. What is cost of equity capital?
3. Define cost of capital.
1. What are the factors determining cost of capital?
2. What are the components of cost of capital?
3. What are the types of cost of capital?
4. How do you calculate cost of capital?
Further Reading:

P.K. TMH
3rd ed, TMH
173
Capital Structure
UNIT - XIV CAPITAL STRUCTURE
Structure
NOTES 14.1 Introduction
14.6 Difference between Capital Structure and Financial Structure
14.7 Difference between Capital structure and Capitalization
14.14 Dividend Policy
14.1 Introduction
As mentioned in chapter 1, one of the objectives of financial
management wealth maximization. Since the finance manager is
responsible to procure the required funds for a firm from different sources,
he has to select a finance mix or capital structure which maximizes
shareholders wealth. For designing the capital structure, he is required to
select such a mix of sources of finance overall cost of capital is minimum.
In this chapter, let us pay our attention designing capital structure taking
into account the cost of capital to the firm.
Capital structure refers to the mix of sources from where the long
term funds required in a firm may be raised i.e. what should be the
proportions of equity share capital, preference share capital, internal
sources, debentures and other sources of funds in the total amount of
capital which a firm may raise for establishing its business.
The term capital structure has been defined by several authors
differently. Some of the definitions are as follows
(i) I.M. Pandey: Capital structure refers to the composition of long-term
sources of funds such as debentures, long term debt, preference share
capital and ordinary share capital including reserves and surpluses
(retained earnings).
(ii) Weston and Brigham: Capital structure is the permanent financing of
the firm, represented primarily by long term debt, preferred stock, and
common equity, but excluding all short-term credit. Common equity
includes common stock, capital surplus and accumulated earnings,
(iii) John J. Hampton: Capital structure is the combination of debt equity
securities that comprise a firm's financing of its assets.
(iv) R.H. Wessel: The term capital structure is frequently used to the long-
term sources of funds employed in a business enterprise.
(v)W. Gerstenberg: Capital structure refers to the kind of securities that
make up the capitalization.
(vi) Guthman and Dougali: From a strictly financial point of view, the
optimum capital structure is achieved by balancing the financing so as to
achieve the lowest average cost of long-term funds. This, in turn. produces
174
the maximum market value of the total securities issued against a given Capital Structure
amount of corporate finance.
We can thus, define capital structure as the overall mix of components of
capitalisation. It is a composite function and includes the following NOTES
decisions:
(a) Shares: Equity shares, Preference shares.
(b) Debt: Debentures, bonds, public deposits, loans from banks and
financial institutions.
(ii)Ratio or proportion of securities: The ratio or proportion of securities
in any capital structure is an important decision. The decision of capital
mix is called capital gearing.
The capital gearing may be high, low or even. When the proportion of
equity share capital is high in comparison with other securities in the total
capitalization, it is low geared and in the opposite case, it is high geared
and at the same time, if equity share capital is equal to the other securities,
it is called evenly geared.
There may be four fundamental patterns of capital structure as follows:
(i) Equity share capital only (including Reserves & surplus)
(ii) Equity share capital and preference share capital.
(ii) Equity, preference share capital and long-term debt. i.e. Debentures,
bonds and loans from financial institutions etc.
(iv) Equity share capital and long-term debt.
14.6 Difference between Capital Structure and Financial
Structure
The term capital structure differs from financial structure. Financial
structure Refers to the composition or make up of the entire liabilities side
of the balance sheet of a firm. It shows the way in which the firm's assets
are financed. It includes long term as well as short term sources of finance.
Capital structure is the permanent financing of the firm represented
primarily by long term debt and shareholders’ funds but excluding all
short-term credit. Thus, a firm's capital structure is only a part of its
financial structure.
14.7 Difference between Capital structure and
Capitalization
Following are the major differences between Capital Structure
Capitalization:
Basis Capital Structure Capitalization
1.Coverage It refers to mix of various It refers to all long-term
sources of capital e.g. securities e.g. equity, debt
Capital, debt, etc. and free reserves not
2.Scope It is an overall policy meant for distribution.
decision about the It is implementation of
proportion of various policy decision about
sources of long-term capital structure.
finance.
3.Nature It is a qualitative decision It is a quantitative
decision.
175
Capital Structure
The capital structure is said to be optimum capital structure when
the firm has selected such a combination of equity and debt so that the
NOTES
wealth of firm is maximum. At this capital structure, the cost of capital is
minimum and market price per share is maximum.
It is, however, difficult to find out optimum debt and equity mix
where the capital structure would be optimum because it is difficult to
measure a fall in the market value of an equity share on account of increase
in risk due to high debt content in the capital structure.
In theory one can speak of an optimum capital structure but in
practice appropriate capital structure is more realistic term than the former.
(i) Minimum cost: An appropriate capital structure should attempt to
establish the mix of securities in such a way as to raise the requisite funds
at the lowest possible cost. As the cost of various sources of capital is not
equal in all circumstances, it should be ascertained on the basis of weighted
average cost of capital. The management should aim at keeping the issue
expenses and fixed annual payments at a minimum in order to maximize
the return to equity shareholders.
(ii)Maximum return: An appropriate capital structure should be devised
in such a way so as to maximize the profit of the firm. In order to
maximize profit, the firm should follow a proper policy of trading on
equity so as to minimize the cost of capital.
(iii) Minimum risk: An appropriate capital structure should possess the
quality of minimum risk. Risk, such as increase in taxes, rates of interest,
Costs etc. and decrease in prices and value of shares as well as natural
calamities adversely affects the firm's earnings. Therefore, the capital
structure should be devised in such a way as to enable it to afford the
burden of these risks easily.
(iv) Maximum control: An appropriate capital structure has also the
quality of retaining control of the existing equity shareholders on the
affairs of the firm. Generally, the ultimate control of the firm rests with the
equity shareholders who have the right to elect directors. Thus, while
determining the issue of securities, the question of control in management
should be given due consideration. In case the firm issues a large number
of equity shares, the existing shareholders may not be able to retain control.
The firm should, therefore, issue preference shares or debentures to the
public instead of equity shares because preference shares carry limited
voting rights and debentures do not have any voting rights. Thus, the
capital structure of a firm should not be changed in such a way which
would adversely affect the voting structure of the existing shareholders,
dilute their control on the firm's affairs.
(v) Flexibility: An appropriate capital structure should have the quality of
flexibility in it. A flexible capital structure enables the firm to make the
necessary changes in it according to the changing conditions. In other
words, under flexible capital structure, a firm can procure more capital
whenever required or redeem the surplus capital.
(vi) Proper liquidity: An appropriate capital structure has to maintain
proper liquidity which is essential for the solvency of the firm. In order to
achieve proper liquidity, all debts which threaten the solvency of the firm
should be avoided and a proper balance between fixed assets and current
assets should be maintained according to the nature and size of business.
176
(vii) Conservatism: A firm has to follow the policy of conservatism in Capital Structure
devising the capital structure. This would help in maintaining the debt
capacity of the firm even in unfavourable circumstances.
(viii) Full utilisation: An appropriate capital structure is needed for NOTES
optimum utilization of financial resources of a firm. Both under
capitalization and over capitalization are injurious to the financial interest
of a firm. Thus, there should be a proper co-ordination between the
optimum of capital and the financial needs of a firm. A fair capitalization
enables a firm to make full utilization of the available capital at minimum
cost.
(ix) Balanced leverage: An appropriate capital structure should attempt to
secure a balanced leverage by issuing both types of securities i.e.
ownership securities and creditorship securities. Generally, shares are
issued when the rate of capitalization is high, and debentures are issued
when rate of interest is low.
(x) Simplicity: An appropriate capital structure should be easy to
understand and easy to operate. For this purpose, the number and type of
securities issued should be limited.
The following factors must be considered while determining the capital
structure of a firm:
(i) Trading on equity: The concept of trading on equity is based on the
concept of taking advantage of equity i.e. owner funds to earn additional
profits. In case, where the rate of return of firm is higher than the cost of
borrowed funds i.e. preference shares or debentures or public deposits or
debts, the firm shall prefer to arrange more funds from these sources, so
that it earns additional profits after paying fixed rate on these sources. So,
trading on equity is an arrangement under which the finance manager
raises funds by issuing securities which carry fixed rate of interest or
dividend which is less than average earnings of the firm to increase the
return on equity shares. This can be explained by the following example.
Capital Structure A Ltd., B Ltd.,
(i)Equity 40 lakh 8 lakh
(ii) 15% Debentures 8 lakh 40 lakh
Gross income 9.2 lakh 9.2 lakh
Less: Interest on 1.2 lakh 6.0 lakh
debentures 8 lakh 3.20 lakh
Net earnings
Earnings on shares: 8/40 x 100 = 3.20/8 x 100 =
Net earnings/Equity 20% 40%
capital x 100
So, the rate of return of B Ltd is higher than A Ltd. This additional earning
due to borrowing more of fixed interest funds is called trading on equity.
Merits of trading on equity:
(a) Trading on equity maximises returns for the shareholders
(b) It helps declare higher dividend.
(c) It helps to retain more profit.
(d) The control in management is in the hands of limited number of
persons.
Limitation: It is not suitable if earnings of firm are lower than the fixed rate
carried by debt funds.
177
Capital Structure (ii)Stability on sales: An established firm which has a growing market and
high sales does not have any difficulty in meeting its fixed commitments.
Interest on debentures has to be paid regardless of profits. If sales are on
NOTES the rise, interest payments can be met and therefore, a firm is able to
employ more debt in its capital structure. If sales are fluctuating and
unstable, then the firm will not be able to pay interest charges as and when
they become due. Therefore, it is better not to employ too much debt in its
capital structure.
(iii) Exercise control: The control of a firm is entrusted to the board of
directors elected by the equity shareholders. If the board of directors and
shareholders of a firm wish to retain control over the firm in their hands,
they should not allow further issue of equity shares to the public. In such a
case, more funds can be raised by issuing preference share and debentures.
(iv)Cost of capital: Cost of capital, as stated earlier, is the payment made
by firm to obtain capital. Thus, interest is the cost of debentures or loans
and the dividend paid by the firm is the cost of preference and equity
capitals. It is to be noted that rate of dividend on preference Capital is fixed
which is generally lower than that of equity capital. The cost of debentures
is generally lower and tax deductible. Therefore, a firm may prefer as much
debt as it possibly can subject to its earring Capacity so as to enable the
firm to keep on paying its interest obligation.
(v)Statutory requirements: The structure of capital of a firm is also
Influenced by the requirements of the statutes applicable to it. For
Example, banking companies have been prohibited by the Banking
Regulation Act from issuing any type of securities except equity shares.
(vi) Capital market conditions: The conditions prevailing in the capital
market also influences the determination of the securities to be issued. For
instance, during depression, people do not like to take risk and so are not
interested in equity shares. But during boom, investors are ready to take
risk and invest in equity shares. Therefore, debentures and preference
shares which carry fixed rates of return may be marketed
(vii) Corporate taxation: Under e Income tax laws, dividend on shares is
not deductible while interest paid on borrowed capital is allowed as
deduction. Cost of raising finance through borrowing is deductible in the
year in which it is incurred. if it is incurred during the pre-commencement
period, it is to be capitalized. Cost of issue of shares is allowed as
deduction. Owing to these provisions, corporate taxation plays an
important role in determining the choice between sources of financing.
(viii) Government policies: Government policies are a major factor in
determining capital structure. For example, a change in the lending policies
of financial institutions may mean a complete change in the financial
pattern to be followed in the firms. Similarly, the Rules and Regulations
frame by SEBI considerably affect the capital issue policy of various firms.
Monetary and fiscal policies of the Government also affect the capital
structure decision.
(ix) Flexibility: It denotes the capacity of the business and its management
to adjust to expected and unexpected changes in the business environment.
The capital structure should provide maximum freedom to changes at all
times.
(x) Timing: Closely related to flexibility is the timing for issue of
securities. Proper timing of a security issue often brings substantial savings
because of the dynamic nature of the capital market. Intelligent
178
management tries to anticipate the climate in capital market with view to Capital Structure
minimize the cost of raising funds and also to minimize the dilution
resulting from an issue of new equity shares.
(xi) Size of the firm: Small firms rely heavily on owner's funds, while NOTES
large and widely held firms are generally considered to be less risky by the
investors. Such large firm can issue different types of debt instruments or
securities.
(xii) Purpose of financing: In case funds are required for productive
Purposes like manufacturing etc., the firm may raise funds through long
terms sources On the other hand, if the funds are required for non -
productive purposes like welfare facilities to employees such as schools,
hospitals, etc., the firm may rely only on internal resources.
(xiii) Period of finance: Funds required for medium- and long-term
periods, say 8 to 10 years, may be raised by way of borrowings, but if the
funds are for permanent requirement, it will be appropriate to raise them by
issue of equity shares.
(xiv) Requirement of investors: Different of types of securities are issued
to different classes of investors according to their requirements. Sometimes
the investor may be motivated by the options and advantages available
with a security e.g. double options, convertibility, security of Principal and
interest, etc.
(xv) Provision for future growth: Future growth consideration and future
requirements of capital should also be considered while planning the
capital structure.
A widely used financial technique of EBIT-EPS Analysis is
generally applied to de e an appropriate capital structure of a firm. This
technique involves of the EBIT comparison the choice of alternative
methods of financing under various ass options of combination of sources
with the capital structure would be one which, for a given level of EBIT,
would ensure the largest earnings per share (EPS). Alternatively, the choice
of combination should ensure the market price per share (Market
price=EPS x PE ratio).
Indifference point refers to the EBIT level at which EPS remains
unchanged irrespective of debt-equity mix. Given the total amount of
capitalization and the on bonds, a firm reaches indifference point when it
earns exactly the me interest amount rate of income what it has promised to
pay on debt. In other words, rate of return on capital employed is equal to
rate of interest on t at Indifference point. Indifference point of EBT
changes with variation in the total funds to be raised or the interest rate to
be paid on borrowed capital.
The indifference point can be determined with the help of following
formula:
x = EBIT
I1=Interest under financial Plan 1
I2=Interest under financial Plan 2
T=Tax rate
P. D= Preference Dividend
179
Capital Structure N1=-No. of equity shares (or) Equity share capital under Plan 1
N2=No of equity shares (or) Equity share capital under Plan 2
NOTES
The objective of a firm should be directed towards the
maximization of the value of the firm. The capital structure decision should
be examined from the point of view fits impact on the value of the firm. If
the value of the firm can be affected by capital structure or financing
decision, a firm would like to have a capital structure which maximizes the
market value of the firm.
There are broadly four approaches in this regard. These are:
(i)Net Income (NI) Approach
(ii) Net operating Income (NOI) Approach
(iii) Traditional Approach
(iv)Modigliani and Miller Approach
These approaches analyse relationship between the leverage, cost of capital
and the value of the firm in different ways. However, the following
assumptions are made to understand the relationship:
(b) There are only two sources of funds Viz. Debt and Equity (No
preference share capital).
(c) The total assets of the firm and its capital employed are constant. (No
change in capital employed). However, Debt-Equity mix can be changed.
This can be done by
(i) either by borrowing debt to repurchase (redeem) equity shares or
(ii) by raising equity capital to retire (repay) debt.
(d) All residual earnings are distributed to equity shareholders (No retained
earnings)
(e)The firm earns operating profit and it is expected to grow. No losses).
(f) The business risk is assumed to be constant and is not affected by the
Financing mix decision (No change in fixed cost or operating risks).
(g) There are no corporate or personal taxes (No taxation)
(h) The investors have the same subjective probability distribution of
expected earnings (No difference in investor expectations).
(i)Cost of debt (Kd) is less than cost of equity (Ke). (Low cost of deb).
(i) Net Income (NI) Approach: This approach has been suggested by
Durand. According to this approach, a firm can increase it’s or lower the
Overall cost of capital by increasing the proportion of debt in the capital
structure. In other words, if the degree of financial leverage in increases,
the weighted average cost of capital will decline with every increase in the
debt content in total capital employed, while the value firm will increase.
Reverse will happen in a converse situation.
The NI Approach is based on the following three assumptions:
(a)There are no corporate taxes.
(b) The cost of debt (Kd) is less than cost of equity (Ke).
(c) The use of debt content does not change the risk perception of
investors.
As a result, both the Kd and Ke remain constant.
The total market value of the firm (V)under the N1 approach is
determined with the help of the following formula:
V= S+D
Where, V=Total market value of the firm
S=Market value of equity shares
D = Market value of Debt.
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Market value of equity shares (S) = Net income /Equity capitalisation Capital Structure
rate
(or)
= Earnings available to shareholders/Cost of equity (ke) NOTES
The overall cost of capital (ko) or weighted average cost of capital is
Ascertained as follows: ko=EBIT/ Value of firm (V)
(ii) Net Operating Income (NOI) Approach: This approach has been
suggested by Durand. According to this approach, the market value of the
firm is not affected by the capital structure changes the market value of the
firm is ascertained by capitalizing the net operating income at the overall
cost of capital which is constant. The market value of the firm is
determined as follows:
Market value of firm(V) = EBIT (Net operating Income) / Overall cost of
capital (Ko)
The value of equity can be ascertained by applying the following equation:
Value of equity (S) - Market value of firm (V)-Market value of debt (D)
Cost of equity (Ke) = EBT (Earnings after interest, before tax) / Value of
equity (S)
The NOI approach is based on the following assumptions:
(a)The overall cost of capital remains constant for all degree of debt-equity
mix
(b) The market capitalizes the value of firm as a whole. Thus, the split
between debt and equity is not important.
(c) The use of less costly debt funds increases the risk of shareholders. This
causes the equity capitalization rate to increase. Thus, the advantage of
debt is set off exactly by increase in equity capitalization rate.
(d) There are no corporate taxes.
(e) The cost of debt is constant.
(iii) Traditional Approach: This approach is also known as intermediate
approach as it takes a midway between NI approach (hat the value of the
firm can be increased by increasing financial leverage) and NO1 approach
(that the value of firm is constant irrespective of the degree of financial
leverage). According to this approach, the use of debt up to a point is
advantageous. It can help to reduce the overall cost of capital and increase
the value of the firm. Beyond this point, the debt increases the financial
risk of shareholders. As a result, cost of equity also increases. The benefit
of debt is neutralized by the increased cost of equity. Thus, up to a point,
the content of debt in capital structure will be favourable. Beyond that
point, the use of debt will adversely affect the value of the firm. At that
point, the capital structure is optimal, and the overall cost of capital will be
the least.
iv) Modigliani and Miller Approach: Modigliani and Miller have
explained the relationship between cost of capital, capital structure and
total value of the firm under two conditions:
(a) When there are no corporate taxes
(b) When there are corporate taxes
I. When there are no Corporate Taxes
The MM approach is identical to NO1 approach, when there are no
corporate taxes. Modigliani and Miller argued that in the absence of taxes,
the cost of capital and value of the firm are not affected by capital structure
or debt-equity mix. They gave a simple argument in support of their
approach. They argued that according to traditional approach, cost of
181
Capital Structure capital is the weighted average of cost of debt and cost of equity etc. The
cost of equity, they argued, is determined from the level of shareholders'
expectations. Now if shareholders expect 15% from a particular firm, they
NOTES do take into account the debt-equity ratio and they expect 15% merely
because they find that 15% covers the particular risk which this firm
entails. Suppose further that the debt content in the capital structure of this
firm increases; this means that in the eyes of shareholders, the risk of the
firm increases, since debt is a riskier mode of finance. Hence, shareholders
will now start expecting a higher rate of return from the shares of the firm.
Hence, each change in the debt-equity mix is automatically offset by a
change in the expectations of the shareholders from the equity share
capital. This is because a change in debt equity ratio changes the risk
element of the firm, which in turn changes the expectations of the
shareholders from the particular shares of the firm. Modigliani and Miller,
therefore, argued that financial leverage has nothing to do with the overall
cost of capital and the overall cost of capital is equal to the capitalization
rate of pure equity stream of its class of risk. Hence financial leverage has
no impact on share market prices nor on the cost of capital.
Modigliani and Miller make the following propositions:
(a) The total market value of a firm and its cost of capital are independent
of its capital structure. The total market value of the firm s given by
capitalizing the expected stream of operating earnings at a discount rate
considered appropriate for its risk class.
b) The cost of equity (Ke) is equal to capitalization rate of purely equity
stream plus a premium for financial risk. The financial risk increases with
more debt content in the capital structure. As a result, Ke increases in a
manner to offset exactly the use of less expensive source of funds.
c) The cut off rate for investment purposes is completely independent of
the way in which the investment is financed.
Assumptions
MM approach is based on the following assumptions:
(a) The capital markets are perfect. This means that investors are free to
buy and sell securities. They are well informed about the risk-return on all
types of securities. There are no transaction costs. The investors behave
rationally. They can borrow without registrations on the same terms as the
firms do.
(b) The firms classified into homogenous risk classes. All firms within the
same class will have the same degree of business risk.
(c) All investors have the same expectations from a firm's net operating
income (EBIT) which are necessary to evaluate the value of a firm.
(d) 100% pay-out ratio i.e., all earnings are distributed to shareholders as
dividends.
(e) There are no corporate taxes.
Arbitrage process:
Modigliani and Miller hypothesis reveals that the total value of a
firm is determined by its operating income or EBIT. It is independent of
the debt equity mix. Two firms which are identical in all respects except
their capital structure, cannot have different market values or different cost
of capital. If market value of the firms differ, arbitrage process will take
place and make them equal.
For example, suppose there are two firms X and Y in the same risk class.
Firm x is financed by equity and firm Y has a capital structure which
182
includes deb. Their market values do not differ for a long time. If the Capital Structure
market value of firm Y is higher than firm X, the shareholders/ investors of
firm Y will dispose of the shares of the overvalued firm Y and will
purchase the shares of undervalued firm X In addition, firm X has no debt. NOTES
Therefore, shareholders /investors of firm Y borrow on their personal
account (Substitution of personal leverage for corporate leverage) and use
the additional funds for buying shares of firm X. As a result, the market
price of firm Y share will decline due to selling pressure and that of firm
share will increase. This process will continue till both of them attain the
Same market value. As such, as soon as the firms reach the identical
position, the average cost of capital and the value of the firm will be equal.
So, the total value of the firm and average cost of capital are independent.
II. When there are Corporate Taxes
Modigliani and Miller agreed that the capital structure will affect
the value of the firm and the cost of capital when taxes are applicable to
corporate income .if a firm uses debt in its capital structure, the cost of
capital will decline and market value of the firm will increase. This is
because interest is deductible expense for tax purposes and therefore, the
effective cost of debt is less than the contractual rate of interest. A levered
firm (firm which uses debt) can therefore have more earnings to its equity
shareholders than an unlevered firm (firm which does not use deb). This
makes debt financing advantageous and value of the levered firm will be
higher than that of an unlevered firm. A firm can achieve optimum capital
structure by maximizing debt financing. According to MM approach, the
value of unlevered firm can be determined with the help of the following
formula:
Where,
EBIT = Earnings before interest and taxes
Ke= Cost of equity
T = lax rate.
(or)
Vu= EAT/Ke= Earnings available to shareholders / Cost of equity
Value of levered firm can be ascertained as given below.
Value of levered firm m (VL) -Value of unlevered firm + (Tax
rate x Debt).
Criticism of MM Approach
The propositions of MM approach have been criticized by
numerous authorities. Mostly criticism is about perfect market assumption
and the arbitrage assumption. MM hypothesis argue that through arbitrage,
investors would quickly eliminate any inequalities between the value of
levered firms and value of unlevered firms in the same risk class. The basic
argument here is that individual arbitragers, through the use of personal
leverage, can alter corporate leverage. This argument is not valid in the
practical world, for it is extremely doubtful that individual investors would
substitute personal leverage for corporate leverage, since they do not have
the same risk characteristics. The MM approach assumes availability of
free and Up to date information This is also not normally valid.
To conclude, one may say that the controversy between the
traditionalists and supporters of MM approach cannot be resolved due to
lack of empirical research. Traditionalists argue that the cost of capital of a Self-Instructional Material
183
Capital Structure firm can be lowered and the market value of the shares can be increased by
a careful use of financial leverage. However, after certain stage as the firm
becomes highly geared, it becomes too risky for investors and lenders.
NOTES Hence, beyond a point, overall Cost of capital begins to rise. This point
indicates the optimal or appropriate capital structure. AMM argue that in
the absence of corporate income taxes, Overall cost of capital is
independent of the capital structure of the firm.
ILLUSTRATION
I.EBIT-EPS Analysis
1. Dubin Ltd has equity share capital of Rs. 1200000 divided into
shares of Rs. 100 each. It wishes to raise further Rs. 600000 for
expansion-cum-modernisation scheme. The company plans the
following financing alternatives:
Plan A – By issuing equity share only.
Plan B – Rs. 200000 by issuing equity shares and Rs.400000
through debentures @10% p.a.
Plan C – Rs. 200000 by issuing equity shares and Rs. 400000 by
issuing 9% preference shares.
Plan D – By Raising tern loan only at 10% p.a.
You are required to suggest the best alternative giving your
comment assuming that the estimated EBIT after expansion is
Rs.2,25,000 and corporate rate of tax is 40%.
Particulars Plan A Plan B Plan C plan D
Earnings before
interest and taxes 2,25,000 2,25,000 2,25,000 2,25,000
(EBIT) - 40,000 - 60,000
(-) Interest on debt
Earnings before tax 2,25,000 1,85,000 2,25,000 1,65,000
(EBT) 90,000 74,000 90,000 66,000
(-) Tax @ 40%
Earnings after tax 1,35,000 1,11,000 1,35,000 99,000
(-) Pref. dividend - - 36,000 -
Profit for equity 1,35,000 1,11,000 99,000 99,000
shareholders
Workings:
Interest on debt
plan B = 4,00,000 x10 % = 40,000
Plan D = 6,00,000 x 10% = 60,000
EPS:
Plan A = 1,35,000 / 18,000 = 7.50
Plan B = 1,11,000 / 14,000 = 7.93
Plan C = 99,000 / 14,000 = 7.07
Plan D = 99,000 / 12,000 = 8.25
Analysis: EPS of Rs.8.25 is highest in case of plan D. Hence, it is

suggested that plan D may be implemented i.e., raising the required funds
of Rs.600000 by way of borrowing term loan at 10% per annum.
II. Indifference point
184
1. A new project requires an investment of Rs. 1200000.Two Capital Structure
alternative methods of financing are under consideration:
(i) Issue of Equity shares of Rs.10 each for Rs.1200000
(ii) Issue of equity shares of Rs.10 each for Rs.800000 and issue NOTES
of 15% Debentures for Rs.400000
Find out the indifference level of EBIT assuming a
tax rate of 35% verify your answer.
Solution:
Indifference level of EBIT is calculated as under:
EPS under plan I = EPS under plan 2
(Equity financing) (Equity and Debt financing)
x = EBIT =?
I1=Interest under plan 1 = 0
I2 = Interest under plan 2 = 400000 x 15% = Rs.60000
T = Tax rate = 35%
N1 = No. of equity shares under plan 1 = 120000
N2 = No. of equity shares under plan 2 = 80000
By cross multiplication
0.65x(8) = 0.65x(12) – 3.9(12)
5.2x = 7.8x – 46.8
5.2x – 7.8x = -46.8
-2.6x = -46.8
X=46.8/2.6 = 18 or 18 x 10000 = Rs.180000
Indifference level of EBIT is Rs.118000 and at that level, EPS of plan
1 and plan 2 should be equal. This can be verified as given below:
Verification:
Particulars Plan 1 Plan 2
Rs. Rs.
EBIT 1,80,000 1,80,000
Less: Interest - 60,000
EBT 1,80,000 1,20,000
Less: Tax @ 35% 63,000 42,000
EAT 1,17,000 78,000
EPS 0.975 0.975
WORKING NOTE:
EPS =
Plan 1 = 1,17,000 / 1,20,000 = 0.975

185
Capital Structure plan 2 = 78,000 / 80,000 = 0.975
III. Net Income Approach

NOTES 1.Jennifer Ltd. is expecting an annual EBIT of Rs. 200000.The company
has Rs. 200000 in 10% Debentures. The equity capitalization rate (ke) is
12%. You are required to ascertain the total value of the firm and overall
cost of capital. What happens if the company borrows Rs. 200000 at 10%
to repay equity capital?
Solution:
Value of firm
Under NI approach = Market value of equity + Market value of debt
(i) Calculation of market value of equity
Rs.
Earnings before interest & taxes 2,00,000
(EBIT) 20,000
(-) Interest (2,00,000 x 10%)
Earnings available to equity 1,80,000
shareholders
Market value of equity =
= 1,80,000 / 12 % = Rs. 15,00,000
(ii) Calculation of value of firm
Value of firm = Market value of equity + Market value of

debt
= 1500000 + 200000
= Rs. 1700000
(iii)Calculation of overall cost of capital (k0)
K0 = EBIT/value of firm x 100
= 200000/1700000 x 100 = 11.76%
Calculation of value of firm when the company borrows Rs. 2 lakh to

pay off equity capital
(i) Calculate of market value of equity
Rs.
Earnings before interest & taxes 2,00,000
(EBIT) 40,000
Earnings available to equity 1,80,000

shareholders
Market value of equity = 1,60,000 / 12% = Rs. 13,33,333.

(ii) Calculate of value of firm
Value of firm = Market value of equity + Market value of debt
= 13,33,333 + 4,00,000
= Rs. 17,33,333.
Self-Instructional Material (iii) Calculation of overall cost of capital K0

186
K0 = EBIT/value of firm x 100 Capital Structure
= 2,00,000 / 17,33,333 x 100
= 11.54%
Analysis: Under net Income approach, increase in debt content leads to NOTES
increase in value of firm and decrease in overall cost of capital.
IV. Net operating Income Approach
1. Dewey Ltd. has an EBIT of Rs. 450000. The cost of debt is
10% and the outstanding debt is Rs. 1200000. The overall
capitalization rate (k0) is 15%. Calculation the total value of the
firm and equity capitalization rate under NOI approach.
Solution:
(i) Calculation of Market value of firm
Market value of firm = EBIT/ overall cost of capital

(k0) x 100
= 450000/15%
= Rs. 3000000
(ii) Calculation of Market value of equity
Market value of firm = Market value of equity +
Market value of debt
/Market value of equity = Market value of firm –
Market value of debt
= 3000000 – 1200000
= Rs. 1800000
(iii)Calculation of earnings available to equity shareholders
Rs.
EBIT 4,50,000
(-) Interest (12,00,000 x 10%) 1,20,000
Earnings available of equity 3,30,000
shareholders
(iv) Calculation of equity capitalization rate (ke)
= 3,30,000 / 18,00,000 x 100

= 18.33%
14.14 DIVIDEND POLICY
14.14.1 Introduction:
Since the primary objective of financial management is to
maximise the market value of equity shares, we may ask here, what is the
relationship between dividend policy and market price of equity shares?
Does a high dividend payment decrease, increase or does not affect at all
the market price of equity shares? These are controversial and unresolved
questions in corporate finance. An attempt has been made in this chapter to
find answers for these questions. Before we deal with different aspects of
dividend policy, let us first understand the concept of dividend.
14.14.2 Meaning of Dividend
The term dividend refers to that part of the profit (after tax) which
is distributed among the owners/shareholders of the firm. In other words, it
is a taxable payment declared by a firm’s board of directors and given to its
shareholders out of the firm’s current or retained earnings usually
187
Capital Structure quarterly. Dividends are usually given as cash (cash dividend), but they can
also take the form of stock (stock dividend) or other property. Dividend
provide an incentive to own stock in stable firms even if they are not
NOTES experiencing much growth. Firms are not required to pay dividends. The
firms that offers dividends are most often firms that have progressed
beyond the growth phase and no longer benefit sufficiently by reinvesting
their profits. So, they usually choose to pay them out to their shareholders,
also called pay out.
14.14.3 Types of Dividends
Following are the different types of dividends offered to the
shareholders of the firm:
(i) Regular Dividend: It is paid annually, proposed by the board of
directors and approved by the shareholders in general meeting. It is also
known as final dividend because it is usually paid after the finalization of
accounts. It is generally paid in cash as a percentage of paid up capital, say
10% or 15% of the capital. Sometimes it is paid per share. No dividend is
paid on calls-in-advance or calls-in-arrear.
(ii) Interim Dividend: If Articles so permit, the directors may
decide to pay dividend at any time between the two Annual General
Meetings before finalizing the accounts. It is generally declared and paid
when firm has earned heavy profits or abnormal profits during the year and
directors wish to pay the profits to shareholders. Such payment of dividend
in between the two Annual General Meetings before finalization of
accounts is called Interim Dividend. No interim dividend can be declared
or paid unless depreciation for the full year (not proportionately) has been
provided for. It is thus an extra dividend paid during the year requiring no
need of approval of the Annual General Meeting. It is paid in cash.
(iii) Stock Dividend: Stock dividend is in the form of issue of
bonus shares to the equity shareholders in lieu or addition to the case
dividend. It is a permanent capitalization of earnings. It will increase the
capital and reduce reserve and surpluses. It has no impact on the wealth of
shareholders. Shareholders who receive stock dividend receive more
shared of the firm’s stock, but because the firm’s assets and liabilities
remain the same, the price of the stock must decline to account for the
dilution. For shareholders, this situation resembles a slice of cake. You can
divide the slice into two, three or four pieces and no matter how many
ways you slice it, its overall size remains the same. After a stock dividend,
shareholders receive more shares, but their proportionate ownership
interest in the firm remains the same and the market price declines
proportionately.
Stock dividends usually are expressed as a percentage of the
number of shares outstanding. For example, if a firm announces a 10%
stock dividend and has 1 million shares outstanding, the total shares
outstanding are increased to 1.1 million shares after the stock dividend is
issued.
(iv) Bond Dividend: In rare instances, dividends are paid in the
form of bonds for a long-term period. The firm generally pays interest on
these bonds and repay the bonds on maturity. Bond dividend enables the
firm to postpone payment of cash.
(v) Property Dividend: Sometimes, dividend is paid in the form of
asset instead of payment of dividend in cash. The distribution of dividend
188
is made whenever the asset is no longer required in the business such as Capital Structure
investment or stock of finished goods.
But it is however important to note that in India, distribution of
dividend is permissible in the form of cash or bonus shares only. NOTES
Distribution of dividend in any other form is not allowed.
14.14. 4 Meaning of Dividend Policy:
Dividend policy refers to the policy chalked out by firms regarding
the amount they would pay to their shareholders as dividend. Once firms
make profits, they have to decide on what to do with these profits. The
firms have two options with them:
They can retain these profits within the firm.
They can pay these profits in the form of dividends to their
shareholders.
The dividend policy to be adopted by the firm is based on these two
options. If the firm pays dividends, it affects the cash flow position of the
firm but earns goodwill among the investors who, therefore, may be
willing to provide additional funds for the financing of investment plans of
the firm. On the other hand, the profit which are not distributed as
dividends become an easily available source of funds at no explicit costs.
However, in the case of ploughing back of profits, the firm may lose the
goodwill and confidence of the investors and may also defy the standards
set by other firms. Therefore, in taking the dividend policy, the finance
manager has to strike a balance between distribution and retention. He
should allocate the earnings between dividends and retained earnings in
such a way that the value of the firm (i.e., wealth of shareholders) is
maximized.
14.14.5 Definition of Dividend Policy:
The term dividend policy has been defined by some authors as
given below:
(i) Weston and Brigham: Dividend policy determines the division
of earnings between payments to shareholders and retained earnings.
(ii) Gitman: The firm’s dividend policy represents a plan of action
to be followed whenever the dividend decision must be made.
14.14.6 Nature of Dividend Policy:
The above discussion has brought to light the nature of dividend
policy as given bellow:
(i) Tied up with retained earnings: A dividend policy is tied up
with the retained earnings policy. It has the effect of dividing net earnings
of the firm into two parts: retained earnings and dividend.
(ii) Influence on financing decision: Dividend policy has an
influence on the financing decision of the business. Distribution of
dividends reduces the cash funds of the business and to that extent it has to
depend upon external sources of finance. The cost of funds raised from
external sources is relatively higher than the cost of retained earnings. The
management will decide to pay dividend when the firm does not have
profitable investment opportunities.
(iii) Impact on shares: Dividend policy of the firm has far
reaching consequences on the share prices, growth rate of the business and
the wealth of shareholders. Due to market imperfections and uncertainty,
shareholders give a higher weightage to the current dividends rather than
future dividends and capital gains.
189
Capital Structure Thus, the payment of dividends influences the market price of shares.
Higher the rate of dividends, greater the price of shares and vice versa.
Higher market price of shares and bigger current dividends enhance the
NOTES wealth of shareholders.
(iv) Optimal dividend policy: As dividend is an active decision
variable, it has to be intelligently managed by the finance manager who
should endeavour to formulate an optimal dividend policy i.e., a policy
with few or no dividends payment fluctuations, over a long period of time
, having a favourable impact on the wealth of shareholders.
14.14.7 Objectives of Dividend Policy:
Following are the major objectives of dividend policy of a firm.
(i) Providing sufficient financing: As dividend policy has a direct bearing
on retained earnings of a firm, the first objective of its dividend policy
should be to ensure that retain earnings are sufficient enough to finance the
investment requirements of the firm.
(ii) Return to shareholders: The second objective of a dividend policy
should be to ensure a reasonable rate of return to shareholders in the form
of dividend in order to satisfy their desire for current income and develop
their confidence in the firm’s successful operations.
(i) Wealth maximization: The third objective of a firm’s dividend
policy should be to maximise the shareholder’s wealth in
the long run through retention of earnings and their
investment in profitable projects.
14.14.8 Factors determining Dividend Policy:
Following are the factors which influence the dividend policy of a
firm:
(i) Stability of earnings: The nature of business has an important bearing
on the dividend policy. Industrial units having stability of earnings may
formulate a more consistent dividend policy than those having an uneven
flow of incomes because they can predict easily their savings and earnings.
Usually firms dealing in necessities suffer less from oscillating earnings
than those dealing in luxuries or fancy goods.
(ii) Age of firm: Age of the firm counts much in deciding the dividend
policy. A newly established firm may require much of its earnings for
expansion and plant improvement and may adopt a rigid dividend policy.
While, on the other hand, an older company can formulate a clear cut and
more consistent policy regarding dividend.
(iii) Regularity and stability in dividend payment: Dividend should be
paid regularly because each investor is interested in the regular payment of
dividend. The management should, in spite of regular payment of dividend,
consider that the rate of dividend should be all the more constant. For the
purpose, sometimes firms maintain dividend equalization fund.
(iv) Time for payment of dividend: When should the dividend be paid is
another consideration. Payment of dividend means outflow of cash. It is,
therefore, desirable to distribute dividend at a time when cash is least
needed by the firm because there are peak times as well as lean periods of
expenditure. Wise management should plan the payment of dividend in
such a manner that there is no cash outflow at a time when the firm is
already in need of funds.
(v) Liquidity of funds: Availability of cash and sound financial position is
also an important factor in dividend decision. A dividend represents a cash
flow and the greater the fund and the liquidity of the firm, the better the
190
ability to pay dividend. The liquidity of a firm depends very much on the Capital Structure
investment and finance decisions of the firm which in turn determine the
rate of expansion and the manner of financing. If cash position is weak,
stock dividend can be distributed and if cash position is good, the firm can NOTES
distribute the cash dividend.
(xi)Policy of control: If the directors want to have control on firm,
they would not like to add new shareholders and therefore, declare
dividend at low rate. Because by adding new shareholders, they fear
dilution of control and diversion of policies and programmes of the
existing management. So, they prefer to meet the need for funds through
retained earnings. If the directors do not bother about the control of affairs,
they will follow a liberal dividend policy. Thus, control is an influencing
factor in framing the dividend policy.
(vii) Repayment of loan: Firms having loan indebtedness are
vowed to a high rate of retention earnings, unless some other arrangements
are made for the redemption of debt on maturity. It will naturally lower
down the rate of dividend. Sometimes, the lenders (mostly institutional
lenders) put restrictions on the dividend distribution till such time their
loan is outstanding. Formal loan contracts generally provide a certain
standard of liquidity and solvency to be maintained. Management is bound
to consider such restrictions and to limit the rate of dividend payout .
(viii)Government policies: The earning capacity of the firm is
widely affected by the change in fiscal, industrial, labour, control and other
government policies. Sometimes government restricts the distribution of
dividend beyond a certain percentage in a particular industry or in all
spheres of business activity as was done in emergency. The dividend policy
has to be modified or formulated by firms according to such restrictions.
(ix)Legal requirements: In deciding on the dividend, the directors
take the legal requirements too into consideration. In order to protect the
interests of creditors, and outsiders, the Companies Act 1956 prescribes
certain guidelines in respect of the distribution and payment of dividend.
Moreover, a firm is required to provide for depreciation on its fixed and
tangible assets before declaring dividend on shares. It proposes that
dividend should not be distributed out of capital in any case. Likewise,
contractual obligations should also be fulfilled, for example, payment of
dividend on preference shares in priority over ordinary dividend.
(x)Trade cycles: Business cycles also exercise influence upon
dividend policy. Dividend period is adjusted according to the business
oscillations. During the boom, prudent management creates reserves for
contingencies which follow the inflationary period. High rates of dividend
can be used as a tool for marketing the securities in an otherwise depressed
market. The financial solvency can be proved and maintained by the firms
in dull years if adequate reserves have been built up.
(xi) Need for additional capital: Firms retain a part of their profits
for strengthening their financial position. The income may be conserved
for meeting the increased requirement of working capital or of future
expansion. Small companies usually find difficulties in raising finance for
their needs of increased working capital for expansion programmes. They,
having no other alternative, use their ploughed back profits. Thus, such
firms distribute dividend at low rates and retain a large part of profits.
(xii) Ability to borrow: Well established and large firms have
better access to the capital market than the new firms and may borrow
191
Capital Structure funds from the external sources if there arises any need. Such firms may
have a better dividend pay-out ratio. Whereas smaller firms have to depend
on their internal sources and therefore they will have to build up good
NOTES reserves by reducing the dividend pay-out ratio for meeting any obligation
requiring heavy funds.
(xiii) Extent of share distribution: Nature of ownership also
affects the dividend decision. A closely held firm is likely to get the assent
of the shareholders for the suspension of dividend or for following a
conservative dividend policy. On the other hand, a firm having a good
number of shareholders widely distributed and forming low- or middle-
income group, would face great difficulty in securing such assent because
they will emphasise to distribute higher dividend.
(xiv) Past dividend rates: While formulating the dividend policy,
the directors must keep in mind the dividends paid in past years. The
current rate should be around the average past rate. If it is abnormally
increased the shares will be subjected to speculation. In a new concern, the
firm should consider the dividend policy of the rival organisations.
(xv) Taxation: The tax status of the major shareholders also affects
the dividend decision sometimes. For example, if a firm is owned by a few
shareholders in the high-income tax bracket, it would be in their interest
not to receive too high an amount of dividend. Such shareholders may be
interested in taking their return from the investment in the form of capital
gains rather than in the form of dividends.
14.14.9 Types of Dividend Policy
Following are the different types of dividend policy that are
generally pursued in firms:
(i) Generous Dividend Policy: Firms which adopt this dividend
policy, reward shareholders generously by stepping up total dividend
payment over time Typically, these firms maintain the dividend rate at a
certain level (15% to 25%) and issue bonus shares when reserves position
and earnings potential permit. Such firms normally have a strong
shareholders orientation.
(ii) Erratic Dividend Policy: Firms which follow this dividend
policy, do not bother about the welfare of equity shareholders. Dividends
are paid erratically whenever the management believes that it will not
strain its resources.
(iii) Stable Dividend Policy: Firms which adopt this dividend
policy pay a fixed number of dividends regularly irrespective of
fluctuations in earnings year after year. This policy attaches equal
importance to the financial requirements of the firm and interest of the
shareholders. The stable dividend may be in any of the following three
forms.
(a) Constant dividend per share: Firm follows a policy of paying certain
fixed amount per share as dividend.
(b) Constant pay-out ratio: Firm pays fixed percentage of earnings every
year. With this policy, the amount of dividend will fluctuate in direct
proportion to earnings.
(c) Constant dividend per share plus extra dividend: Firm usually pays
a fixed dividend to the shareholders and additional dividend in a year of
good earnings.
14.14.10 Advantages of Stable Dividend Policy
(i)This policy provides regular income to investors of the firm.
192
(ii) It helps to maintain stability in market values of the firm's shares. Capital Structure
(iii) Firms which follow this policy enjoy a high degree of investor
confidence.
(iv) Firms with stable dividend policy have always high credit standing in NOTES
the market. They can raise as much funds as they like from the market
because of widespread demand of their shares.
14.14.11 Limitation of Stable Dividend Policy
The greatest danger associated with a stable dividend policy is that
once it is adopted by the firm, it cannot be changed without seriously
affecting the confidence of shareholders in management and the credit
worthiness of the firm Therefore it is prudent that the dividend rate is fixed
at a lower level so that it can be maintained even in years with reduced
profits.
14.14.12 Dividend Theories
There are conflicting opinions regarding impact of dividend
decision on the value of firm. The dividend theories are broadly classified
into two groups i.e. 1. Theories of relevance, and 2. Theories of
irrelevance.
1. Theories of Relevance (Relevance concept of Dividend)
These theories associated with Walter and Gordon models hold that
the dividend policy of a firm has a direct effect on the position of the firm
in the stock exchange. Because higher dividend increases the value of
shares, whereas low dividend decreases its value in the market due to the
fact that dividend actually presents information relating to the profit
earning capacity or profitability of a firm to the investors. Two models
representing this argument may be discussed below:
(a)Walter's Model
Professor James. E. Walter argues that dividend policy is an active
variable that influences share price and also value of the firm. Both
dividend policy and investment policy are inseparable business decisions.
In determining the significance of dividend policy, Walter holds that the
relationship between the firm's internal rate of return (r) and Cost of
Capital (k) is crucial. If the r> k, the firm should retain the earnings. It
should distribute its earnings if r < k so that the shareholders can make
higher earnings by investing elsewhere. Thus, Walter has related dividend
policy with investment opportunities of the firm. Where firm has ample
investment opportunities promising higher return than cost of capital, it
should retain earnings. Such a firm is called growth firm. Optimum
dividend policy for such a firm would be no dividend distribution.
On the contrary, if a firm lacks in such investment opportunities as
could assure rate of return higher than cost of capital, it should distribute its
earnings. Cent-per cent distribution of earnings constitutes the optimum
dividend policy of such firm called declining firm.
There is another category of firm whose internal rate of return is
equal to cost of capital. Such firm is known as normal firm. In such firm,
shareholders are indifferent between retention and distribution of earnings.
14.14.13 Assumptions
Walter's proposition is based on the following assumptions:
(i)Retained earnings represent the only source of financing for the firm.
(ii) The return on the firm's investment remains constant.
(iii) The cost of capital for the firm remains constant.
193
Capital Structure (iv) The firm has an infinite life.
(v) All the earnings are distributed or reinvested in the firm.
(vi) Earnings per share and dividend remain constant in determining a
NOTES given value.
Walter's Formula
The following formula can be applied to determine the market price
per share under Walter's model:
D+ x (E-D)
K
Market price per share (P) =
K
where
D=Dividend per share
r=Rate of return on investment by firm
k=Cost of Capital
E=Earnings per share.
Inference / implications
As pointed earlier, the following inferences are to be made in
Walter's modal:
(a) The optimal payment ratio for a growth firm is Nil.
(b) Pay-out ratio f for a normal firm is irrelevant.
(c) Optimal pay-out ratio for a declining firm is 100%
(d) Higher the retention ratio, higher is the value of the firm and vice versa
Criticisms
(i) No external financing: This assumption may lead to sub-optimal
investment opportunities since it is not always possible to go in for equity
financing, particularly when the equity funding is costlier than the external
financing.
(ii) Constant rate of return: When the amount of investments increases
the return made for every incremental rupee of investment falls.
(iii) Constant opportunity cost: Firm's cost of capital does not remain
constant. It changes with changes in the firm's risk. Firm's risk undergoes a
change over time. By assuming a constant discount rate (i.e., cost of
capital), this model ignores the effect of risk on the value of the firm.
(b) Gordon's Model
Myron J. Gorden has also put forth a model arguing for relevance
of dividend decision to valuation of firm. The model is founded on the
following
(i) The firm is an equity firm. No external financing is used, and
investment programmes are financed exclusively by retained earnings.
(ii) The internal rate of return (r) and appropriate discount rate (k) for the
firm are constant.
(iii)The firm has perpetual life and its stream of earnings are perpetual.
(iv) The corporate taxes do not exist.
(v) The retention ratio (b) once decided upon is s constant. Thus, the
growth rate (g) (g= br) is also constant.
(vi) Cost of capital (k) is greater than the growth rate (g).
Like Walter, relevance of dividend policy to valuation of firm has
been held by Gordon. He is of the view that investors always prefer
dividend as current income to dividend to be obtained in future because
they are rational and would be non chalant to take risk. The payment of
current dividends completely removes any possibility of risk. They would
194
lay less emphasis on future dividends as compared to the current dividend. Capital Structure
This is why when a firm retains is earnings, its share value receives set
back. Investors preference for current dividend exists even in situation
where r= k. This sharply contrasts with Walter's model which holds that NOTES
investors are indifferent between dividends and retention when r=k.
Gordon's Formula
Gordon has provided the following formula to determine the market
value of a share.
Market value per share (P) =

where,
D=Dividend per share k=Cost of capital
g=Growth rate = b x r E=Earnings per share
b=Retention ratio r=Rate of return.
Implications
(a) The optimal pay-out ratio for a growth firm is Nil
(b) The pay-out ratio for a normal firm is irrelevant
(c) The optimal pay-out ratio for a declining firm is 100%.
Criticisms
(i)Assumption of 100% equity funding defeats the objective of
maximization of wealth, by leveraging against a lower cost of debt capital.
(ii) Constant rate of return and current opportunity cost is not in tune with
realities.
2.Theories of Irrelevance (Irrelevance concept of dividend)
These theories associated with Modigliani and Miller hold that
dividend policy has no effect on the share prices of a firm and is therefore
of no consequence. Investors are basically indifferent between current cash
dividends and future capital gains. They are basically interested in getting
higher return on their investments. If the firm has adequate investment
opportunities giving a higher rate of return than the cost of retained
earnings, the investors will be satisfied with the firm for retaining the
earnings. However, in case, the expected return on projects is less than
what it would cost, the investors would prefer to receive dividends. So, it is
needless to mention that a dividend decision is nothing but a financing
decision. In short, if the firm has profitable investment opportunities, it will
retain the earnings for investment purposes or if not, the said earnings
should be distributed by way of divided among the investors/shareholders.
Modigliani-Miller Hypothesis (M.M. Model)

Modigliani-Miller argue that value of a firm is determined by its
earnings potentiality and investment pattern and not by dividend
distribution. According to them, the dividend decision is irrelevant, and it
does not affect the market value of equity shares, because the increase in
wealth of shareholders resulting from dividend payments will be offset
subsequently when additional share capital is raised. If the additional
capital is raised in order to meet the funds requirement, it will dilute the
existing share capital which will reduce the share value to the original
position.
Assumptions
The above theory is based on the following assumptions:
195
Capital Structure 1. Capital markets are prefect. Investors are free to buy and sell securities.
There are no transaction costs. The investors behave rationally. They can
borrow without restrictions on the same terms as the firms do.
NOTES 2. There are no corporate and personal taxes. If taxes exist, the tax rates are
the same for dividend and capital gains.
3. The firm has a fixed investment policy under which at each year end, it
invests a specific amount as capital expenditure.
4. Investors are able to predict future dividends and l future market prices
and there is only one discount rate for the entire period.
5. All investments are funded either by equity or by retained earnings.
Determination of Market price of share
Under M.M. Model, the market price of a share at the beginning of
the period (Po) is equal to the present value of dividends received at the
end of the period plus the market price of the share at the end of the period.
Po = Present value of Dividends received + Market price of the
share at the end of the period.
This can be expressed as follows:
Po =
The market price of the share at the end of the period (P1) can be
ascertained as follows:
P1=po(1+ke)-D1
where,
P1= Market price per share at the end of the period.
Po=Market price per share at the beginning of the period i.e.,
current market price.
Ke= Cost of equity capital
D1= Dividend per share at the end of the period.
Determination of No. of New shares
The investment requirements of a firm can be financed by retained
earnings or issue of new shares or both. The number of new shares to be
issued can be determined as follows:
Investment Proposed. xxx
less: Retained earnings available for investment:
Net income xx
(-) Dividends distributed. xx
xxx
Amount to be raised by issue of new shares. xxx
No. of New shares =
Implications
1. Higher the retention ratio, higher is the capital appreciation enjoyed by
the shareholders. The capital appreciation is equal to the amount of
earnings retained.
2. If the firm distributes earnings by way of dividends, the shareholders
enjoy dividends equal to the amount of capital appreciation if the firm had
retained the number of dividends.
Criticisms
The MM model may be criticized as follows:
196
(i) The assumption of perfect capital market is theoretical in nature as the Capital Structure
perfect capital market is never found in practice
(ii) Following propositions on dividend are impracticable and unrealistic:
(a) Investors can switch between capital gains and dividends NOTES
(b) Dividends are irrelevant, and
(c) Dividends do not determine the firm value.
(iii) The Situation of zero taxes is not possible
(iv) The assumption of no stock floatation or time lag and no transaction
costs are impossible.
ILLUSTRATIONS
Illustrations:1 (Growth firm)-Walter Model
The cost of capital and the rate of return on investment of Rafael
Ltd. are 10% and 18% respectively. The company has 5 lakh equity shares
of Rs. 10 each and earnings per share are Rs. 20. Compute the market price
per share and value of firm in the following sit ns. Use Walter Model and
comment on the results.
(i)No retention, (ii) 40% retention, (iii) 80% retention.
Solution:
(i) 0% retention: 100 % pay-out
r
D+ (E-D)
K
Market price per share under Walter Model =
K
D=Dividend per share = EPS x Pay-out

=20x 100% = Rs. 20
r=Rate of return =18%
k=Cost of capital =10%
E=Earnings per share =Rs. 20
0.18
20 + (20-20)
0.10
Market price per share =
0.10
= 20 / 0.10 = Rs. 200.
Value of firm: No. of equity shares x Market price per share
=5,00,000x 200
=Rs. 10,00,00,000
(ii) 40% retention; 60% pay-out
D = per share :20 x 60% = Rs.12
0.18
12 + (20-12)
0.10
0.10
26.4
= = Rs.264
0.10
Value of firm: 5,00,000 shares x Rs. 264 =Rs. 13,20,00,000
(iii) 80% retention: 20% pay-out
197
Capital Structure D= Dividend per share 20x 20%=Rs.4
0.18
4+ (20-4)
NOTES 0.10
0.10
32.8
= = Rs.328
0.10
Value of Firm: 5,00,000 shares× 328 = Rs. 16.40,00,000
Analysis: Rafeal Ltd is a growth firm (r>k). As pay-out increases,
the value of firm decreases. Ideal pay-out is 0%.
Illustration: 2 (Normal firm)-Walter Model
The earnings per share of Nadal Ltd. are Rs. 15 and the rate of
capitalization applicable to the company is 12%. The productivity of
earnings (r) is 12%.
Compute the market value of the company's share if the pay-out is
(i) 20%; (ii) 50% (iii) 70%. Which is the optimum pay-out?
Solution:
Computation of market value per share
(i) Pay-out 20%
r
D+ (E -D)
K
K
D = Dividend per share = EPS x Pay-out ratio

=15x 20% = Rs.3
r= Rate of return =12%
k= Cost of capital = 12%
E=Earnings per share = Rs. 15
0.12
3+ (15-3)
0.12
0.12
15
= = Rs.125
0.12
(ii) Payout = 50%
D=Dividend per share =15 x 50%=Rs. 7.50

0.12
7.50+ (15-7.50)
0.12
0.12
198
Capital Structure
15
= = Rs.328
0.10 NOTES
(iii) Pay-out is 70%
D=Dividend per share=15x 70%=Rs, 10.5
0.12
10.5+ (15-10.5)
0.12
0.12
15
= = Rs.125
0.12
Analysis: Nadal Ltd. is a normal firm (r-k). Market value per share
remains the same for all pay outs. Hence there is no optimum pay-out.
Illustration: 3 (Declining firm)-Walter Model

The earnings per share of Wick Mayer Ltd. are Rs. 12. The rate of
capitalization is 15% and the rate of return on investment is 9%.
Compute the market price per share using Walter's formula if the
dividend pay-out is (a) 25% (b) 50% and (c) 100%. Which is the
ideal pay-out?
Solution:
(i) Computation of market price per share when pay-out is 25%
r
D+ (E-D)
k
k
D=Dividend per share=EPS x Pay-out ratio

=12 x 25%Rs. 3
r=Rate of return=9%
k=Cost of capital=15%
E=Earnings per share-Rs. 12
0.09
3+ (12-3)
0.15
0.15
8.4
= = Rs.56
0.15
(ii) Computation of market price per share when payout is 50%
D=Dividend per share = 12x 50%=Rs.6
0.09
6+ (12-6)
199
Capital Structure 0.15
0.15
NOTES 9.6
= = Rs.64
0.15
(iii) Computation of market price per share when pay-out is 100°%
D=Dividend per share = 12x 100% = Rs. 12
0.09
12+ (12-12)
0.15
Market price per share
0.15
12
= = Rs.80
0.15
Analysis: Wickmayer Ltd. Is a declining firm (r <k). Market price
per share is the highest when pay-out ratio is 100% Hence, the ideal pay-
out ratio for the company is 100%.
Illustration: 5
The following information is available in respect of Gill Ltd:
Earnings per share: RS. 15 Cost of capital: 10%
Find out the market price of the share applying Walter Model under
different rates of return of 8%, 10% and 15% for different pay-out ratios of
0%, 40% and 100%.
Solution:
(i) Computation of market price of share if pay-out ratio is 0%
(a) Rate of return (r) = 8%
r
D+ (E-D)
k
k
D = Dividend per share = 15 x 0% = 0
K = Cost of capital = 10%
E = Earnings per share = RS. 15
0.08
0 + (15-0)
0.10
0.10
= 12/0.10 = RS. 120
(b) Rate of return (r) = 10%

0.10
0 + (15-0)
0.10
200
0.10 Capital Structure
= 15/0.10 = RS. 150
(c) Rate of return (r) = 15%
0.15 NOTES
0 + (15-0)
0.10
0.10
= 22.5/0.10 = RS. 225
(ii) Computation of market price of share if pay-out ratio is 40%

r
D+ (E-D)
k
k
D = Dividend per share = 15 x 40% =RS.6
0.08
6 + (15-6)
0.10
0.10
= 13.2/0.10 = RS. 132

0.10
6 + (15-6)
0.10
0.10
= 15/0.10 = RS. 150

Market price of share = 6+ [0.15/0.10] (15-6)/0.10
= 19.5/0.10 = RS. 195
(iii) Computation of market price of share if pay-out ratio is 100%
r
D+ (E-D)
k
k
D = Dividend per share = 15 x 410% =RS.15

0.08
201
Capital Structure 15 + (15-15)
0.10
NOTES 0.10
= 15/0.10 = RS. 150
= 15/0.10 = RS. 150
0.15
15 + (15-15)
0.10
0.10
= 15/0.10 = RS. 150
Illustrations: 6 (Growth firm) – Gordon Model

The following data relates to Yanina Ltd.
Earnings per share = RS.14
Capitalisation rate = 15%
Rate of return = 20%
Determine the market price per share under Gordon’s Model if
retention is (a) 40%, (b) 60%, (c) 20%.
Solution:
Computation of market price per share under Gordon’s Model
(a) Retention ratio = 40%
D
Market value per share (p) =
k-g
D = Dividend per share = Eps x pay-out ratio
= 14x60% = RS. 8.40
g = Growth rate = Retention ratio (b) x Rate of return (r)
= 40% x 20%
= 0.4 x 0.2
= 0.08 x 100 = 8%
8.40
15%-8%
= 8.40/7% = RS. 120
(b) If Retention ratio = 60%
D
k-g
= 14x40% = RS. 5.6
= 60% x 20%
= 0.6 x 0.2
= 0.12 x 100% = 12%
5.6
15%-12%
202
= 5.6/3% = RS. 186.67 Capital Structure
(c) If Retention ratio = 20%
Market price per share = D/K-g
D = Dividend per share = Eps x pay-out ratio NOTES
= 14x80% = RS. 11.20
= 20% x 20%
= 0.2 x 0.2
= 0.04 x 100% = 4%
11.20
15%-4%
= 11.20/11% = RS. 101.182
Analysis: Yanina Ltd is a growth firm (r>k)
Illustration: 7 (Normal firm) – Gordon Model

Du preez Ltd. gives you the following information:
Earnings per share: RS. 45
Cost of capital: 18%
Return on investment: 18%
Ascertain the market value per share using Gordon’s Model, if the pay-
out is (a) 30%, (b) 60%, (c) 90%.
Solution:
(a) pay-out ratio = 30%: Retention ratio = 40%

D
k-g
= 45x30% = RS. 13.50
= 70% x 18%
= 0.7 x 0.18
= 0.126 x 100 = 12.6%
13.50
18%-12.6%
= 13.50/5.40% = RS. 250
(b) pay-out ratio = 60%; Retention ratio = 40%

= 45x60% = RS. 27
= 40% x 18%
= 0.4 x 0.18
= 0.072 x 100% = 7.2%
27
18%-7.2%
= 27/10.8% = RS. 250
203
Capital Structure
(c) pay-out ratio = 90%; Retention ratio = 10%
NOTES = 45x90% = RS. 40.50
= 10% x 18%
= 0.1 x 0.18
= 0.018 x 100% = 1.8%
40.50
18%-1.8%
= 40.50/16.2% = RS. 250
Analysis: Du Preez Ltd is a normal firm (r=k). the share price remains the
same for different pay-out ratios.
Illustration: 8(Declining firm)- Gordon Model
Perkins Ltd. earns a profit of Rs. 35 per share. The rate of
capitalization is 15% and the productivity of retained earnings is 10%.
Using Gordon’s model, determine the market price per share if the pay-
out is (a) 20%, (b) 40% and (c) 70%
Solution:
(a) Pay-out ratio: 20%: Retention ratio :80%
Market price per share = D/k-g
D= Dividend per share = EPS x pay-out ratio
= 35 x 20% = Rs.7
G = Growth rate = Retention ratio (b) x Rate of
return (r)
= 80% x 10%
= 0.8 x 0.10 = 0.08 x 100 = 8%
/Market price per share = 7/15%-8%
= 7/7% = Rs.100
(b) Pay-out ratio = 40% : Retention ratio = 60%
D = Dividend per share = 35 x 40% = Rs.14
G = Growth rate = b x r = 60% x 10%
= 0.6 x 0.10 = 0.06 x 100
= 6%
Market price per share = 14/15%- 6% = 14/9%
= Rs. 155.56
(c) Pay-out ratio = 70%: Retention ratio = 30%
D= Dividend per share = 35 x 70% = Rs.24.5
G = Growth rate = b x r = 30% x 10%
= 0.3 x 0.10 = 0.03 x 100
=3%
Market price per share = 24.5/15%-3%
= 24.5/12% =Rs. 204.17
Analysis: Perkins Ltd. is a declining firm (r<k)
1.What are the differences between capital structure and capitalization?
2. Define capital structure.
3. The earnings per share of N Ltd. are Rs. 15 and the rate of capitalization
applicable to the company is 12%. The productivity of earnings (r) is 12%.
204
Calculate the market value of the company's share if the pay-out is Capital Structure
(i) 20%; (ii) 50% (iii) 70%. Which is the optimum pay-out?
14.16. Answers to Check Your Progress Questions NOTES
1.
Basis Capital Structure Capitalization
1.Coverage It refers to mix of various It refers to all long-term
sources of capital e.g. securities e.g. equity, debt
Capital, debt, etc. and free reserves not
2.Scope It is an overall policy meant for distribution.
decision about the It is implementation of
proportion of various policy decision about
sources of long-term capital structure.
finance.
3.Nature It is a qualitative decision It is a quantitative
decision.
2. Capital structure refers to the composition of long-term sources of funds

such as debentures, long term debt, preference share capital and ordinary
share capital including reserves and surpluses (retained earnings).
3. calculation of market value per share

(i) Pay-out 20%
r
D+ (E -D)
K
K
D = Dividend per share = EPS x Pay-out ratio

=15x 20% = Rs.3
r= Rate of return =12%
k= Cost of capital = 12%
E=Earnings per share = Rs. 15
0.12
3+ (15-3)
0.12
0.12
15
= = Rs.125
0.12
(ii) Pay-out = 50%
D=Dividend per share =15 x 50%=Rs. 7.50
0.12
7.50+ (15-7.50)
0.12
0.12
15
205
Capital Structure = = Rs.328
0.10
(iii) Pay-out is 70%
NOTES D=Dividend per share=15x 70%=Rs, 10.5
0.12
10.5+ (15-10.5)
0.12
0.12
15
= = Rs.125
0.12
Analysis: N Ltd. is a normal firm (r-k). Market value per share
remains the same for all pay outs. Hence there is no optimum pay-out.
1. What are the features of an appropriate capital structure?

2.What are the points to be taken into consideration while determining
capital structure?
3. ABC Ltd has an EBIT of Rs. 1,60,000. Its capital structure consists of
the following securities:
10% Debentures
Rs.5,00,000
12% Preference shares Rs.1,00,000
Equity shares of Rs. I00 Rs.4,00,000
The company is in the 55% tax bracket. You are required to determine:
(a) The company's EPS
(b) The percentage change in EPS associated with 30% increase and 30%
decrease in EBIT
4. Good shape Company has currently an ordinary share capital of Rs, 25
lakh, consisting of 25,000 shares of s. 100 each. The management is
planning to raise another 20 lakh to finance a major programme of
expansion through one of four possible financing plans. The options are as
under:
(a) Entirely through ordinary shares.
(b) RS.10 lakh through ordinary shares and Rs. Lakh through long term
borrowing at 15% interest per annum.
(c) Rs. 5 lakh through ordinary shares and Rs.15 lakh through long term
borrowings at 16% interest per annum.
(d) Rs. 10 lakh through ordinary shares and Rs.10 lakh through preference
shares with 14% dividend.
The company's expected EBIT will be Rs. 8 lakh. Assuming a corporate
tax rate of 50% determine the EPS in each alternative and suggest the best
alternative.
5. Universal Ltd. wants to implement a project for which Rs.60 lakh is to
be raised.
The following financial plans are under evaluation:
Plan A: issue off 6 lakhs equity shares of Rs. 10 each,
Plan B: Issue of 30,000 10% non-convertible debentures of Rs. 100 each
and issue of 3 lakhs equity shares of Rs. 10 each.
206
Assuming a corporate tax of 55%, calculate the indifference point. Capital Structure
6. The following information is available in respect of Khan Ltd.:

Number of shares issued 10,000 NOTES
Market price per share Rs.20
Interest rate 12%
Tax rate 46%
Expected EBIT Rs.15,000
The firm needs Rs.50,000 for investment next year. Should the firm issue
debt or equity to produce higher EPS? Also find out the difference level of
EBIT for the two alternatives. What is the EPS for that EBIT?
7. Krishna Ltd is expecting an annual EBIT of Rs.2,00,000. The company

has Rs.7,00,000 in 10% debentures. The cost of equity capital or
capitalization rate is 12.5%. You are required to calculate the total value of
the firm. Also ascertain the overall cost of capital.
8. Skylekha Ltd. has an EBIT The of Rs.2,50,000. The cost of debt is 8%
and the outstanding debt is Rs.10,00,000. The overall capitalization rate
(Ke)is 12.5%. Calculate the total value of the firm and equity capitalization
rate under NOI Approach.
9. From the following data relating to Vasanth Ltd., calculate the market
value of the company and overall cost of capital:
Net operating income 1,20,000
Total investment 6,00,000
Equity capitalization rate:

(a) If the company uses no debt = 10%
(b) If the company uses a debt of Rs.2,40,000 = 11%.
(c) If the company uses a debt of Rs.3,60,000 =12%
The debt of Rs.2,40,000 can be raised at 5% rate of interest, while the debt
of Rs.3,60,000 can be raised at 7%.
10. (With tax) Merry Lid. has earnings before interest and taxes (EBIT) of
Rs.30,00,000 and a 40% tax rate. Its required rate of return on equity in the
absence of borrowing world is 18%. In the absence of personal taxes, what
is the of the company in MM world (i) with no leverage; (ii) with
Rs.40,00,000 in debt; and (iii) with Rs.70,00,000 in debt?
11. The following information relates to Siddle Ltd:
EPS Rs.10 IRR 18%
Cost of capital 20% Pay-out ratio 40%
Compute the market price under the Walter's model.
12. The cost of capital and the rate of return on investment of WM Ltd. is
10% and 15% respectively. The company has one million equity shares of
Rs. 10 each outstanding and its earnings per share are Rs. 5. Calculate
value of the firm in the following situations using Walter's model: (i) 100%
retention, (ii). 50% retention, and (iii). No retention. Comment on the
results.
13. Details regarding three companies are given below:
A Ltd. B Ltd. CLtd
r= 15% r= 10% r= 8%
ke = 10% ke = 10% ke = 10%
E= Rs. 10 E= Rs. 10 E= Rs. 10
By using Walter's model, you are required to:
207
Capital Structure (i) Calculate the value of an equity share of each these companies when
dividend pay-out ratio is (a) 20%, (b) 50%, of each (c). 0 and (d). 100%.
(ii) Comment on the results drawn.
NOTES 14. Following are the details regarding three companies AI Ltd. and C Ltd.
Details A Ltd B Ltd C Ltd
Internal rate of return. 15% 5% 10%
Cost of equity capital 10% 10% 10%
Earnings per share Rs. 8 Rs. 8 Rs. 8
Calculate the value of an equity share of each of these company applying
Walter’s formula when dividend pay-out ratio (D/P ratio) is (i). 50
applying Walter's Y% and (iii). 25%.
15. Victory Ltd. earns Rs.5 per share. The capitalisation rate is 10% and
the return on investment is 12%. Under Walter's model, determine
(a) the optimum pay-out
(b) the market price of the share at this pay-out.
(c) the market price of the share if the pay-out is 20%
(d) the market price of the share if the pay-out is 40%.
16. The earnings per share of a company are Rs. 8 and the rate of
capitalization applicable to the company is 10% The company has before it
an option of adopting a pay-out ratio of 25% or 50% and 75%. Using
Walter’s formula of dividend pay-out, compute the market value of the
company’s share if the productivity of retained earnings (i)15% (ii) 10%
and (iii) 5%
17. From the data given below relating to Jayant Ltd. determine the market
price per share under Gordon's model:
EPS Rs. 8 Retention ratio (b) = 25%
Capitalisation rate (k) = 10% Rate of return (r) = 15%
18. Calculate the market price of a share of ABC Ltd. under (i) Walter’s
formula, and (ii). Dividend growth modal from the following date:
Earnings per share Rs.5 Dividend per share Rs.3
Cost of capital 16%Internal rate of return on investment 20%
Retention ratio 40%
19. Anand Corporation Ltd. Belongs to a risk class of which the
appropriate capitalisation rate is 10%. It currently has 1,00,000 shares
quoting Rs. 100 each. The company proposes to declare a dividend of Rs. 6
per share at the end of the current fiscal year which has just begun.
Answer the following questions based on Modigliani and miller model and
assumption of no taxes.
(i) What will be the price of the share at the end of the year if dividend is
not declared?
(ii) What will be the price if dividend is declared?
(iii) Assuming that the company pays dividends, has a net income of Rs. 10
lakh and plans new investment of Rs. 20 lakh during the period, how many
new shares must be issued?
(iv) Is the MM Model realistic? What factors might mar is validity?
Further Reading:

208
4. Theory & Problems in Financial Management: Khan, M.Y. Jain, Capital Structure
P.K. TMH
3rd ed, TMH NOTES
Sultan Chand Publications.
209
DISTANCE EDUCATION – CBCS – (2018 – 2019 Academic Year Onwards)
Question Paper Pattern – Accounting & Financial Management
(PG Programs)
Time: 3 Hours Maximum: 75 Marks
Part – A (10 x 2 = 20 Marks)
Answer all questions
1. What do you mean by double entry system of accounting?
2. Explain the term journal.
3. Write at least four objectives of cash flow statement.
4. Define costing.
5. What is meant by management accounting?
6. Write short on BEP
7. What is idle time variance?
8. What is profit maximization?
9. What is working capital?
10. Explain the term master budget.
Part – B (5 x 5 = 25 Marks)
Answer all questions choosing either (A) or (B)
11. (A) How does double entry system of accounting differ from single entry system of accounting?
(or)
(B) What is trail balance? State its objectives.
12. A) From the following particulars, prepare a cost sheet:
Rs.
Opening stock of raw materials 60,000
Raw materials purchased 9,00,000
Wages paid 4,60,000
Factory overheads 1,84,000
Work-in-Progress (Opening) 24,000
Work-in-progress (Closing) 30,000
Raw materials (Closing stock) 50,000
Finished goods (Opening) 1,20,000
Finished goods (Closing) 1,10,000
Selling and distribution expenses 40,000
Sales 18,00,000
Administration expenses 60,000
(or)
(B) From the following information, calculate cash flow from operating activities using
indirect method.
Statement of Profit and Loss A/c
for the year ended on March 31, 2016
Particular Rs. Rs.

Revenue from operations 4,40,000
Expenses:
Cost of materials consumed 2,40,000
Employees benefits expenses 60,000
Depreciation 40,000
Other expenses:
Insurance premium 16,000
Total expenses 3,56,000
Profit before tax 84,000
Less: Income tax 20,000
Profit after tax 64,000
Particular 31.3.2015 31.3.2015

Trade Receivables 66,000 72,000
Trade Payables 34,000 30,000
Inventory 44,000 54,000
Outstanding employees’ benefits 4,000 6,000
Prepaid insurance 10,000 11,000
Income tax payable 6,000 4,000
13. (A) From the following information extracted from the books of a manufacturing company,
compute the operating cycle in days:
Period covered: 365 days
Average period of credit allowed by suppliers: 16 days
Rs.
Average total of debtors outstanding 4,80,000
Raw materials consumption 44,00,000
Total production cost 1,00,00,000
Total cost of sales 1,05,00,000
Sales for the year 1,60,00,000
Value of Average stock maintained:
Raw materials 3,20,000
Work-in-progress 3,50,000
Finished goods 2,60,000
(or)
(B). Determine the working capital requirements of a company from the information given
below:
Operating cycle components:
Raw materials =60 days
W.I.P =45 days
Finished goods =15 days
Debtors = 30 days
Creditors = 60 days
Annual turnover =73 lakh; Cost structure (as % of sale price) is Materials 50%, Labour
30%, Overheads 10 % and Profit 10%. Of the overheads, 30% constitute depreciation.
Desired cash balance to be held at all times: Rs. 3 lakh.
14. (A) Calculate the material mix variance from the following

A 90 units at rs12 each 100 units at rs. 12 each
B 60 units at rs.15 each 50 units at rs. 16 each
(or)
(B) From the following budgeted figures prepare a Cash Budget in respect of three
months to June 30, 2006.
Rs. Rs. Rs. Rs.
January 70,000 50,000 11,000 6,200
February 66,000 58,000 11,600 6,600
March 74,000 60,000 12,000 6,800
April 90,000 66,000 12,400 7,200
May 94,000 72,000 13,000 8,600
June 86,000 60,000 14,000 8,000
2. Materials and overheads are to be paid during the month following the month of
supply.
3. Wages are to be paid during the month in which they are incurred.
4. All sales are on credit basis.
5. The terms of credits are payment by the end of the month following the month of
sales: Half of credit sales are paid when due the other half to be paid within the month
following actual sales.
6. 5% sales commission is to be paid within in the month following sales
9. Plant and machinery worth Rs. 10,000 is to be installed in the month of January and
the payment are to be made in the month of June.
15. (A) What are the factors determining cost of capital?
(or)
(B) What are the differences between capitalization and capital structure?
Part – C (3 x 10 = 30 Marks)
Answer any three out of five questions
16. Elements of Cost – Explain in detail.
17. Pepsi Company produces a single article. Following cost data is given about its product: ‐
Selling price per unit Rs.40 Marginal cost per unit Rs.24 Fixed cost per annum Rs. 16000
Calculate:
(a)P/V ratio
(b) Break even sales
(c) Sales to earn a profit of Rs. 2,000
(d) Profit at sales of Rs. 60,000
(e) New break-even sales, if price is reduced by 10%.
18. M/s. Alpha Manufacturing Company produces two types of products, viz., Raja and Rani and
sells them in Chennai and Mumbai markets. The following information is made available for
the current year:
Market Product Budgeted Sales Actual Sales

Chennai Raja 400 units @ Rs.9 each 500 units @ Rs.9 each
,, Rani 300 units @ Rs.21 each 200 units @ Rs.21 each
Mumbai Raja 600 units @ Rs.9 each 700 units @ Rs.9 each
Rani 500 units @ Rs.21 each 400 units @ Rs.21 each
Market studies reveal that Raja is popular as it is under priced. It is observed that if its price is
increased by Re.1 it will find a readymade market. On the other hand, Rani is over priced and
market could absorb more sales if its price is reduced to Rs.20. The management has agreed to
give effect to the above price changes.
On the above basis, the following estimates have been prepared by Sales Manager:
% increase in sales over current budget

Product
Chennai Mumbai
Raja 10% 5%
Rani 20% 10%
With the help of an intensive advertisement campaign, the following additional sales above the
estimated sales of sales manager are possible:
Product Chennai Mumbai

Raja 60 units 70 units
Rani 40 units 50 units
You are required to prepare a sales budget.
19. A firm usually forecast cash flows in nominal terms and discounts at a 10.25% nominal rate.
The firm is considering a project at present involving an immediate cash flow of Rs. 20,000 and
has forecasted cash flows in real terms i.e., in terms of current purchasing power of rupees as
follows:
Year 1 2 3
Cash inflow (Rs.) 10000 16000 12000
The firm expects inflation to be at the rate of 5% p.a

Calculate NPA
20. Current scenario of financial management in India – explain

PG MCA Computer Applications 315 21 Accounting and Financial Management 5777

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ALAGAPPA UNIVERSITY

[Accredited with ’A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle

DIRECTORATE OF DISTANCE EDUCATION

ACCOUNTING AND FINANCIAL

Copy Right Reserved For Private use only

“The Copyright shall be vested with Alagappa University”

UNIT – V Cost Sheet 48 - 66

UNIT – XI CAPITAL BUDGETING 112 - 136

Natural Person’s Artificial Persons’ Representatives’

b) Protection of Properties Function:

Dr. Capital account Cr.

Dr. Machinery account Cr.

Dr. Indian Bank account Cr. NOTES

Dr. Purchase account Cr.

Dr. Kamala account Cr.

Dr. Discount account Cr.

Dr. Sales account Cr.

Dr. Balaji account Cr.

Dr. Interest on capital account Cr.

Dr. Plant Account Cr.

Dr. Land and Building Account Cr.

Dr. Proposed Dividend Account Cr.

Cash inflows from operating activities

Net cash from operating activities (A) 3,13,000

UNIT IV - COST AND MANAGEMENT

4.9. Check Your Progress

Self-Assessment Questions and Exercise:

Essay Type Questions:

committee on Terminology, American Institute of Certified Public

5.5.2. Various methods of Cost Accounting

Mention the difficulties involved in installation of a costing system

5.12.2. Classification According to the Function of Companies. Under

Selling Price per unit

Work Cost 30640 383.00 34580 345.80

Office overheads – (20% 6128 76.60 69196 69.16

2. Historical cost, Future costs, Replacement cost, Standard cost, Estimated

Long Answer Questions:

Orient (Rs.) Luminas (Rs.)

Works overhead is 60% of wages and office overhead 20% on work

UNIT -VI BREAK EVEN ANALYSIS

Needless to mention here that RES will be ascertained by dropping a

6.5. Check Your Progress

2. It is difficult to apply formulate in a company. It is a short-run

Self-Assessment Questions and Exercise:

UNIT - VII STANDARD COSTING AND NOTES

= Rs. 14 (Adverse) MPV = (SP – AP) x AQ = (1 – 1.50) x 20

Here Standard Yield Rate =

Net standard output = Gross output – Standard loss

Material Yield Variance=

e) Recovered or Absorbed overheads = Standard rate per unit x Actual

(ii) Variable Overhead Efficiency Variance:

(ii)On the basis of standard hours: Fixed Overhead Volume Variance =

Actual Price per kg

A) Material usage or quantity variance

7.4. Answers to Check Your Progress Questions

Self-Assessment Questions and Exercise:

According to Rowland and William, “Budgets are the individual objectives

a. Past sales figures and trend b. Salesmen’s estimates

Month Sales (Rs.) Month Sales (Rs.)

Month Sales Sales estimation based on cash sales ratio

January 1,10,000 (1,10,000/25,00,000) x 30,00,000 = 1,32,000

February 1,15,000 (1,15,000/25,00,000) x 30,00,000 = 1,38,000

March 1,00,000 (1,00,000/25,00,000) x 30,00,000 = 1,20,000

April 1,40,000 (1,40,000/25,00,000) x 30,00,000 = 1,68,000