FM Notes Unit 3&4

BA 7203 - FINANCIAL MANAGEMENT PEC/MBA
UNIT-III
Concept and measurement of cost of capital - Specific cost and overall cost of capital.
Leverages - Operating and Financial leverage – measurement of leverages – degree of
Operating & Financial leverage – Combined leverage, EBIT – EPS Analysis- Indifference
point. Capital structure – Theories – Net Income Approach, Net Operating Income
Approach, MM Approach – Determinants of Capital structure.
Dividend decision- Issues in dividend decisions, Importance, Relevance & Irrelevance
theories –Walter‟s – Model, Gordon‟s model and MM model. – Factors determining
dividend policy – Types of dividend policies – forms of dividend
COST OF CAPITAL
Definition:
“The cost of capital is the minimum rate of return or cut-off rate for capital expenditure” –
Solomon Ezra
“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” – Hamplon John.J
“The cost of Capital represents a cut-off rate for the allocation of capital to investment
projects. It is the rate of return on a project that will leave unchanged the market price of the
stock”. - James C. Van Horne
IMPORTANCE OF COST OF CAPITAL
1. Designing the capital structure: The cost of capital is the significant factor in
designing a balanced and optimal capital structure of a firm. While designing it, the
management has to consider the objective of maximizing the value of the firm and
minimizing cost of capital. Comparing the various specific costs of different sources of
capital, the financial manager can select the best and the most economical source of
finance and can designed a sound and balanced capital structure.
2. Capital budgeting decisions: The cost of capital sources as a very useful tool in the
process of making capital budgeting decisions. Acceptance or rejection of any
investment proposal depends upon the cost of capital. A proposal shall not be accepted
till its rate of return is greater than the cost of capital. In various methods of discounted
cash flows of capital budgeting, cost of capital measured the financial performance and
determines acceptability of all investment proposals by discounting the cash flows.
3. Comparative study of sources of financing: There are various sources of financing a
project. Out of these, which source should be used at a particular point of time is to be
decided by comparing costs of different sources of financing. The source which bears
the minimum cost of capital would be selected. Although cost of capital is an important
factor in such decisions, but equally important are the considerations of retaining
control and of avoiding risks.
4. Evaluations of financial performance: Cost of capital can be used to evaluate the
financial performance of the capital projects. Such as evaluations can be done by
comparing actual profitability of the project undertaken with the actual cost of capital
of funds raise to finance the project. If the actual profitability of the project is more
than the actual cost of capital, the performance can be evaluated as satisfactory.
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5. Knowledge of firms expected income and inherent risks: Investors can know the
firms expected income and risks inherent there in by cost of capital. If a firms cost of
capital is high, it means the firms present rate of earnings is less, risk is more and
capital structure is imbalanced, in such situations, investors expect higher rate of
return.
6. Financing and Dividend Decisions: The concept of capital can be conveniently
employed as a tool in making other important financial decisions. On the basis,
decisions can be taken regarding dividend policy, capitalization of profits and
selections of sources of working capital.
ASSUMPTIONS OF COST OF CAPITAL

1. Business risk Unaffected by acceptance of the new projects
2. Financial risk of the firm remains unaffected by adopting new Project
3. Cost of capital is determined on an After tax basis
4. Cost of capital is affected by demand and supply of funds
CLASSIFICATIONS OF COST OF CAPITAL
1. Explicit and Implicit cost of capital
2. Future Costs and Historical costs
3. Specific cost and Composite costs
4. Average cost and marginal cost (WACC)
5. Sunk costs – They are usually fixed and conclude the costs of long lived assets
already acquired.
6. Opportunity cost
MEASUREMENT OF COST OF CAPITAL
Components of cost of capital:
a) Cost of Equity Capital (Ke)
b) Cost of Preference capital (Kp)
c) Cost of Debt capital (Kd)
d) Cost of Retained Earnings (Kr)
Combined cost of capital or composite cost of capital or 'Weighted Average Cost of
Capital (WACC)
Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which
each category of capital is proportionately weighted.
All sources of capital, including common stock, preferred stock, bonds and any other long-
term debt, are included in a WACC calculation. A firm’s WACC increases as the beta and
rate of return on equity increase, as an increase in WACC denotes a decrease in valuation and
an increase in risk.
Approach s of WACC
A) Book value weights and
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B) Market value weights

The book value weights are readily available from balance sheet for all types of firms and are
very simple to calculate. On the other hand, for Market Value weights, the market values
have to be determined and it is a real difficult task to acquire accurate data for the same
especially the value of equity when the entity is not listed. Still Market Value WACC is
considered appropriate by analysts because an investor would demand market required rate of
return on the market value of the capital and not the book value of the capital.
CAPITAL STRUCTURE
“Capital structure is the proportion of Debt and Preference and Equity shares on a firm’s
balance sheet”.
Capital structure refers to the composition of long term sources of funds, such as debentures,
long-term debts, preference share capital and ordinary share capital including reserves&
surplus (retained earnings)-IM PONDEY
OPTIMUM CAPITAL STRUCTURE

“The capital structure or combination of debts and Equity that leads to the maximum value
of the firm”
“Optimum capital structure is the capital structure at which the weighted average cost of
capital is minimum and there by maximum value of the firm”
FACTORS DETERMINING CAPITAL STRUCTURE
1. Trading on Equity- The word “equity” denotes the ownership of the company.
Trading on equity means taking advantage of equity share capital to borrowed funds
on reasonable basis. It refers to additional profits that equity shareholders earn
because of issuance of debentures and preference shares. Trading on equity becomes
more important when expectations of shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum voting
rights in a concern as compared to the preference shareholders and debenture holders.
Preference shareholders have reasonably less voting rights while debenture holders
have no voting rights. If the company’s management policies are such that they want
to retain their voting rights in their hands, the capital structure consists of debenture
holders and loans rather than equity shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be such
that there is both contractions as well as relaxation in plans. Debentures and loans can
be refunded back as the time requires. While equity capital cannot be refunded at any
point which provides rigidity to plans. Therefore, in order to make the capital
structure possible, the company should go for issue of debentures and other loans.
4. Choice of investors- The Company’s policy generally is to have different categories
of investors for securities. Therefore, a capital structure should give enough choice to
all kind of investors to invest. Bold and adventurous investors generally go for equity
shares and loans and debentures are generally raised keeping into mind conscious
investors.
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5. Capital market condition- In the lifetime of the company, the market price of the
shares has got an important influence. During the depression period, the company’s
capital structure generally consists of debentures and loans. While in period of boons
and inflation, the company’s capital should consist of share capital generally equity
shares.
6. Period of financing- When company wants to raise finance for short period, it goes
for loans from banks and other institutions; while for long period it goes for issue of
shares and debentures.
7. Cost of financing- In a capital structure, the company has to look to the factor of cost
when securities are raised. It is seen that debentures at the time of profit earning of
company prove to be a cheaper source of finance as compared to equity shares where
equity shareholders demand an extra share in profits.
8. Stability of sales- An established business which has a growing market and high sales
turnover, the company is in position to meet fixed commitments. Interest on
debentures has to be paid regardless of profit. Therefore, when sales are high, thereby
the profits are high and company is in better position to meet such fixed commitments
like interest on debentures and dividends on preference shares. If company is having
unstable sales, then the company is not in position to meet fixed obligations. So,
equity capital proves to be safe in such cases.
9. Sizes of a company- Small size business firms capital structure generally consists of
loans from banks and retained profits. While on the other hand, big companies having
goodwill, stability and an established profit can easily go for issuance of shares and
debentures as well as loans and borrowings from financial institutions. The bigger the
size, the wider is total capitalization.
CHARACTERISTICS OF A BALANCED CAPITAL STRUCTURE

1. Simplicity: All businessmen are not educated. A complicated capital structure may
not be understood by all; on the contrary it may raise suspicions and create
confusion. A capital structure must be as simple as possible.
2. Minimum cost: An optimum capital structure is one which maximises earning per
equity share and minimizes cost of financing.
3. Maximum returns: An optimum capital structure makes the value of the firm
maximum.
4. Minimum Risk: An optimum capital structure is one which maximises earning per
equity share and minimizes cost of financing (Minimum risk).
5. Maximum control: The capital structure should be designed in such a way that it
involves minimum risk of loss of control of the firm.
6. Flexibility: The capital structure of a firm should be such that it can raise funds as
when required.
7. Proper liquidity: In a sound capital structure, content of debt will be a reasonable
proportion of the total capital employed in the business. As a result, it has minimum
risk of becoming insolvent.
8. Conservatism: The debt content in the capital structure of a firm should be within
its borrowing limits. It should be free from the risk of insolvency.
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9. Full utilization: full utilization of the capital stock, quasi-fixed factors, the resource
stock, the state of technology, and all variable factors of production necessary to
achieve an economic optimum such as minimum or least cost production or
maximum profit.
10. Balanced leveraged: Optimal debt-equity mix in the capital structure of a company
would be that point where the weighted average cost of capital is minimum.
Optimum debt- equity proportion establishes balance between owned capital and
debt capital. The firm should be cautious about the financial risk associated with the
maximum utilisation of debt.
CAPITAL GEARING:
“The term Capital gearing is used to describe the ratio between the ordinary shares capital
and fixed interest bearing securities of a company”
Kinds of capital gearing:
1. High gearing- when the proportion of equity capital to the total capital is low (Equity
and fixed bearing security ratio-1:4)
2. Low gearing - when the proportion of equity capital to the total capital of the
company is high (Equity and fixed bearing security ratio-4:1)
TRADING ON EQUITY:
Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to
increase its earnings on common stock. For example, a corporation might use long term debt
to purchase assets that are expected to earn more than the interest on the debt.
Trading on equity acts as a lever to magnify the influence of fluctuations in earnings. Any
fluctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share
(EPS) by operation of trading on equity larger the magnitude of debt in capital structure, the
higher is the variation in EPS given any variation.
INDIFFERENT POINT
Indifferent point/level is that EBIT level at which the Earnings Per Share (EPS) is the same
for two alternative financial plans. The indifferent point can be defined as "the level of EBIT
beyond which the benefits of financial leverage begin to operate with respect to Earnings Per
share (EPS)".
If the EBIT exceeds the indifference point level of EBIT, the use of fixed-cost source of
funds would be beneficial from the EPS viewpoint. In this case, financial leverage would be
favorable. In the reverse scenario, if the expected level of EBIT is less than the indifference
point, the advantage of EPS would be available from the use of equity capital and not debt
capital.
The point of indifference can be calculated using the following formula:
Where:
X = EBIT indifference level
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I1 = Fixed interest costs under alternative 1.

I2 = Fixed interest costs under alternative 2.
PD = Preference dividend, if any.
T = Tax rate
S1 = Number of equity shares outstanding under alternative 1.
S2 = Number of equity shares outstanding under alternative 2.
CAPITAL STRUCTURE THEORIES
1. Traditional Approach
2. Net income approach (NI)
3. Net operating income approach (NOI)
4. Modigliani - Miller approach
1. TRADITIONAL APROACH
It is accepted by all that the judicious use of debt will increase the value of the firm and
reduce the cost of capital. So, the optimum capital structure is the point at which the value of
the firm is highest and the cost of capital is at its lowest point. Practically, this approach
encompasses all the ground between the Net Income Approach and the Net Operating Income
Approach, i.e., it may be called Intermediate Approach.
The traditional approach explains that up to a certain point, debt-equity mix will cause the
market value of the firm to rise and the cost of capital to decline. But after attaining the
optimum level, any additional debt will cause to decrease the market value and to increase the
cost of capital.
In other words, after attaining the optimum level, any additional debt taken will offset the use
of cheaper debt capital since the average cost of capital will increase along with a
corresponding increase in the average cost of debt capital.
Thus, the basic propositions of this approach are:
(a) The cost of debt capital, Kd, remains constant more or less up to a certain level and
thereafter rises.
(b) The cost of equity capital Ke, remains constant more or less or rises gradually up to a
certain level and thereafter increases rapidly.
(c) The average cost of capital, WACC, decreases up to a certain level remains unchanged
more or less and thereafter rises after attaining a certain level.
2. NET INCOME (NI) Approach:
According to NI approach a firm may increase the total value of the firm by lowering its cost
of capital.
When cost of capital is lowest and the value of the firm is greatest, we call it the optimum
capital structure for the firm and, at this point, the market price per share is maximised.
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The same is possible continuously by lowering its cost of capital by the use of debt capital. In
other words, using more debt capital with a corresponding reduction in cost of capital, the
value of the firm will increase.
The same is possible only when:
(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);
(ii) There are no taxes; and
(iii) The use of debt does not change the risk perception of the investors since the
degree of leverage is increased to that extent.
Since the amount of debt in the capital structure increases, weighted average cost of capital
decreases which leads to increase the total value of the firm. So, the increased amount of debt
with constant amount of cost of equity and cost of debt will highlight the earnings of the
shareholders.
3. NET OPERATING INCOME APPROACH (NOI)
According to NOI approach is diametrically opposite to the NI approach. The essence of this
approach is that capital structure decision of a corporate does not affect its cost of capital and
the valuation, and, hence, irrelevant.
The main argument of NOI is that an increase in the proportion of debt in the capital structure
would lead to an increase in the financial risk of the equity holders. To compensate for the
increased risk , they would require a high rate of return (Ke) on their investment. As a result,
the advantage of the lower cost of debt would exactly be neutralized by the increase in the
cost of equity. The cost of debt has two components:
i) Explicit, represents rate of interest and
ii) Implicit, represents the in the cost of equity capital
4. MODIGLIANI – MILLER APPROACH (M M)
This approach was devised by Modigliani and Miller during 1950s. The fundamentals of
Modigliani and Miller Approach resemble that of Net operating income Approach.
Modigliani and Miller advocate capital structure irrelevancy theory. This suggests that the
valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is
highly leveraged or has lower debt component in the financing mix, it has no bearing on the
value of a firm.
Modigliani and Miller Approach further states that the market value of a firm is affected by
its future growth prospect apart from the risk involved in the investment. The theory stated
that value of the firm is not dependent on the choice of capital structure or financing decision
of the firm. If a company has high growth prospect, its market value is higher and hence its
stock prices would be high. If investors do not see attractive growth prospects in a firm, the
market value of that firm would not be that great.
Assumptions of Modigliani and Miller Approach
 There are no taxes.
 Transaction cost for buying and selling securities as well as bankruptcy cost is nil.
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 There is a symmetry of information. This means that an investor will have access to
same information that a corporation would and investors would behave rationally.
 The cost of borrowing is the same for investors as well as companies.
 Debt financing does not affect companies EBIT.
 Perfect capital market:
 There are large number of buyers and sellers
 Securities are infinitely divisible
 Investors are free to buy / sell securities
 Investors can borrow without restrictions on the same terms and conditions as
firms can
 Investors are rational and behave accordingly
LEVERAGE
The term leverage is used to describe the companies’ ability to use the fixed cost assets or
funds to magnify the return to its owners.
Definition: “Leverage is the employment of an asset or funds for which the firm pays a fixed
cost or fixed returns.”- James Horne.
TYPES OF LEVERAGE;
a) Financial leverage refers to the use of debt to acquire additional assets. Financial
leverage is also known as trading on equity.
Financial leverage (FL) = EBIT / EBT (EBIT- Interest)
b) Operating leverage involves using a large proportion of fixed costs to variable costs
in the operations of the firm.
Operating Leverage (OL) = Contribution / EBIT
c) Combined Leverage: A degree of combined leverage (DCL) is a leverage ratio that
summarizes the combined effect that the degree of operating leverage (DOL) and the
degree of financial leverage have on earnings per share (EPS), given a particular
change in sales.
Composite Leverage (CL) = OL x FL
DIVIDEND THEORIES
DIVIDEND POLICIES
Dividend policy is the set of guidelines a company uses to decide how much of its earnings it
will pay out to shareholders. Some evidence suggests that investors are not concerned with a
company's dividend policy since they can sell a portion of their portfolio of equities if they
want cash.
Dividend policy of a firm, thus affects the long term financing and wealth of shareholders.
The important aspect of dividend policy is to determine the amount of earnings to be
distributed to shareholders and the amount to be retained in the firm. Retained earnings are
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the most significant internal sources of financing the growth of the firm. On the other hand
dividend is the right of the shareholders to participate in the profit. They should receive fair
amount of the profit. Therefore the company should distribute reasonable amount of
dividends.
The value of the firm can be maximized if the shareholders wealth is maximized.
Shareholders returns consists of two components:-
 Dividend and
 Capital gains
Dividend policy has a direct influence on their components of returns.
 Growth= Retention* Rate of return (G = B*R)
- Dividend Payout = DPS/ EPS
Eg.
Rs.100: @20% EPS= Dividend Rs.16 and Retained Earnings Rs.4 High payout
Rs.100: @20% EPS= Dividend Rs. 4 and Retained Earnings Rs.16 Low payout
FACTORS DETERMINING (Affecting) DIVIDEND DECISIONS

1. 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.
2. Age of corporation. Age of the corporation counts much in deciding the dividend policy.
A newly established company 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.
3. Liquidity of Funds. Availability of cash and sound financial position is also an important
factor in dividend decisions.
4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A
closely held company 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 company
having a good number of shareholders widely distributed and forming low or medium income
group, would face a great difficulty in securing such assent because they will emphasise to
distribute higher dividend.
5. Needs for Additional Capital. Companies retain a part of their profits for strengthening
their financial position. The income may be conserved for meeting the increased
requirements 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
Companies distribute dividend at low rates and retain a big part of profits.
6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend
policy is adjusted according to the business oscillations.
7. Government Policies. The earnings capacity of the enterprise is widely affected by the
change in fiscal, industrial, labour, control and other government policies. Sometimes
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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.
8. Taxation Policy. High taxation reduces the earnings of the companies and consequently
the rate of dividend is lowered down. Sometimes government levies dividend-tax of
distribution of dividend beyond a certain limit. It also affects the capital formation.
9. 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 company 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 capita, in any case. Likewise, contractual obligation should
also be fulfilled, for example, payment of dividend on preference shares in priority over
ordinary dividend.
10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in
mind the dividend paid in past years. The current rate should be around the average past rates.
If it has been abnormally increased the shares will be subjected to speculation.
11. Ability to Borrow. Well established and large firms have better access to the capital
market than the new Companies and may borrow funds from the external sources if there
arises any need. Such Companies may have a better dividend pay-out ratio.
12. Policy of Control. Policy of control is another determining factor is so far as dividends
are concerned. If the directors want to have control on company, they would not like to add
new shareholders and therefore, declare a 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 needs through retained earing. 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.
13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of
retention earnings, unless one 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 still such time their loan is
outstanding.
14. Time for Payment of Dividend. Wise management should plan the payment of dividend
in such a manner that there is no cash outflow at a time when the undertaking is already in
need of urgent finances.
15. Regularity and stability in Dividend Payment. Dividends should be paid regularly
because each investor is interested in the regular payment of dividend. The management
should, inspite of regular payment of dividend, consider that the rate of dividend should be all
the most constant. For this purpose sometimes companies maintain dividend equalization
Fund.
DIVIDEND POLICY MATTERS - EXPERTS VIEWS

It is essential to separate the effect of dividend changes for the effect on investment and
financing decision. Do changes in dividend policy alone affect the value of the firm? What
factors are important in formulating a dividend policy in practice? The relationship between
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dividend policy and value of the firm, different theories have been advanced, these theories
are graphed in to two.
According to one school of thought, dividend decision does not affect the shareholders
wealth and hence the valuation of the firm. On the other hand according to the other school
of thought, dividend decision materially affects the shareholders wealth and also the value of
the firm.
Two schools views are:-
 Irrelevance concept of dividend or the theory of irrelevance.
 The relevance concept of dividend or the theory of relevance
DIVIDEND IRRELEVANCE
a) Residual approach:
If a firm wish to avoid new shares, that internally generating the equity. Which can be paid
out of what is leftover? The left over is called residual dividend approach.
If there is a profit can be given to shareholders or retain the earnings may be taken as a
residual decisions and there is Profitable investment opportunity otherwise pay it as dividend
b) Modigliani and miller’s approach:-
MM have expressed in the most comprehensive manner in support of the theory or
irrelevance, They maintain the dividend policy has no effect on the market price of the shares
and the value of the firm is determined by the earning capacity of the firm or its investment
policy – it does not affect the value of the firm.
A firm operating perfect capital market conditions may face one of the following three
situations regarding the payment of dividend
1. The firm has sufficient cash to pay dividend
2. The firm does not have sufficient cash to pay dividends, and therefore it issues new
shares to finance the payment of dividends
3. The firm does not pay dividends, but a shareholder needs cash (homemade
dividend- by selling a part of his shares at the market (fair) price in the capital market
for obtaining cash).
MM’s hypothesis of irrelevance is based on the following assumptions (Hypothesis)
1) There are perfect capital markets where investors behave rationally.
2) Information about the company is available to all without any cost and transaction
and flotation cost do not exist.
3) Perfect capital market also implies that no investment is large enough to affect the
market price of the shares.
4) There are either no taxes or there is no difference in the tax rates applicable to
dividends and capital gains.
5) The firm has a rigid investment policy.
6) Risk of uncertainty does not exist. That is, investors are able to forecast future
prices and dividends with certainty.
Thus, r = k= k t, for all times.
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MM hypothesis can explain the market price of a share in the beginning of the period (Po) is
equal to the present value of dividend paid at the end of the period ( P 1) plus the market price
of the share at the end of the period.
From MM’s fundamental principle of valuation described by the following equation;
P0 = d1 + p1
1+ke
where po = market price per share at the beginning of the period.
d1 = dividend to be received at the end of the period.
P1 = market price per share at the end of the period.
Ke = cost of equity capital or rate of capitalization
The value of P1 can be derived by the above equation as under:

P1= p0 ( 1 + ke ) – D1
MM also can explain in another form presuming that investment to find out the new issue
shares of equity shares
ii) Number of shares to be issued

M = I – ( E –nD1 )
P1
iii) The value of the firm can be ascertained by using the formula
N p0 = ( n +M ) p1 – ( I –E )
1 + Ke
where M = number of shares to be issue
I = investment required
E = total earnings of the firm during the period.
P1 = market price per share at the end of the period.
Ke = cost of equity capital
n = no of shares outstanding at the beginning of the period
P1= dividend to be paid at the end of the period
Np0= value of the firm.
CRITICISM OF MM APPROACH
MM hypothesis has been criticized on account of various Unrealistic assumptions as given
below.
1. Perfect capital market does not exist in reality.
2. Information about the company is not available to all the persons.
3. The firms have to incur flotation costs while issuing securities.
4. Taxes do exist and there is normally different tax treatment for dividends and capital
gain.
5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees etc while doing any transaction.
7. Shareholder may prefer current income as compared to further gains
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THE RELEVANCE CONCEPT OF DIVIDEND (OR) THE THEORY OF

RELEVANCE
The other school of thought of dividend decision holds that the dividend decisions
considerably affect the value of the firm. The advocates of the school of thought include
Myron Gordon, john linter, James Walter and Richardson. According to them the theory of
relevance, we have explained below two theories representing this notion:
1. Walter’s approach
2. Gordon's approach
Walter’s approach:
Prof. Walter’s approach supports the doctrine that dividend decisions are relevant and affect
the value of the firm. It shows the importance of the relationship between the firms’ rate of
return ‘r ‘and its cost of capital ‘k’ in determining the dividend policy that will maximize the
wealth of shareholder. Walter’s model is based on the following assumptions
Walter’s model is based on the following assumptions
A) The investments of the firms are financed through retained earnings only and the firm
does not use external source of funds like debt or new issues.
B) The firm’s rate of return ‘r’ and its cost of capital ‘k’ are constant.
C) 100% payout or retention- all earnings are either distributed as dividend or reinvestment
internally immediately.
D) Earnings and dividends do not change while determining the value.
E) The firm has a very large or infinite life.
Walter’s formula to determine the market price per share is as follows:
P= D + r (E – D)
__Ke______ or P= D+ r (E- D) / Ke
Ke Ke Ke
Where: - P = market price per share
D = dividend per share (DPS); r = rate of return (average)
E = EPS, Ke = Cost of Capital
According to Walter the firms can be divided into three based on the rate of return and
cost of capital.
GROWTH FIRM (r > k)
These firms expand rapidly because of simple investment opportunity yielding rates (r)
higher than the opportunity cost of capital (k). These firms are able to reinvest earnings at a
rate (r) which is higher than the rate expected by shareholders (k). they will maximize the
value per share if they follow a policy of retaining all earnings for internal investment.
*Retain all earnings where r > k
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NORMAL FIRM (r = k)
Most of the firms do not have unlimited surplus generating investment opportunities, yielding
returns higher than the opportunity cost of capital. These firms earn on their investments, rate
of return equal to the cost of capital, r = k. The dividend policy has no effect on the market
value per share in walter’s model.
 Dividend (or retention) policy has no effect where r = k.
DECLINING FIRM (no growth firm) (r < k)
Some firms do not have any profitable investment opportunity to invest the earnings. Such
firms would earn on their investments rate of return less than the minimum rate required by
the investors. Investors of such firm would like earnings to be distributed to them so that they
may either spend it or invest elsewhere to get a rate higher than earned by the declining firms.
* Distribute all the earnings where r < k
CRITICISM OF WALTER’S MODEL
Walter’s model is quite useful to show the effect of dividend policy on all equity firms under
different assumptions about the rate of return. The following is a critical evaluation of some
of the assumption underlying the model.
1. The basic assumption that investments are financed through retained earnings only is
seldom true in real world. Firms do raise funds by external financing.
2. The IRR also does not remain constant. As a matter of fact with incurring investment
the IRR also changes.
3. The assumption on cost of capital (k) will remain constant also does not hold good. A
risk pattern does not constant.
GORDON’S MODEL
Myron Gordon has also given a model on the lines of Prof. James E. Walter. Suggesting
that dividends are relevant and the dividends decision of firm affect its value; the crux of the
argument of gordons model is that value of a rupee of dividend income is more than the value
of a rupee of capital gain. This is an account of uncertainty of future and its shareholders
discount future dividends at a high rate.
According to Gordon the market value of the share is equal to the present value of the future
stream of dividends
Symbolically: - P = E (1 – b) (or) P= D
Ke – br Ke – g
Where: - P = price per share
E = EPS
B = retention ratio
Ke = cost of capital
br (g) = growth rate (or) rate of return (r * retention = g )
D = dividend per share
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Gordon's model is based on the following assumptions

1. Constant return ( r ) and constant cost of capital ( Ke)
2. Perpetual earnings
3. The firm in an all equity firm and it has no debt.
4. No taxes, corporate taxes do not exist.
5. Constant retention.
6. Cost of capital greater than growth rate i.e. Ke > g.
STABILITY OF DIVIDEND
Dividend practices:
1. Constant dividend per share
2. Constant percentage of net earnings
3. Small constant dividend per share plus extra dividend
4. Dividend as fixed percentage of market value
Significance of stable dividend:
1. Confidence among shareholders
2. Investors desire for current income
3. Institutional investors’ requirements
4. Stability in market price of shares
5. Raising additional finance
6. Market for debentures and preference shares
7. Reducing the chances of loss of control
FORMS OF DIVIDEND
When dividend is paid out of profit it is called “profit dividend” and when it is paid out of
capital it is called “liquidation”. Usually there are 4 forms of dividend.
a) Cash dividend: it is the common method to pay the dividend. Here the shareholders get
cash in form of dividend but for this purpose the company must have adequate liquid
resources.
b) Scrip or bond dividend: it is the promise made by the company to the shareholders to pay
them at future specific date. This form of payment is generally used in case the company
doesn’t have sufficient money.
c) Stock dividend: here the company issue bonus share to the existing shareholders. This
form of payment is also used in case the company doesn’t have sufficient money.
d) Property dividend: it means payment made to the shareholders in form of property rather
than cash.
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STOCK SPLIT
Share split is a method to increase the number of outstanding shares through a proportional
reduction in the par value of shares. A share split affects only the par value and the number of
outstanding shares, the shareholders total fund remain unchanged.
REASONS FOR STOCK SPLIT
The reasons for splitting of a firms ordinary share:
 To make trading in shares attractive
 To signal the possibility of higher profits in the future
 To give higher dividends to shareholders
UNIT-IV
Principles of working capital: Concepts, Needs, Determinants, issues and estimation of
working capital - Accounts Receivables Management and factoring - Inventory
management - Cash management - Working capital finance: Trade credit, Bank finance
and Commercial paper
WORKING CAPITAL MANAGEMENT
Definition
According to J.S.Mill, the Sum of the Current Assets is the Working Capital.
“Working Capital is the amount of funds necessary to cover the cost of operating the
enterprise” By Shubin
Working capital refers to a part of sources of funds of a business concern used for financing
short term purposes or current assets such as cash in hand, cash at bank, marketable
securities, and bills receivables, stock of raw materials, work in progress and finished goods,
consumable stores, advance payment of tax, prepaid expenses and the like.
Working Capital decisions requires much of the Finance Manager’s time, and also have an
impact on the creditability / goodwill of the Firm. Hence, Working Capital levels are said to
be adequate when-
 Current Assets are greater than Current Liabilities, (i.e. Positive Net Working Capital)
 Current Ratio = Current Assets ÷ Current Liabilities is about 2:1. This may differ
from industry to industry.
 Quick Ratio = Quick Assets ÷ Quick Liabilities is at least 1:1. This may also differ
from industry to industry.
 Current Assets ÷ Fixed Assets ratio is neither too high (conservative policy) nor too
low (aggressive policy).
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TYPES OF WORKING CAPITAL

On the basis of Concept
1. Gross working Capital
Gross Working Capital (GWC): Current assets in the balance sheet of a company are
known as gross working capital. Current assets are those short term assets which can be
converted into cash within a period of one year. The grey area in the management of current
assets or gross working capital is its unpredictability.
2. Net working Capital
It is simply the difference of current assets and the current liabilities in the balance sheet of a
business.
On the basis of Requirements

 Permanent Working Capital: It is otherwise called as Fixed Working Capital.
 Temporary Working Capital: It is otherwise called as Fluctuating or Variable
Working Capital.
OBJECTIVE OF WORKING CAPITAL MANAGEMENT
1. To ensure optimum investment in Current assets
2. To maintain liquidity and profitability in use of funds
3. To ensure adequate flow of funds for current operations.
SOURCES OF WORKING CAPITAL
The two segments of working capital viz., regular or fixed or permanent and variable are
financed by the long-term and the short-term sources of funds respectively.
The main sources of long-term funds are shares, debentures, term- loans, retained earnings
etc.
The sources of short-term funds used for financing variable part of working capital
mainly include the following:
1. Loans from commercial banks
2. Public deposits
3. Trade credit
4. Factoring
5. Discounting bills of exchange
6. Bank overdraft and cash credit
7. Advances from customers
8. Accrual accounts
1. Loans from Commercial Banks:
Small-scale enterprises can raise loans from the commercial banks with or without security.
This method of financing does not require any legal formality except that of creating a
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mortgage on the assets. Loan can be paid in lump sum or in parts. The short-term loans can
also be obtained from banks on the personal security of the directors of a country. Such loans
are known as clean advances. Bank finance is made available to small- scale enterprises at
concessional rate of interest. Hence, it is generally a cheaper source of financing working
capital requirements of enterprise. However, this method of raising funds for working capital
is a time-consuming process.
2. Public Deposits:
Often companies find it easy and convenient to raise short- term funds by inviting
shareholders, employees and the general public to deposit their savings with the company. It
is a simple method of raising funds from public for which the company has only to advertise
and inform the public that it is authorised by the Companies Act 1956, to accept public
deposits. Public deposits can be invited by offering a higher rate of interest than the interest
allowed on bank deposits.
3. Trade Credit:
Just as the companies sell goods on credit, they also buy raw materials, components and other
goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e.,
trade creditors for credit purchases are regarded as sources of finance. Generally, suppliers
grant credit to their clients for a period of 3 to 6 months.
4. Factoring:
Factoring is a financial service designed to help firms in managing their book debts and
receivables in a better manner. The book debts and receivables are assigned to a bank called
the 'factor' and cash is realised in advance from the bank. For rendering these services, the fee
or commission charged is usually a percentage of the value of the book debts/receivables
factored.
This is a method of raising short-term capital and known as 'factoring'. On the one hand, it
helps the supplier companies to secure finance against their book debts and receivables, and
on the other, it also helps in saving the effort of collecting the book debts.
The disadvantage of factoring is that customers who are really in genuine difficulty do not get
the opportunity of delaying payment which they might have otherwise got from the supplier
company.
5. Discounting Bills of Exchange:
When goods are sold on credit, bills of exchange are generally drawn for acceptance by the
buyers of goods. The bills are generally drawn for a period of 3 to 6 months. In practice, the
writer of the bill, instead of holding the bill till the date of maturity, prefers to discount them
with commercial banks on payment of a charge known as discount.
6. Bank Overdraft and Cash Credit:
Overdraft is a facility extended by the banks to their current account holders for a short-
period generally a week. A current account holder is allowed to withdraw from its current
deposit account upto a certain limit over the balance with the bank. The interest is charged
only on the amount actually overdrawn. The overdraft facility is also granted against
securities.
.7. Advances from Customers:
One way of raising funds for short-term requirement is to demand for advance from one's
own customers. Examples of advances from the customers are advance paid at the time of
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booking a car, a telephone connection, a flat, etc. This has become an increasingly popular
source of short-term finance among the small business enterprises mainly due to two reasons.
First, the enterprises do not pay any interest on advances from their customers. Second, if any
company pays interest on advances, that too at a nominal rate. Thus, advances from
customers become one of the cheapest sources of raising funds for meeting working capital
requirements of companies.
8. Accrual Accounts:
Generally, there is a certain amount of time gap between incomes is earned and is actually
received or expenditure becomes due and is actually paid. Salaries, wages and taxes, for
example, become due at the end of the month but are usually paid in the first week of the next
month. Thus, the outstanding salaries and wages as expenses for a week help the enterprise in
meeting their working capital requirements. This source of raising funds does not involve any
cost.
NEED AND SIGNIFICANCE OF WORKING CAPITAL
Working capital is the life blood and nerve center of business. Working capital is very
essential to maintain smooth running of a business. No business can run successfully without
an adequate amount of working capital. The main advantages or importance of working
capital are as follows:
1. Strengthen the Solvency
Working capital helps to operate the business smoothly without any financial problem for
making the payment of short-term liabilities. Purchase of raw materials and payment of
salary, wages and overhead can be made without any delay. Adequate working capital helps
in maintaining solvency of the business by providing uninterrupted flow of production.
2. Enhance Goodwill
Sufficient working capital enables a business concern to make prompt payments and hence
helps in creating and maintaining goodwill. Goodwill is enhanced because all current
liabilities and operating expenses are paid on time.
3. Easy Obtaining Loan
A firm having adequate working capital, high solvency and good credit rating can arrange
loans from banks and financial institutions in easy and favorable terms.
4. Regular Supply of Raw Material
Quick payment of credit purchase of raw materials ensures the regular supply of raw
materials from suppliers. Suppliers are satisfied by the payment on time. It ensures regular
supply of raw materials and continuous production.
5. Smooth Business Operation
Working capital is really a life blood of any business organization which maintains the firm
in well condition. Any day to day financial requirement can be met without any shortage of
fund. All expenses and current liabilities are paid on time.
6. Ability to Face Crisis
Adequate working capital enables a firm to face business crisis in emergencies such as
depression.
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FACTORS DETERMINING OR AFFECTING WORKING CAPITAL

Main factors affecting the working capital are as follows:
(1) Nature of Business:
The requirement of working capital depends on the nature of business. The nature of business
is usually of two types: Manufacturing Business and Trading Business. In the case of
manufacturing business it takes a lot of time in converting raw material into finished goods.
Therefore, capital remains invested for a long time in raw material, semi-finished goods and
the stocking of the finished goods.
(2) Scale of Operations:
There is a direct link between the working capital and the scale of operations. In other words,
more working capital is required in case of big organisations while less working capital is
needed in case of small organisations.
(3) Business Cycle:
The need for the working capital is affected by various stages of the business cycle. During
the boom period, the demand of a product increases and sales also increase. Therefore, more
working capital is needed. On the contrary, during the period of depression, the demand
declines and it affects both the production and sales of goods. Therefore, in such a situation
less working capital is required.
(4) Seasonal Factors:
Some goods are demanded throughout the year while others have seasonal demand. Goods
which have uniform demand the whole year their production and sale are continuous.
Consequently, such enterprises need little working capital.
On the other hand, some goods have seasonal demand but the same are produced almost the
whole year so that their supply is available readily when demanded. Such enterprises have to
maintain large stocks of raw material and finished products and so they need large amount of
working capital for this purpose. Woolen mills are a good example of it.
(5) Production Cycle:
Production cycle means the time involved in converting raw material into finished product.
The longer this period, the more will be the time for which the capital remains blocked in raw
material and semi-manufactured products.
Thus, more working capital will be needed. On the contrary, where period of production
cycle is little, less working capital will be needed.
(6) Credit Allowed:
Those enterprises which sell goods on cash payment basis need little working capital but
those who provide credit facilities to the customers need more working capital.
(7) Credit Availed:
If raw material and other inputs are easily available on credit, less working capital is needed.
On the contrary, if these things are not available on credit then to make cash payment quickly
large amount of working capital will be needed.
(8) Operating Efficiency:
Operating efficiency means efficiently completing the various business operations. Operating
efficiency of every organisation happens to be different.
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Some such examples are: (i) converting raw material into finished goods at the earliest, (ii)
selling the finished goods quickly, and (iii) quickly getting payments from the debtors. A
company which has a better operating efficiency has to invest less in stock and the debtors.
(9) Availability of Raw Material:
Availability of raw material also influences the amount of working capital. If the enterprise
makes use of such raw material which is available easily throughout the year, then less
working capital will be required, because there will be no need to stock it in large quantity.
(10) Growth Prospects:
Growth means the development of the scale of business operations (production, sales, etc.).
The organisations which have sufficient possibilities of growth require more working capital,
while the case is different in respect of companies with less growth prospects.
(11) Level of Competition:
High level of competition increases the need for more working capital. In order to face
competition, more stock is required for quick delivery and credit facility for a long period has
to be made available.
(12) Inflation:
Inflation means rise in prices. In such a situation more capital is required than before in order
to maintain the previous scale of production and sales. Therefore, with the increasing rate of
inflation, there is a corresponding increase in the working capital.
DISADVANTAGES OF WORKING CAPITAL IN EXCESS

1. Idle funds lead to no profits for the business and no proper return
2. Unnecessary purchasing and accumulation of inventories lead to more loss
3. More bad debts
4. It results into overall inefficiency in the organization
5. Relationship with banks and other financial institutions may not be maintained
DANGERS OF SHORTAGE WORKING CAPITAL
1. A concern cannot pay its short- term liability in time
2. The bulk purchases is not possible
3. Difficult to meet day to day operations
4. Full efficiency in operation is not possible
5. The rate of return on investment will fall
WORKING CAPITAL FORECAST
While forecasting the working capital the following three factors should be borne in mind.
a) Profit should be ignored
b) Calculation of stock of finished goods and debtors should be made at cost
c) Working in process calculation. it depends upon its degree of completion regarding
Raw material, Labour and overheads.(100% for materials and 50% for labour and
overheads)
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Hard core WC or Core Current Assets

Core current assets are that part of current assets which are minimum of different that are
necessary for maintaining uninterrupted flow of production. A minimum amount of raw
material, WIP, Finished goods etc, that are required to be kept for running a company are
called hard core working capital.
OPERATING CYCLE
Operating cycle involves the conversion of sales into cash.
Gross Operating Cycle = RMCP+ WIPCP+FGCP+RCP

 RMCP = Raw materials conversion period.
 WIPCP= Work in progress conversion period.
 FGCP = Finished goods conversion period.
 RCP = Receivables conversion period.
RMCP = (Average Stock of Raw Materials/ Raw Material Consumption per Day)
WIPCP = (Average Stock of work in progress / Total cost of production per day)
FGCP = (Average stock of finished goods / Total cost of Sales per day)
RCP = (Average Accounts Receivables / Net credit sales per day)
Net operating cycle period = (Gross operating cycle period – Payable Deferal Period)
Payable Deferal Period = (Average Payables / Net Credit Purchases per day)
CASH MANAGEMENT
The term cash management refers to the management of cash and ‘near cash assets’. While
cash includes coins, currency notes, cheque, bank drafts and the demand deposits, the nearer
cash assets include marketable securities and time deposits with the banks. Such securities are
easily converted in to cash.
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Motives for holding cash

• Transaction motives- Inflow and Out flow of cash
• Precautionary motive- To meet unexpected contingencies
• Speculative motive – Unexpected business opportunities
• Compensation motive- Banks keep minimum balance for render free services to the
customers
CASH FORECASTING AND BUDGETING

Cash forecasts are needed to prepare cash budgets. Cash forecasting may be done on short-
term and Long-term basis normally one year and over the period
Short term cash forecasting
To determine operating cash requirement
To anticipate short term financing
To manage investment of surplus cash
Short term cash forecasting methods
1. The Receipts and disbursement method
2. The adjusted Net income method
Long term cash forecasting
-Future financial needs
-To evaluate proposed capital projects
- To improve corporate planning
The short term forecasting methods can also be used in long term forecasting
FLOAT IN CASH MANAGEMENT

Cash float refers to the difference between the cash balance recorded in your accounting
system's cash account and the amount of cash showing in your company's bank account
balances. Disbursement float occurs when you write a check and the recipient has not yet
cashed the check. Collection float occurs when you deposit a check but the bank has not yet
credited your account. The net float is the sum of disbursement and collection floats.
LOCK BOX SYSTEM:

A lockbox system is an arrangement of several lockboxes that are strategically placed near
geographic clusters of company customers, so that aggregate mail time from the customers to
the lockboxes is minimized. A lockbox system is encouraged by banks, which earn a fixed
monthly fee for each lockbox, as well as a servicing charge for each payment processed.
Banks provide a periodic reviewing service to match the addresses from which customers are
issuing their payments to lockbox locations, to see if the lockbox configuration is optimized.
If not, lockboxes are shifted to more customer-centric locations, and customers are notified to
alter their remit-to addresses to the new locations. Continually shifting lockbox locations is
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not recommended, since it annoys the accounts payable employees of customers, which must
keep updating the pay-to addresses in their computer systems.
A lockbox system is an excellent way to reduce mail float for a larger company that has a
national or international customer base. It is rarely necessary for a smaller company with a
local customer base to use more than a single lockbox at a local bank.
As the method of payment gradually shifts away from checks and in favor of electronic
payments, the need for lockbox systems is likely to decline.
RECEIVABLE MANAGEMENT
Receivables, also termed as trade credit or debtors are component of current assets. When a
firm sells its product in credit, account receivables are created.
Account receivables are the money receivable in some future date for the credit sale of goods
and services at present. These days, most business transactions are in credit. Most companies,
when they face competition, use credit sales as an important tool for sales promotion. As a
sales promotion tool, credit sale enhances firm's sales revenue and ultimately pushes up the
profitability. But after the credit sale has been made, the actual collection of cash may be
delayed for months. As these late payments stretch out over time, they may cause substantial
drop in a company's profit margin. Since the extension of credit involves both cost and
benefits, the firm's manager must be able to measure them to determine the ultimate effect of
credits sales.
SIGNIFICANCE AND PURPOSE OF RECEIVABLE MANAGEMENT

The basic purpose of firm's receivable management is to determine effective credit policy that
increases the efficiency of firm's credit and collection department and contributes to the
maximization of value of the firm. The specific purposes of receivable management are as
follows:
1. To evaluate the creditworthiness of customers before granting or extending the credit.
2. To minimize the cost of investment in receivables.
3. To minimize the possible bad debt losses.
4. To formulate the credit terms in such a way that results into maximization of sales
revenue and still maintaining minimum investment in receivables.
5. To minimize the cost of running credit and collection department.
6. To maintain a trade-off between costs and benefits associated to credit policy.
Objective of Receivables Management
1. Promoting Sales
2. Increasing profits
3. Meeting competition
FACTORS AFFECTING THE SIZE OF RECEIVABLES:
The size of receivables is determined by a number of factors for receivables being a major
component of current assets. As most of them varies from business the business in
accordance with the nature and type of business. Therefore, to discuss all of them would
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prove irrelevant and time consuming. Some main and common factors determining the level
of receivable are presented by way of diagram in figure given below and are discuses below:
1. Stability of Sales
Stability of sales refers to the elements of continuity and consistency in the sales. In other
words the seasonal nature of sales violates the continuity of sales in between the year. So, the
sale of such a usiness in a particular season would be large needing a large a size of
receivables. Similarly, if a firm supplies goods on installment basis it will require a large
investment in receivables.
2. Terms of Sale
A firm may affect its sales either on cash basis or on credit basis. As a matter of fact credit is
the soul of a business. It also leads to higher profit level through expansion of sales. The
higher the volume of sales made on credit, the higher will be the volume of receivables and
vice-versa.
3. The Volume of Credit Sales
It plays the most important role in determination of the level of receivables. As the terms of
trade remains more or less similar to most of the industries. So, a firm dealing with a high
level of sales will have large volume of receivables.
4. Credit Policy
A firm practicing lenient or relatively liberal credit policy its size of receivables will be
comparatively large than the firm with more rigid or signet credit policy. It is because of two
prominent reasons:
 A lenient credit policy leads to greater defaults in payments by financially weak
customers resulting in bigger volume of receivables.
 A lenient credit policy encourages the financially sound customers to delay payments
again resulting in the increase in the size of receivables.
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5. Terms of Sale
The period for which credit is granted to a customer duly brings about increase or decrease in
receivables. The shorter the credit period, the lesser is the amount of receivables. As short
term credit ties the funds for a short period only. Therefore, a company does not require
holding unnecessary investment by way of receivables.
6. Cash Discount
Cash discount on one hand attracts the customers for payments before the lapse of credit
period. As a tempting offer of lesser payments is proposed to the customer in this system, if a
customer succeeds in paying within the stipulated period. On the other hand reduces the
working capital requirements of the concern. Thus, decreasing the receivables management.
7. Collection Policy.
The policy, practice and procedure adopted by a business enterprise in granting credit,
deciding as to the amount of credit and the procedure selected for the collection of the same
also greatly influence the level of receivables of a concern. The more lenient or liberal to
credit and collection policies the more receivables are required for the purpose of investment.
8. Collection Collected
If an enterprise is efficient enough in encasing the payment attached to the receivables within
the stipulated period granted to the customer. Then, it will opt for keeping the level of
receivables low. Whereas, enterprise experiencing undue delay in collection of payments will
always have to maintain large receivables.
9. Bills Discounting and Endorsement
If the firm opts for discounting its bills, with the bank or endorsing the bills to the third party,
for meeting its obligations. In such circumstances, it would lower the level of receivables
required in conducting business.
10. Quality of Customer
If a company deals specifically with financially sound and credit worthy customers then it
would definitely receive all the payments in due time. As a result the firm can comfortably do
with a lesser amount of receivables than in case where a company deals with customers
having financially weaker position.
11. Miscellaneous
There are certain general factors such as price level variations, attitude of management type
and nature of business, availability of funds and the lies that play considerably important role
in determining the quantum of receivables
FACTORING SERVICES
Factoring is defined as “an outright purchase of credit approved accounts receivables, with
the factor assuming bad debt losses.” Factoring is an asset based method of financing as well
as specialized service being the purchase of book debts of a company by the factor, thus
realizing the capital tied up in accounts.
Factoring is the process whereby a third party buys a company's invoices at a discount for
that company to raise capital. Factoring is a form of alternate financing, otherwise known as
“accounts receivable financing” that provides businesses with immediate cash for their
invoices, Factoring Sometimes referred to as a Full Service Factoring, this provides the
26
complete answer to slow-paying customers, shortage of working capital and if needed,

protection against bad debt losses.
Mechanism of Factoring:
The mechanism of factoring is summed tip as below:
(i) An agreement is entered into between the selling firm and the factor firm. The agreement
provides the basis and the scope of the understanding reached between the two for rendering
factor services.
(ii) The sales documents should contain the instructions to make payments directly to the
factor who is assigned the job of collection of receivables.
(iii) When the payment is received by the factor, the account of the selling firm is credited by
the factor after deducting its fees, charges, interest etc. as agreed.
(iv) The factor may provide advance finance to the selling firm if the conditions of the
agreement so require.
The mechanism of factoring has been shown in the following figure:
Types of Factoring:
A number of factoring arrangements are possible depending upon the agreement reached
between the selling firm and the factor.
However, following are some of the important types of factoring arrangements:
1. Recourse and Non-Recourse Factoring:
In a recourse factoring arrangement, the factor has recourse to the client (selling firm) if the
receivables purchased turn out to be bad, i.e., the risk of bad debts is to be borne by the client
and the factor does not assume the risks of default associated with receivables. The difference
between recourse and non-recourse factoring is mainly on account of risk factor.
Whereas, in case of non-recourse factoring, the risk or loss on account of non-payment by the
customers of the client is to be borne by the factor and he cannot claim this amount from the
selling firm. Since the factor bears the risk of non-payment, commission or fees charged for
the services in case of non-recourse factoring is higher than under the recourse factoring.
2. Advance and Maturity Factoring:
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Under advance factoring arrangement, certain percentage of receivables is paid in advance to

the client, the balance being paid on the guaranteed payment date.
But, in case of maturity factoring, no advance is paid to the client and the payment is made to
the client only on collection of receivables or the guaranteed payment date as may be agreed
between the parties. Thus, maturity factoring consists of the sale of accounts receivables to a
factor with no payment of advance funds at the time of sale.
3. Conventional or Full Factoring:
In conventional or full factoring, the factor performs almost all the services of factoring
including non-recourse and advance factoring. It is also known as old Line Factoring.
4. Domestic and Export Factoring:
The basic difference between the domestic and export factoring is on account of the number
of parties involved. In domestic factoring three parties are involved, namely, the selling firms
(client), the factor and the customer of the client (buyer).
In contrast, four parties are involved in case of export or cross-border factoring. Namely, the
exporter (selling firm or client), the importer or the customer, the export factor and the import
factor. Since, two factors are involved in the export factoring; it is also called two-factor
system of factoring.
Forfaiting:
The term forfaiting is similar to export factoring. It is a form of financing of export
receivables. Forfaiting in essence means the forfeiting of the right to future payments through
discounting future cash flows.
Thus the difference between forfaiting and factoring is that forfaiting provides hundred
percent finance in advance against receivables whereas, in factoring only certain (usually 75
to 85) percentage of receivables is available as advance finance.
Moreover, forfaiting is purely financing arrangement whereas, factoring also includes other
services such as administration of credit sales, collection of receivables, maintenance of sales
ledger, etc.
Benefits of Factoring:
A firm that enters into factoring agreement is benefited in a number of ways as it is relieved
from the problem of collection management and it can concentrate on other important
business activities.
Some of the important benefits are outlined as under:
(a) It ensures a definite pattern of cash inflows from the credit sales.
(b) It serves as a source of short-term finance.
(c) It ensures better management of receivables as factor firm agency for the same.
(d) It enables the selling firms to transfer the risk of non-payments, defaults or bad debts to
the factoring firms in case of non-recourse factoring.
(e) It relieves the selling firms from the burden of credit management and enables them to
concentrate on other important business activities.
(f) It saves in cost as well as space as it is a substitute for in-house collection department.
(g) In provides better opportunities for working capital management.
28
(h) The selling firm is also benefited by advisory services rendered by a factor.
Limitations of Factoring:
In spite of May services offered by factoring, it suffers from certain limitations.
The most critical fall outs of factoring include:
(i) The high cost of factoring as compared to other sources of short-term finance,
(ii) The perception of financial weakness about the firm availing factoring services, and
(iii) Adverse impact of tough stance taken by factor, against a defaulting buyer, upon the
borrower resulting into reduced future sales.
INVENTORY MANAGEMENT
Meaning of inventory
Inventory means stock of finished goods only. In a manufacturing concern, it may include
raw materials, work in process and stores, etc. Inventory includes the following things:
(a) Raw Material: Raw material form a major input into the organisation. They are required
to carry out production activities uninterruptedly. The quantity of raw materials required will
be determined by the rate of consumption and the time required for replenishing the supplies.
The factors like the availability of raw materials and government regulations etc. too affect
the stock of raw materials.
(b) Work in Progress: The work-in-progress is that stage of stocks which are in between raw
materials and finished goods. The raw materials enter the process of manufacture but they are
yet to attain a final shape of finished goods. The quantum of work in progress depends upon
the time taken in the manufacturing process. The greater the time taken in manufacturing, the
more will be the amount of work in progress.
(c) Consumables: These are the materials which are needed to smoothen the process of
production. These materials do not directly enter production but they act as catalysts, etc.
Consumables may be classified according to their consumption and criticality.
(d) Finished goods: These are the goods which are ready for the consumers. The stock of
finished goods provides a buffer between production and market. The purpose of maintaining
inventory is to ensure proper supply of goods to customers.
(e) Spares: Spares also form a part of inventory. The consumption pattern of raw materials,
consumables, finished goods are different from that of spares. The stocking policies of spares
are different from industry to industry. Some industries like transport will require more spares
than the other concerns. The costly spare parts like engines, maintenance spares etc. are not
discarded after use, rather they are kept in ready position for further use.
Purpose/Benefits of Holding Inventors
There are three main purposes or motives of holding inventories:
(i) The Transaction Motive which facilitates continuous production and timely
execution of sales orders.
29
(ii) The Precautionary Motive which necessitates the holding of inventories for
meeting the unpredictable changes in demand and supplies of materials.
(iii) The Speculative Motive which induces to keep inventories for taking advantage
of price fluctuations, saving in re-ordering costs and quantity discounts, etc.
Risk and Costs of Holding Inventors
The holding of inventories involves blocking of a firm’s funds and incurrence of capital
and other costs. It also exposes the firm to certain risks. The various costs and risks involved
in holding inventories are as below:
(i) Capital costs: Maintaining of inventories results in blocking of the firm’s financial
resources. The firm has, therefore, to arrange for additional funds to meet the cost of
inventories. The funds may be arranged from own resources or from outsiders. But in
both cases, the firm incurs a cost. In the former case, there is an opportunity cost of
investment while in later case the firm has to pay interest to outsiders.
(ii) Cost of Ordering: The costs of ordering include the cost of acquisition of inventories.
It is the cost of preparation and execution of an order, including cost of paper work and
communicating with supplier. There is always minimum cot involve whenever an order
for replenishment of good is placed. The total annual cost of ordering is equal to cost per
order multiplied by the number of order placed in a year.
(iii)Cost of Stock-outs: A stock out is a situation when the firm is not having units of an
item in store but there is demand for that either from the customers or the production
department. The stock out refer to demand for an item whose inventory level is reduced to
zero and insufficient level. There is always a cost of stock out in the sense that the firm
faces a situation of lost sales or back orders. Stock out are quite often expensive.
(iv) Storage and Handling Costs. Holding of inventories also involves costs on storage as
well as handling of materials. The storage costs include the rental of the godown,
insurance charge etc.
(v) Risk of Price Decline. There is always a risk of reduction in the prices of inventories
by the suppliers in holding inventories. This may be due to increased market supplies,
competition or general depression in the market.
(vi) Risk of Obsolescence. The inventories may become obsolete due to improved
technology, changes in requirements, change in customer’s tastes etc.
(vii)Risk Deterioration in Quality: The quality of the materials may also deteriorate
while the inventories are kept in stores.
INVENTORY MANAGEMENT
It is necessary for every management to give proper attention to inventory management. A
proper planning of purchasing, handling storing and accounting should form a part of
inventory management. An efficient system of inventory management will determine (a)
what to purchase (b) how much to purchase (c) from where to purchase (d) where to store,
etc.
There are conflicting interests of different departmental heads over the issue of inventory.
The finance manager will try to invest less in inventory because for him it is an idle
30
investment, whereas production manager will emphasize to acquire more and more inventory
as he does not want any interruption in production due to shortage of inventory. The purpose
of inventory management is to keep the stocks in such a way that neither there is over-
stocking nor under-stocking. The over-stocking will mean reduction of liquidity and starving
of other production processes; under-stocking, on the other hand, will result in stoppage of
work. The investments in inventory should be kept in reasonable limits.
OBJECTS OF INVENTORY MANAGEMENT

The main objectives of inventory management are operational and financial. The operational
objectives mean that the materials and spares should be available in sufficient quantity so that
work is not disrupted for want of inventory. The financial objective means that investments in
inventories should not remain idle and minimum working capital should be locked in it. The
following are the objectives of inventory management:
(1) To ensure continuous supply of materials spares and finished goods so that
production should not suffer at any time and the customers demand should also be
met.
(2) To avoid both over-stocking and under-stocking of inventory.
(3) To keep material cost under control so that they contribute in reducing cost of
production and overall costs.
(4) To minimise losses through deterioration, pilferage, wastages and damages.
(5) To ensure perpetual inventory control so that materials shown in stock ledgers
should be actually lying in the stores.
(6) To ensure right quality goods at reasonable prices.
(7) To maintain investments in inventories at the optimum level as required by the
operational and sales activities.
(8) To eliminate duplication in ordering or replenishing stocks. This is possible with
help of centralising purchases.
(9) To facilitate furnishing of data for short term and long term planning and control of
inventory.
(10) To design proper organisation of inventory. A clear cut accountability should be fixed
at various levels of management.
ESSENTIALS OF GOOD INVENTORY SYSTEM

(1) Classifications and Identification of inventories
The inventory includes raw materials, semi-finished goods, finished goods and components
etc. of several descriptions. In order to facilitate prompt recording, locating and dealing, each
item of inventory must be assigned a particular code for proper identification and must be
divided and sub-divided in groups. A B C analysis of inventory is very helpful in this regard.
(2) Standardisation and Simplification of Inventories
31
In order to control inventories properly, standardization of materials is necessary.

Standardisation refers to the fixation of standards of materials for the use in the production of
finished goods, and sets the specification of components and tools to be used in order to
control the quality of goods manufactured. Simplification of inventories refers to the
elimination of excess types and sizes of types. It leads to reduction in inventories and its
carrying costs.
(3) Adequate Storage Facilities
Adequate storage facilities are necessary to have the proper control of inventory. It shall
reduce the wastage due to leakage, wear and tear, rust and dust and also reduce the wastage
of martial due to mishandling.
(4) Setting Minimum and Maximum limits
In order to avoid over and under investment in inventories, minimum and maximum limits
for each item of inventories should be fixed. It also ensures the availability of material during
production process. While fixing the minimum and maximum points, re-order point should
also be fixed before hands.
(5) Fixing Economic Order Quantity
It is also a basic consideration in inventory control problem as how much quantity of a
particular item should be ordered at a time. In determining the E O Q, the two opposing costs
are to be balanced i.e., ordering costs and carrying costs.
(6) Adequate Inventory Records and Reports
An efficient inventory control necessitates proper inventory records and reports because
various inventory records contain information to meet the needs of purchasing, production,
sales etc. Any particular information regarding any particular item of inventory may be had
from such records. Such information may be about-quantity in hand, in transit and on plants,
unit cost, EOQ re-ordering points, safety level etc, for each item of inventory. Reports and
statements should be so designed so as to keep the clerical cost of maintaining these records
at a minimum.
INVENTORY CONTROL TECHNIQUES
Tools and Techniques of inventory Management
Effective Inventory management requires an effective control system for inventories. A
proper inventory control not only helps in solving the acute problem of liquidity but also
increases profits and causes substantial reduction in the working capital of the concern. The
following are the important tools and techniques of inventory management and control:
1. Determination of Stock Levels.
2. Determination of Safety Stocks.
3. Determination of Economic Order Quantity
4. A.B.C. Analysis
5. VED Analysis
6. Inventory Turnover Ratios
7. Aging Schedule of Inventories
8. Just in Time Inventory
32
1. Determination of Stock Levels

Carrying of too much and too little of inventories is detrimental to the firm. If the inventory
level is too little, the firm will face frequent stock-outs involving heavy ordering cost and if
the inventory level is too high it will be unnecessary tie-up of capital. Therefore, an efficient
inventory management requires that a firm should maintain an optimum level of inventory
where inventory costs are the minimum and at the same time there is not stock-out which
may result in loss of sale or stoppage of production. Various stock levels are discussed as
such.
(a) Minimum Level: This represents the quantity which must be maintained in hand at all
times. If stocks are less than the minimum level then the work will stop due to
shortage of materials. Following factors are taken into account while fixing minimum
stock level:
Lead Time: A purchasing firm requires some time to process the order and time is also
required by supplying firm to execute the order. The time taken in processing the order and
then executing it is known as lead time.
Rate of Consumption: It is the average consumption of materials in the factory. The rate
of consumption will be decided on the basis pas experiences and production plans.
Nature of Material: The nature of material also affects the minimum level. If material is
required only against special orders of customer then minimum stock will not be required for
such materials.
Minimum stock level = Re-ordering level-(Normal consumption
x Normal Re-order period).
(b) Re-ordering Level: When the quantity of materials reaches at a certain figure then fresh
order is sent to get materials again. The order is sent before the materials reach minimum
stock level. Reordering level is fixed between minimum and maximum level. The rate of
consumption, number of days required to replenish the stock and maximum quantity of
material required on any day are taken into account while fixing reordering level.
Re-ordering Level = Maximum Consumption x Maximum Re-order period.
(c) Maximum Level: It is the quantity of materials beyond which a firm should not exceed its
stocks. If the quantity exceeds maximum level limit then it will be overstocking. A firm
should avoid overstocking because it will result in high material costs.
Maximum Stock Level = Re-ordering Level+ Re-ordering Quantity
-(Minimum Consumption x Minimum Re-ordering period).
(d) Danger Level: It is the level beyond which materials should not fall in any case. If danger
level arises then immediate steps should be taken to replenish the stock even if more cost is
incurred in arranging the materials. If materials are not arranged immediately there is
possibility of stoppage of work.
Danger Level = Average Consumption x Maximum reorder period
for emergency purchases.
(e) Average Stock Level
33
The average stock level is calculated as such:

Average Stock level = Minimum Stock Level +½ of re-order quantity
2. Determination of Safety Stocks
Safety stock is a buffer to meet some unanticipated increase in usage. It fluctuates
over a period of time. The demand for materials may fluctuate and delivery of inventory may
also be delayed and in such a situation the firm can face a problem of stock-out. The stock-
out can prove costly by affecting the smooth working of the concern. In order to protect
against the stock out arising out of usage fluctuations, firms usually maintain some margin of
safety or safety stocks. Two costs are involved in the determination of this stock i.e.
opportunity cost of stock-outs and the carrying costs. The stock out of raw materials cause
production disruption resulting in higher cost of production. Similarly, the stock out of
finished goods result into failure of firm in competition, as firm cannot provide proper
customer service. If a firm maintains low level of safety frequent stock out will occur
resulting in large opportunity coast. On the other hand larger quantity of safety stock involves
higher carrying costs.
3. Economic Order Quantity (EOQ)
A decision about how much to order has great significance in inventory management. The
quantity to be purchased should neither be small nor big because costs of buying and carrying
materials are very high. Economic order quantity is the size of the lot to be purchased which
is economically viable. This is the quantity of materials which can be purchased at minimum
costs. Generally, economic order quantity is the point at which inventory carrying costs are
equal to order costs. In determining economic order quantity it is assumed that cost of a
managing inventory is made of solely of two parts i.e. ordering costs and carrying costs.
(A) Ordering Costs: These are costs that are associated with the purchasing or
ordering of materials. These costs include:
(1) Inspection costs of incoming materials.
(2) Cost of stationery, typing, postage, telephone charges etc.
(3) Expenses incurred on transportation of goods purchased.
These costs are also known as buying costs and will arise only when some purchases are
made.
(B) Carrying Costs: These are costs for holding the inventories. These costs will not
be incurred if inventories are not carried. These costs include:
(1) The cost of capital invested in inventories. An interest will be paid on the amount of
capital locked up in inventories.
(2) Cost of storage which could have been used for other purposes.
(3) Insurance Cost
(4) Cost of spoilage in handling of materials
Assumptions of EOQ: While calculating EOQ the following assumptions are made.
34
1. The supply of goods is satisfactory. The goods can be purchased whenever these are
needed.
2. The quality to be purchased by the concern is certain.
3. The prices of goods are stable. It results to stabilize carrying costs.
4. A-B-C Analysis
Under A-B-C analysis, the materials are divided into three categories viz, A, B and C. Past
experience has shown that almost 10 per cent of the items contribute to 70 percent of value of
consumption and this category is called ‘A’ Category. About 20 per cent of value of
consumption and this category is called ‘A’ Category. About 20 per cent of the items
contribute about 20 per cent of value of consumption and this is known as category ‘B’
materials. Category ‘C’ covers about 70 per cent of items of materials which contribute only
10 per cent of value of consumption. There may be some variation in different organizations
and an adjustment can be made in these percentages.
A-B-C analysis helps to concentrate more efforts on category A since greatest monetary
advantage will come by controlling these items. An attention should be paid in estimating
requirements, purchasing, maintaining safety stocks and properly storing of ‘A’ category
materials. These items are kept under a constant review so that substantial material cost may
be controlled. The control of ‘C’ items may be relaxed and these stocks may be purchased for
the year. A little more attention should be given towards ‘B’ category items and their
purchase should be undertaken a quarterly or half-yearly intervals.
5. VED Analysis
The VED analysis is used generally for spare parts. The requirements and urgency of spare
parts is different from that of materials. A-B-C analysis may not be properly used for spare
parts. Spare parts are classified as Vital (V), Essential (E) and Desirable (D) The vital spares
are a must for running the concern smoothly and these must be stored adequately. The non-
availability of vital spares will cause havoc in the concern. The E type of spares are also
necessary but their stocks may be kept at low figures. The stocking of D type of spares may
be avoided at times. If the lead time of these spares is less, then stocking of these spares can
be avoided.
6. Inventory Turnover Ratios
Inventory turnover ratios are calculated to indicate whether inventories have been used
efficiently or not. The purpose is to ensure the blocking of only required minimum funds in
inventory. The Inventory Turnover Ratio also known as stock velocity is normally calculated
as sales/average inventory or cost of goods sold/average inventory cost.
7. Aging Schedule of Inventories
Classification of inventories according to the period (age) of their holding also helps in
identifying slow moving inventories thereby helping in effective control and management of
inventories. The following table shows aging of inventories of a firm.
35
AGING SCHEDULE OF INVENTORIES

Item Age Date of Acquisition Amount %age to
Name/Code Classification (Rs.) total
011 0-15 days June 25,1996 30,000 15
002 16-30 days June 10,1996 60,000 30
003 31-45 days May 20,1996 50,000 25
004 46-60 days May 5,1996 40,000 20
005 61 and above April 12,1996 20,000 10
2,00,000 100
9. Just in Time Inventory (JIT)

JIT is a modern approach to inventory management and goal is essentially to minimize such
inventories and thereby maximizing the turnover. In JIT, affirm keeps only enough inventory
on hand to meet immediate production needs. The JIT system reduces inventory carrying
costs by requiring that the raw materials are procured just in time to be placed into
production. Additionally, the work in process inventory is minimized by eliminating the
inventory buffers between different production departments. If JIT is to be implemented
successfully there must be high degree of coordination and cooperation between the suppliers
and manufacturers and among different production centers.
ROLE OF FINANCE MANAGER IN INVENTORY CONTROL

1. Optimum investment in inventories.
2. Ensuring continuous supply of inventories (JIT)
3. Minimizing the carrying cost and time.
4. Maintain sufficient finished goods inventory for smooth sales operation, and efficient
customer service.
5. Minimizing the risk of holding inventories.
36

FM Notes Unit 3&4

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BA 7203 - FINANCIAL MANAGEMENT PEC/MBA

ASSUMPTIONS OF COST OF CAPITAL

B) Market value weights

OPTIMUM CAPITAL STRUCTURE

CHARACTERISTICS OF A BALANCED CAPITAL STRUCTURE

X = EBIT indifference level

I1 = Fixed interest costs under alternative 1.

CAPITAL STRUCTURE THEORIES

FACTORS DETERMINING (Affecting) DIVIDEND DECISIONS

government restricts the distribution of dividend beyond a certain percentage in a particular

DIVIDEND POLICY MATTERS - EXPERTS VIEWS

The value of P1 can be derived by the above equation as under:

ii) Number of shares to be issued

THE RELEVANCE CONCEPT OF DIVIDEND (OR) THE THEORY OF

Gordon's model is based on the following assumptions

TYPES OF WORKING CAPITAL

On the basis of Requirements

FACTORS DETERMINING OR AFFECTING WORKING CAPITAL

DISADVANTAGES OF WORKING CAPITAL IN EXCESS

Hard core WC or Core Current Assets

Gross Operating Cycle = RMCP+ WIPCP+FGCP+RCP

Motives for holding cash

CASH FORECASTING AND BUDGETING

FLOAT IN CASH MANAGEMENT

LOCK BOX SYSTEM:

SIGNIFICANCE AND PURPOSE OF RECEIVABLE MANAGEMENT

complete answer to slow-paying customers, shortage of working capital and if needed,

Under advance factoring arrangement, certain percentage of receivables is paid in advance to

OBJECTS OF INVENTORY MANAGEMENT

ESSENTIALS OF GOOD INVENTORY SYSTEM

In order to control inventories properly, standardization of materials is necessary.

1. Determination of Stock Levels

The average stock level is calculated as such:

AGING SCHEDULE OF INVENTORIES

9. Just in Time Inventory (JIT)

ROLE OF FINANCE MANAGER IN INVENTORY CONTROL

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