MODULE-1

Introduction to Finance and Financial management

Meaning:
Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the
enterprise.

Definition:
“Financial management is the application of the planning and control functions of the
finance function”
-Howard & Upton

“Financial management is an area of financial decision-making harmonizing individual

motives and enterprise goal.”
-Weston & Brigham

Objectives Of Finance management:

The financial management is generally concerned with procurement, allocation and

control of financial resources of a concern. The objectives can be;

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should
be utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures
so that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition
of capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements:

A finance manager has to make estimation with regards to capital requirements

of the company. This will depend upon expected costs and profits and future
programmes and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition:

Once the estimation have been made, the capital structure have to be decided.
This involves short- term and long- term debt equity analysis. This will depend
upon the proportion of equity capital a company is possessing and additional
funds which have to be raised from outside parties.

3. Choice of sources of funds:

For additional funds to be procured, a company has many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and
period of financing.

4. Investment of funds:

The finance manager has to decide to allocate funds into profitable ventures so
that there is safety on investment and regular returns is possible.

5. Disposal of surplus:

The net profits decision have to be made by the finance manager. This can be
done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and

other benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovation, diversification plans of the company.
6. Management of cash:

Finance manager has to make decisions with regards to cash management.

Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintenance of enough stock, purchase of raw materials, etc.

7. Financial controls:

The finance manager has not only to plan, procure and utilize the funds but he
also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.
Role of Finance Manager
Introduction:
A financial manager is a person who takes care of all the important financial functions
of an organization. The person in charge should maintain a far sightedness in order to
ensure that the funds are utilized in the most efficient manner. His actions directly
affect the Profitability, growth and goodwill of the firm.
Following are the Role of financial Manager;

• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets

1. Raising of Funds:

In order to meet the obligation of the business it is important to have enough

cash and liquidity. A firm can raise funds by the way of equity and debt. It is the
responsibility of a financial manager to decide the ratio between debt and
equity. It is important to maintain a good balance between equity and debt.

2. Allocation of funds:

Once the funds are raised through different channels the next important
function is to allocate the funds. The funds should be allocated in such a manner
that they are optimally used. In order to allocate funds in the best possible
manner the following point must be considered

▪ The size of the firm and its growth capability

▪ Status of assets whether they are long-term or short-term
▪ Mode by which the funds are raised

3. Profit Planning:

Profit earning is one of the prime functions of any business organization. Profit
earning is important for survival and sustenance of any organization. Profit
planning refers to proper usage of the profit generated by the firm. Profit arises
due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output. A healthy mix of
variable and fixed factors of production can lead to an increase in the
profitability of the firm.
 4. Understanding Capital Markets:

Shares of a company are traded on stock exchange and there is a continuous

sale and purchase of securities. Hence a clear understanding of capital market
is an important function of a financial manager. When securities are traded on
stock market there involves a huge amount of risk involved. Therefore, a
financial manager understands and calculates the risk involved in this trading
of shares and debentures.

Sources Of Finance

Sources of finance for business are equity, debt, debentures, retained earnings,
term loans, working capital loans, letter of credit, euro issue, venture funding etc.
These sources of funds are used in different situations. They are classified based on
time period, ownership and control, and their source of generation.

According to Time Period

1 Long-Term Sources of Finance

2 Medium Term Sources of Finance
3 Short Term Sources of Finance
4 Owned Capital
5 Borrowed Capital
6 Internal Sources
7 External Sources

1. Long-term sources of finance:

Long-term financing means capital requirements for a period of more than 5

years to 10, 15, 20 years or maybe more depending on other factors.

Capital expenditures in fixed assets like plant and machinery, land and building,
etc of business are funded using long-term sources of finance. Part of working
capital which permanently stays with the business is also financed with long-
term sources of funds. Long-term financing sources can be in the form of any of
them:

• Share Capital or Equity Share

• Preference Capital or Preference Share
• Retained Earnings or Internal Accruals
• Debentures / Bonds
• Term Loans from Financial Institutes, Government, and Commercial Banks
• Venture Funding
• Asset Securitization
• International Financing by way of Euro Issue, Foreign Currency Loans, ADR,
GDR, etc.

2. Medium Term Sources of finance:

Medium term financing means financing for a period of 3 to 5 years and is used
generally for two reasons. When long-term capital is not available for the time
being and when deferred revenue expenditures like advertisements are made
which are to be written off over a period of 3 to 5 years. Medium term financing
sources can in the form of one of them:
• Preference Capital or Preference Shares
• Debenture / Bonds
• Medium Term Loans from
- Financial Institutes
- Government, and
- Commercial Banks
• Lease Finance
• Hire Purchase Finance

3. Short Term Sources of Finance:

Short term financing means financing for a period of less than 1 year. The need
for short-term finance arises to finance the current assets of a business like an
inventory of raw material and finished goods, debtors, minimum cash and bank
balance etc. Short-term financing is also named as working capital financing.
Short term finances are available in the form of:

• Trade Credit
• Short Term Loans like Working Capital Loans from Commercial Banks
• Fixed Deposits for a period of 1 year or less
• Advances received from customers
• Creditors
• Payables
• Factoring Services
• Bill Discounting, etc.
According to Ownership and Control

4. Owned capital:

Owned capital also refers to equity. It is sourced from promoters of the company or from the
general public by issuing new equity shares. Promoters start the business by bringing in the
required money for a start-up. Following are the sources of Owned Capital:

• Equity
• Preference
• Retained Earnings
• Convertible Debentures
• Venture Fund or Private Equity

5. Borrowed Capital:

Borrowed or debt capital is the finance arranged from outside sources. They include:
• Financial institutions
• Commercial banks or
• The general public in case of debentures

In this type of capital, the borrower has a charge on the assets of the business which means
the company will pay the borrower by selling the assets in case of liquidation. Another feature
of the borrowed fund is a regular payment of fixed interest and repayment of capital.

According to Source of Generation

6. Internal Sources:

The internal sources of capital is the one which is generated internally by the business. These
are as follows:
Retained profits
Reduction or controlling of working capital
Sale of assets etc.

The internal source of funds has the same characteristics of owned capital. The best part of
the internal sourcing of capital is that the business grows by itself and does not depend on
outside parties.

7. External Sources:

It is the capital generated from outside the business. Apart from the internal sources of funds,
all the sources are external sources. Deciding the right source of fund is a crucial business
decision taken by top-level finance managers. The usage of the wrong source increases the
cost of funds which in turn would have a direct impact on the feasibility of the project under
concern. Improper match of the type of capital with business requirements may go against
the smooth functioning of the business.
Capital Market and Money Market
Financial market are divided in two types depends on duration for which they need money.
There are two types of financial market. They are;

• Money Market and

• Capital Market

1. Money Market:

It is one part of financial market where instruments like securities ,bonds having short
term maturities usually less than one year are traded is know as Money market.
Organization or Financial institutions having short term money requirement less than
one year to meet immediate needs like buying inventories, raw material, paying loans
come to Money Market. It involves lending and borrowing of short term funds. Money
market instruments like treasury bills, certificate of deposit and bills of exchange are
traded their having maturity less than one year. Investment in money market is safe
but it gives low rate of return. Money Market is regulated by R.B.I in India.

Money Market instruments

1. Treasury Bills
2. Commercial Papers
3. Certificate of Deposit
4. Bankers Acceptance
5. Repurchase Agreement

Treasury Bills are also know as T-Bills. This is one of safest instrument to invest. T-bills are
issued by RBI backed by government security. RBI issue treasury bills on the behalf of central
government to meet the short term liquidity needs of central government bills are issued at
a discount to face value, on maturity face value is paid to holder.

Commercial papers are issue by private organizations or financial institutions having strong
credit rating to meet short term liquidity requirements. These are unsecured instruments as
these are not backed by any security. The return on commercial papers is usually higher than
T-bills. Different rating agencies rate the commercial paper before issue by any organization.
If commercial paper carrying good rating means it is safe to invest and carrying lower risk of
default .

Certificate of Deposit (CD) is another money market instrument. CDs can be issued
by scheduled commercial banks and All-India Financial Institutions (FIs) that have been
permitted by RBI to raise short-term resources. Minimum amount of a CD should be Rs.1 lakh,
i.e., the minimum deposit that could be accepted from a single subscriber should not be less
than Rs.1 lakh.

Bankers Acceptance is another money market instrument to meet short term liquidity
requirement. In this, company provides bank guarantee to seller to pay amount of good
purchased at agreed future date. In case buyer failed to pay on agreed date, the seller can
invoke bank guarantee . It is usually used to finance export and import.

Repurchase agreement is also know as Repo. It is another money market instrument. In this
one party sell his asset usually government securities to other party and agreed to buy this
asset on future agreed date. The seller pays an interest rate, called the repo rate, when buying
back the securities. This is like a short term loan given by buyer of security to seller of security
to meet immediate financial needs.

2. CAPITAL MARKET:

Capital market is also very important part of Indian financial system. This segment of financial
market meant to meet long term financial needs usually more than one year or more.
Companies like manufacturing, infrastructure power generation and governments which
need funds for longer duration period raise money from capital market. Individuals and
financial institutions who have surplus fund and want to earn higher rate of interest usually
invest in capital market .
Capital market Instruments

1. Equity
Equity market generally know as stock. In this the company want to raise money and issue shares in
share market like B.S.E or N.S.E to individual or financial institutions who want to invest their surplus
money.

2. Bond
Bond market is also know as Debt market. A debt instrument is used by government or organization
to generate funds for longer duration. The relation between person who invest in debt instrument is
of lender and borrower. This gives no ownership right. A person receives fixed rate of interest on debt
instrument.

Time value of money [TVM]

The time value of money (TVM) is the concept that money you have now is worth more
than the identical sum in the future due to its potential earning capacity. This core
principle of finance holds that provided money can earn interest, any amount of
money is worth more the sooner it is received. TVM is also sometimes referred to as
present discounted value.

Compounding

Compounding is the process in which an asset's earnings, from either capital gains or
interest, are reinvested to generate additional earnings.

OR

Compounding is the process in which an asset's earnings, from either capital

gains or interest, are reinvested to generate additional earnings over time. This
growth, calculated using exponential functions, occurs because the investment will
generate earnings from both its initial principal and the accumulated earnings from
preceding periods. Compounding, therefore, differs from linear growth, where only
the principal earns interest each period.

(compounding intervals and continuous compounding Refer from

internet either make it clear with help of Ma’am)

Discounting:

Discounting is the process of determining the present value of a payment or a stream of

payments that is to be received in the future. Given the time value of money, a dollar is worth
more today than it would be worth tomorrow. Discounting is the primary factor used in
pricing a stream of tomorrow's cash flows.

Future value of a single cash flow

Future value of a single cash flow refers to how much a single cash flow today would grow to over a
period of time if put in an investment that pays compound interest.
The formula for calculating future value is:
Example : What will be Future Value of Rs 25000 invested after 10 years, if the Rate of Interest is
10% PA, then what will be the future value of the investment after 20 years

Solution :
As we know, Fv=PV(1+R)T
Pv=25000, R =10%, T=10years (20-10 years, as the amount, will be invested for net 10years only)
Hence, FV = 25000 (1+0.1)10 = Rs 64843.56

ANNUITY
An annuity is a series of payments made at equal intervals.
Examples of annuities are regular deposits to a savings account, monthly home mortgage payments,
monthly insurance payments and pension payments. Annuities can be classified by the frequency of
payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any
other regular interval of time. Annuities may be calculated by mathematical functions known as
"annuity functions".

TYPES OF ANNUITIES

1. Timing of payments

Payments of an annuity-immediate are made at the end of payment periods, so that

interest accrues between the issue of the annuity and the first payment. Payments of
an annuity-due are made at the beginning of payment periods, so a payment is made
immediately on issuer.

2. Contingency of payments

Annuities that provide payments that will be paid over a period known in advance
are annuities certain or guaranteed annuities. Annuities paid only under certain
circumstances are contingent annuities. A common example is a life annuity, which is
paid over the remaining lifetime of the annuitant.

3. Variability of payments
 • Fixed annuities – These are annuities with fixed payments. If provided by an insurance
company, the company guarantees a fixed return on the initial investment. Fixed
annuities are not regulated by the Securities and Exchange Commission.
• Variable annuities – Registered products that are regulated by the SEC in the United
States of America. They allow direct investment into various funds that are specially
created for Variable annuities. Typically, the insurance company guarantees a certain
death benefit or lifetime withdrawal benefits.
• Equity-indexed annuities – Annuities with payments linked to an index. Typically, the
minimum payment will be 0% and the maximum will be predetermined. The
performance of an index determines whether the minimum, the maximum or
something in between is credited to the customer.

4. Deferral of payments

An annuity that begins payments only after a period is a deferred annuity (usually after retirement).
An annuity that begins payments as soon as the customer has paid, without a deferral period is
an immediate annuity. An annuity is the series of periodic payments received by an investor on a
future date, and the term “deferred annuity” refers to the delayed annuity in the form of instalment
or lump-sum payments rather than an immediate stream of income.

PRESENT VALUE OF A SINGLE CASH FLOW

Present value of a single cash flow refers to how much a single cash flow in the future will be
worth today. The present value is calculated by discounting the future cash flow for the given
time period at a specified discount rate.

The formula for calculating future value is:

FV = Future value of money

r = Annual interest rate
T = Number of years
M = Number of periods based on compounding frequency

Introduction to risk and return

Risk, in traditional terms, is viewed as a ‘negative’. Risk is a mix of danger and
opportunity. You cannot have one, without the other. Every investment there is a risk
attached to it. Risk is described as the uncertainty about the actual return that will be
earned through investment. The level of risk differs from one investment to another;
therefore, people invest in different projects as a mean of diversification. There are
two types of investors, risk takers and risk averse. Risk Takers are investors who invest
in projects associated with high risk in order to earn higher profit in return even though
it’s not a 100% guaranteed, and it can be profit or loss. One the other hand, Risk Averse
usually want a guaranteed return so they settle for low risk investments.
Income received on an investment (i.e. Stock or bond) plus any change in market price,
usually expressed as a percent of the beginning market price of the investment
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐆𝐚𝐢𝐧 + 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
Percentage Return = 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐢𝐜𝐞

Relationship between Risk & Return

Relationship between risk and return means to study the effect of both elements on
each other. We measure the effect of increase or decrease risk on return of
investment. Following is the main type of relationship of risk and return

Risk-Return relationship model

1. Direct Relationship between Risk and Return

(A) High Risk - High Return

According to this type of relationship, if investor will take more risk, he will get more
reward. So, he invested million, it means his risk of loss is million dollars. Suppose, he
is earning 10% return. It means, his return is Lakh but he invests more million, it
means his risk of loss of money is million. Now, he will get Lakh return.
(B) Low Risk - Low Return

It is also direct relationship between risk and return. If investor decreases

investment. It means, he is decreasing his risk of loss, at that time, his return will also
decrease.

2. Negative Relationship between Risk and Return

(A) High Risk Low Return

Sometime, investor increases investment amount for getting high return but with
increasing return, he faces low return because it is nature of that project. There is no
benefit to increase investment in such project. Suppose, there are 1,00,000 lotteries
in which you will earn the prize of You have bought 50% of total lotteries. But, if you
buy 75% of lotteries. Prize will same but at increasing of risk, your return will
decrease.

(B) Low Risk High Return

There are some projects, if you invest low amount, you can earn high return. For
example, Govt. of India need money. Because, govt. needs this money in emergency
and Govt. is giving high return on small investment. If you get this opportunity and
invest your money, you will get high return on your small risk of loss of money.

BETA
In finance, the beta (β) of a stock or portfolio is a number describing how the return
of an asset is predicted by a benchmark. This benchmark is generally the overall
financial market and is often, estimated via the use of representative indices. Beta
measures systematic risk based on how returns co-move with the overall market.

OBJECTIVE
• The beta or betas that measure risk in models of risk in finance have two basic
characteristics that we need to keep in mind during estimation.
• The first is that they measure the risk added on to a diversified portfolio, rather
than total risk. Thus, it is entirely possible for an investment to be high risk, in
terms of individual risk, but to below risk, in terms of market risk.
 • The second characteristic that all betas share is that they measure the relative
risk of an asset, and thus are standardized around one.

Estimating Beta

• The standard procedure for estimating betas is to regress stock returns (Rj )
against market returns (Rm):
Rj = a + b
R m where a is the intercept and b is the slope of the regression.
• The slope of the regression corresponds to the beta of the stock, and measures
the riskiness of the stock.
• The R squared (R2) of the regression provides an estimate of the proportion of
the risk (variance) of a firm that can be attributed to market risk. The balance
(1 - R2) can be attributed to firm specific risk.
•
Setting up for the Estimation
1.Decide on an estimation period
• Services use periods ranging from 2 to 5 years for the regression
• Longer estimation period provides more data, but firms change.
• Shorter periods can be affected more easily by significant firm-specific
event that occurred during the period.

2. Decide on a return interval - daily, weekly, monthly :

• Shorter intervals yield more observations, but suffer from more noise.
• Noise is created by stocks not trading and biases all betas towards one.

3. Estimate returns (including dividends) on stock:

• Return = PriceEnd-PriceBeginning+ DividendsPeriod)/ PriceBeginning
• Included dividends only in ex-dividend month.

4. Choose a market index, and estimate returns (inclusive of dividends) on the

index for each interval for the period.
EXTERNAL AND INTERNAL FINANCING
internal sources of finance:
• These are funds that are generated internally from within the business
organization. Typical examples of internal sources of finance include funds
generated from business operations i.e. profit from sales

• Internal sources of finances are generally sought out by profit making entities
that are generating enough surplus from their business operations. Internal
sources are typically used for funding day to day operations of the business.

• Examples of internal sources of finance include profits arisen from business

operations, funds generated from sale of assets of the business.

External sources of finance:

• These are funds that are raised through external means i.e., from outside
entities.
External sources of funds can be either raised through debt or equity.
• Debt essentially means any kind of loan or borrowing. This can include loans
from banks, financial institutions, public deposits, letter of credit etc.
• Equity means raising of capital by issue of shares to existing or new
shareholders. These can be ordinary shares or preference shares.
• External sources of funds involve incurring a cost of raising the funds. As
these are raised from outside entities, they need to be compensated for
providing funds
• Examples of external sources of finance include debt funds such as loans,
advances, deposits taken and equity funds such as equity and preference share
capital.
 UNIT-III
CAPITAL STRUCTURE DECISIONS

INTRODUCTION:

Capital structure in simple words refers to debt equity ratio of a company.

In other words it refers to the proportion of debt in the investments of the company.
It is important for a company to have an appropriate capital structure.

MEANING OF CAPITALIZATION:

In broad sense, capitalization is synonymous with financial planning, covering

decisions regarding the amount of capital to be raised, the relative proportions of the
various classes of securities to be issued and the administration of capital.
In its narrow sense, capitalization means the amount at which a firm’s business can
be valued, the sum total of all long-term securities issued by a company and the
surpluses not meant for distribution.

DEFINITIONS OF CAPITALIZATION:

1. According to Doris, “capitalization is the total accounting value of the capital

stock, surplus in whatever form it may appear and long-term debts”
2. According to A.S.Dewing, “ The term capitalization or the valuation of the capital
includes the capital stock and debts”.
3. According to A.F.Lincoin, “capitalization refers to the sum of the outstanding
stocks and funded obligations which may represent wholly fictious values”.
4. According to G.W.Gerstenberg, “ For all practical purposes, capitalization means
the total accounting value of all capital regularly employed in the business”.
5. According to Pearson and Hunt, “ The term capitalization is used to mean the
total of the funds raised on a long term basis, whether debt, preferred, equity or
common equity. The common equity, of course, includes all values belonging to that
interest and not merely stated value of the common stock”.
6. According to W.H. Husband and D.C.Dockerary, “capitalization includes the
amount of capital to be raised, the securities through which is to be raised and the
relative proportion of various classes of securities to be issued and also the
administration of capital”.
ESTIMATION OF CAPITAL REQUIREMENT:

The financial manager should keep in mind the future requirements of funds for
expansion and growth of the company, while estimating the capital needs. On the
other hand, while estimating the capital requirements of the newly promoted
company, the financial manager should give due consideration to the following
factors.

1. Expenses for Promotion:

Required is case of a new company, these include-expenses incurred on discovery of
business idea and examine its viability, registration of the company, establishment
of organization, commencement of business.

2. Cost of Fixed Assets:

Fixed assets including land and building, plant and machinery, furniture and fixtures
etc., need a careful capital requirements estimation.

3. Cost of Current Assets:

This is the capital requires for financing the acquisition of current assets such as
stocks, debtors, bills receivables, prepaid expenses etc.

4. Cost of Financing:
Every company has to incur a huge amount of expenditure for raising finance which
include advertisement, listing, brokerage, commission etc. 5.Cost of Fictitious
Assets:
Most of the companies require to pay huge amount for purchase of intangible assets
such as goodwill, patents, trademarks and copyrights etc.

5. Cost of Sustenance and Development:

While in the initial years, a business may need funds to meet its losses.
In later years, it needs funds for diversification, expansion and growth, as well as for
replacement and renovation of old fixed assets, modernization, innovation, research
and development.

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 on
reasonable basis.
It refers to additional profits that equity shareholders earn because of issuance of
debentures and preference shares.
It is based on the thought that if the rate of dividend on preference capital and the
rate of interest on borrowed capital is lower than the general rate of company’s
earnings, equity shareholders are at advantage which means a company should go
for a judicious blend of preference shares, equity shares as well as debentures.
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 share holders 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 in 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.

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 Boom and Inflation, the 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 the 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 sale, then the company is not in position to meet fixed
obligations. So, equity capital proves to be safe in such cases.
9. Size 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 size, the wider is total capitalization.

FEATURES OF CAPITAL STRUCTURE

Financial manager should develop an appropriate capital structure, which is helpful

to maximize shareholders wealth. This can be possible when all factors which are
relevant to the company’s capital structure and properly analyzed, balanced and
considered.
1. Profitability:
The company should make maximum use of leverage at a minimum cost. In other
words, it should generate maximum returns to owners without adding additional
cost.
2. Flexibility:
Flexible capital structure means it should allow the existing capital structure to
change according to the changing conditions without increasing cost.
It should be possible for the company to provide funds whenever needed to finance
its possible activities.
The company should be able to raise funds whenever the need arises and also retire
debts whenever it becomes too costly to continue with particular source.
3. Solvency:
The use of excessive debt threatens the solvency of the company. Debt should be
used till the point where debt does not add significant risk, otherwise use of debt
should be avoided.
4. Control:
The capital structure should involve minimum dilution of the control of the
company.
A company that issues more and more equity dilutes the power of existing
shareholders as number of shareholders increases.
Also raising of additional funds through public issue may lead to dilution of control.
5. Cost of Capital:
If the cost of any component of capital structure of the company like interest
payment on debts is very high then it can increase the overall cost of the capital of
the company.
In such case the company should minimize the use of that component of capital
structure in its total capital structure in its total capital structure.
6. Flotation Cost :
It is the cost involved in issuing a security or a debt.
If such cost is too high for new issue of any component of capital structure, then the
use of such a source of fund should be minimized.

TYPES OF CAPITAL STRUCTURE

MEANING OF CAPITAL STRUCTURE

Capital structure refers to the kinds of securities and the proportionate amounts that
make up capitalization. It is the mix of different sources of long-term sources such
as equity shares, preference shares, debentures, long-term loans and retained
earnings.
DEFINITION OF CAPITAL STRUCTURE
According to the definition of Gerestenbeg, “Capital Structure of a company refers
to the composition or make up of its capitalization and it includes all long-term
capital resources”.
According to the definition of James C. Van Horne, “The mix of a firm’s
permanent long-term financing represented by debt, preferred stock, and common
stock equity”.
FINANCIAL STRUCTURE
The term financial structure is different from the capital structure. Financial
structure shows the pattern total financing. It measures the extent to which total
funds are available to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure
and capital structure.

Financial Structures Capital Structures

1. It includes both long-term and short-term
sources of funds
2. It means the entire liabilities side of the
balance sheet.
3. Financial structures consist of all sources
of capital.
4. It will not be more important while
determining the value of the firm.
1. It includes only the long-term
sources of funds.
2. It means only the long-term
liabilities of the company.
3. It consist of equity,
preference and retained
earning capital.
4. It is one of the major
determinations of the value of
the firm.

CAPITALIZATION
Capitalization is one of the most important parts of financial decision, which is
related to the total amount of capital employed in the business concern.
According to Guthman and Dougall, “capitalization is the sum of the par value
of `stocks and bonds outstanding”.
“Capitalization is the balance sheet value of stocks and bonds outstands”.
— Bonneville and Dewey

TYPES OF CAPITALIZATION
Capitalization may be classified into the following three important types based on its
nature:
• Over Capitalization
• Under Capitalization
• Water Capitalization

Over Capitalization

Over capitalization refers to the company which possesses an excess of capital in

relation to its activity level and requirements. In simple means, over capitalization is
more capital than actually required and the funds are not properly used.
 According to Bonneville, Dewey and Kelly, over capitalization means, “when a
business is unable to earn fair rate on its outstanding securities”.
Example
A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%.
This company will be said to be properly capitalized. Suppose the capital investment
of the company is Rs. 60,000, it will be over capitalization to the extent of Rs.
1,00,000. The new rate of earning would be:
50,000/60,000×100=8.33%
When the company has over capitalization, the rate of earnings will be reduced from
10% to 8.33%.
Causes of Over Capitalization
Over capitalization arise due to the following important causes:
• Over issue of capital by the company.
• Borrowing large amount of capital at a higher rate of interest.
• Providing inadequate depreciation to the fixed assets.
• Excessive payment for acquisition of goodwill.
• High rate of taxation.
• Under estimation of capitalization rate.
Effects of Over Capitalization
Over capitalization leads to the following important effects:
• Reduce the rate of earning capacity of the shares.
• Difficulties in obtaining necessary capital to the business concern.
• It leads to fall in the market price of the shares.
• It creates problems on re-organization.
• It leads under or mis-utilisation of available resources.

Remedies for Over Capitalization

Over capitalization can be reduced with the help of effective management and
systematic design of the capital structure. The following are the major steps to reduce
over capitalization.
• Efficient management can reduce over capitalization.
• Redemption of preference share capital which consists of high rate of
dividend.
• Reorganization of equity share capital.
• Reduction of debt capital

Under Capitalization

Under capitalization is the opposite concept of over capitalization and it will occur when
the company’s actual capitalization is lower than the capitalization as warranted by its
earning capacity. Under capitalization is not the so called inadequate capital.
Under capitalization can be defined by Gerstenberg, “a corporation may be
undercapitalized when the rate of profit is exceptionally high in the same
industry”.
Hoagland defined under capitalization as “an excess of true assets value over
the aggregate of stocks and bonds outstanding”.
Causes of Under Capitalization
Under capitalization arises due to the following important causes:
• Under estimation of capital requirements.
• Under estimation of initial and future earnings.
• Maintaining high standards of efficiency.
• Conservative dividend policy.
• Desire of control and trading on equity.

Effects of Under Capitalization

Under Capitalization leads certain effects in the company and its shareholders.
• It leads to manipulate the market value of shares.
• It increases the marketability of the shares.
• It may lead to more government control and higher taxation.
• Consumers feel that they are exploited by the company.
• It leads to high competition.

Remedies of Under Capitalization

Under Capitalization may be corrected by taking the following remedial measures:
1. Under capitalization can be compensated with the help of fresh issue of
shares.
2. Increasing the par value of share may help to reduce under capitalization.
3. Under capitalization may be corrected by the issue of bonus shares to the
existing shareholders.
4. Reducing the dividend per share by way of splitting up of shares.

Watered Capitalization
If the stock or capital of the company is not mentioned by assets of equivalent value, it is
called as watered stock. In simple words, watered capital means that the realizable value
of assets of the company is less than its book value.
According to Hoagland’s definition, “A stock is said to be watered when its true
value is less than its book value.”
Causes of Watered Capital

Generally watered capital arises at the time of incorporation of a company but it also
arises during the life time of the business. The following are the main causes of watered
capital:
 1. Acquiring the assets of the company at high price.
2. Adopting ineffective depreciation policy.
3. Worthless intangible assets are purchased at higher pr ice.

Definition of Leverage

James Horne has defined leverage as, “the employment of an asset or fund for which the
firm pays a fixed cost or fixed return.

TYPES OF LEVERAGES
OPERATING LEVERAGE

The leverage associated with investment activities is called as operating leverage. It is

caused due to fixed operating expenses in the company. Operating leverage may be
defined as the company’s ability to use fixed operating costs to magnify the effects of
changes in sales on its earnings before interest and taxes. Operating leverage consists of
two important costs viz., fixed cost and variable cost. When the company is said to have a
high degree of operating leverage if it employs a great amount of fixed cost and smaller
amount of variable cost. Thus, the degree of operating leverage depends upon the amount
of various cost structure. Operating leverage can be determined with the help of a break
even analysis.
Degree of Operating Leverage

The degree of operating leverage may be defined as percentage change in the profits
resulting from a percentage change in the sales. It can be calculated with the help of the
following formula:
FINANCIAL LEVERAGE

Leverage activities with financing activities are called financial leverage. Financial
leverage represents the relationship between the company’s earnings before interest and
taxes (EBIT) or operating profit and the earning available to equity shareholders.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share”. It involves the use of
funds obtained at a fixed cost in the hope of increasing the return to the shareholders.
“The use of long-term fixed interest bearing debt and preference share capital along with
share capital is called financial leverage or trading on equity”.
Financial leverage may be favourable or unfavourable depends upon the use of fixed cost
funds. Favourable financial leverage occurs when the company earns more on the assets
purchased with the funds, then the fixed cost of their use. Hence, it is also called as
positive financial leverage. Unfavourable financial leverage occurs when the company
does not earn as much as the funds cost. Hence, it is also called as negative financial
leverage.
 Financial leverage can be calculated with the help of the following formula:

OP
FL
PBT
Where
FL = Financial leverage
OP = Operating profit
(EBIT) PBT = Profit before
tax.
Degree of Financial Leverage

Degree of financial leverage may be defined as the percentage change in taxable profit as
a result of percentage change in earnings before interest and tax (EBIT). This can be
calculated by the following formula
Percentage change in taxable Income
DFL Precentage change in EBIT
 DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL
LEVERAGE

Operating Leverage Financial Leverage

1. Operating leverage is associated1. Financial leverage is associated with
with investment activities of the financing activities of the company.
company. 2. Financial leverage consists of
2. Operating leverage consists of operating profit of the company.
fixed operating expenses of the 3. It represents the relationship between
company. EBIT and EPS.
3. It represents the ability to use 4. Financial leverage can be calculated
fixed operating cost. by
4. Operating leverage can be calculated OP
by FL = PBT .
C 5. A percentage change in taxable
OL = OP . profit is the result of percentage
5. A percentage change in the profits change in EBIT.
resulting from a percentage change
in the sales is called as degree of 6. Trading on equity is possible only
operating leverage. when the company uses financial
6. Trading on equity is not possible leverage.
while the company is operating 7. Financial leverage depends
leverage. upon the operating profits.
7. Operating leverage depends upon8. Financial leverage will change due to
fixed cost and variable cost. tax rate and interest rate.
8. Tax rate and interest rate will not
affect the operating leverage.

COMBINED LEVERAGE

When the company uses both financial and operating leverage to magnification of any
change in sales into a larger relative changes in earning per share. Combined leverage is
also called as composite leverage or total leverage.
Combined leverage express the relationship between the revenue in the account of sales
and the taxable income.
Combined leverage can be calculated with the help of the following formulas:
CL = OL × FL
EBIT - EPS Break even chart for three different financing alternatives
X1 X

2
DR = 70%
EPS DR = 30%

X3

EBIT

C1 C2 C3

Where,
DR= Debt Ratio
C1, C2, C3 = Indifference
Point X1, X2, X3 =
Financial BEP
Financial BEP

It is the level of EBIT which covers all fixed financing costs of the company. It is the
level of EBIT at which EPS is zero.

Indifference Point

It is the point at which different sets of debt ratios (percentage of debt to total capital
employed in the company) gives the same EPS.

CAPITAL STRUCTURE THEORIES

Capital structure is the major part of the firm’s financial decision which affects the value
of the firm and it leads to change EBIT and market value of the shares. There is a
relationship among the capital structure, cost of capital and value of the firm. The aim of
effective capital structure is to maximize the value of the firm and to reduce the cost of
capital.
There are two major theories explaining the relationship between capital structure, cost of
capital and value of the firm.
Traditional Approach

It is the mix of Net Income approach and Net Operating Income approach. Hence, it is
also called as intermediate approach. According to the traditional approach, mix of debt
and equity capital can increase the value of the firm by reducing overall cost of capital up
to certain level of debt. Traditional approach states that the Ko decreases only within the
Responsible limit of financial leverage and when reaching the minimum level, it starts
increasing with financial leverage.

Assumptions

Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:
• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.

Net Income (NI) Approach

Net income approach suggested by the Durand. According to this approach, the capital
structure decision is relevant to the valuation of the firm. In other words, a change in the
capital structure leads to a corresponding change in the overall cost of capital as well as
the total value of the firm.
According to this approach, use more debt finance to reduce the overall cost of
capital and increase the value of firm.
Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
The use of debt does not change the risk perception of the investor

where
V = S+B
V = Value of firm
S = Market value of
equity
B = Market value of debt
 Market value of the equity can be ascertained by the following formula:
NI
S= Ke

where
NI = Earnings available to equity
shareholder
Ke = Cost of equity/equity capitalization
rate
Format for calculating value of the firm on the basis of NI approach.

Particulars Amount
Net operating income (EBIT) Less: interest XXX
on debenture (i) XXX
Earnings available to equity holder (NI) XXX

XXX
Equity capitalization rate (Ke)
Market value of equity (S) XXX
Market value of debt (B) XXX

Total value of the firm (S+B) XXX

Overall cost of capital = K = EBIT/V(%) XXX
o

Net Operating Income (NOI) Approach

Another modern theory of capital structure, suggested by Durand. This is just the
opposite to the Net Income approach. According to this approach, Capital Structure
decision is irrelevant to the valuation of the firm. The market value of the firm is not at all
affected by the capital structure changes.

According to this approach, the change in capital structure will not lead to any change in
the total value of the firm and market price of shares as well as the overall cost of capital.

NI approach is based on the following important assumptions;

The overall cost of capital remains constant;
There are no corporate taxes;
The market capitalizes the value of the firm as a whole;
Modigliani and Miller Approach
Modigliani and Miller approach states that the financing decision of a firm does not affect
the market value of a firm in a perfect capital market. In other words MM approach
maintains that the average cost of capital does not change with change in the debt
weighted equity mix or capital structures of the firm.

Modigliani and Miller approach is based on the following important assumptions:

• There is a perfect capital market.

• There are no retained earnings.
• There are no corporate taxes.

• The investors act rationally.

• The dividend payout ratio is 100%.

• The business consists of the same level of business risk.

 Marketing Management -2(Two)

Ploughing back of Profits: Means,

1. Purchasing new assets required for betterment, development and
expansion of the company.
2. Replacing the old assets which have become obsolete.
3. Meeting the working capital needs of the company. ADVERTISEMENTS:
4. Repayment of the old debts of the company.

It’s Merits and Demerits

Merits of “Ploughings Back of Profits”:
The device of retaining a part of earning of the company for ploughing them
back into its business is useful to the stability of the company, the welfare of
the shareholders and the society.

a) Advantages to the company:

From the point of view of the company, the policy of retained earnings results
into the following advantages:
1. A cushion to absorb the shocks of depression:
The paramount advantage of the policy of ploughing back of profit is that such
a company is well armed to fight out depressions and seasonal changes in
demand. It acts as a cushion to absorb the shocks of business cycles.

2. Ease in financing the schemes of modernisation and expansion:

When a concern expands its business or when any scheme of modernization,
mechanization or automation is to be implemented, the retained earnings can
be profitably used.
There are two additional benefits of internal financing:
(i) There is no dependence on any outside resource; and
(ii) No charge or encumbrance is created on the property of the company.

3. Follow a stable dividend policy:

If a company has retained its earnings in the form of Dividend Equalisation
Fund, it is in a position to follow a stable dividend policy. Otherwise, high rate
of dividend in one year and lower rate in another year would bring about
fluctuations in the market value of its shares.

4. No dependence on ‘fair-weather friends’:

Public deposits, banks, issues of shares or debentures are like fair weather
friends. Dependence on them is risky. Companies with retained earnings are
free from such risks or uncertainty.

5. Deficiencies of depreciation can be made good:

Companies with retained surpluses can set right any shortfalls in provision for
depreciation and bad and doubtful debts etc.

6. Easy repayment of bonds or debentures:

The undistributed income can also be used for re
tiring the bonds or debentures and thus a company is relieved of the fixed
burden of interest charges.

Demerits of ploughing back of profits:

If the policy of ploughing back is ill-planned and irrational, it may lead to the
following disadvantages:
1. Creation of monopolies:
By continuous ploughing back of profits over a long period of time, concern
may expand to a limit when it may become uncontrollable to manage its
affairs. Thus, re-investment of earnings may lead a company to grow into
monopoly, with all the inherent evils.

2. Manipulation in the share values:

ADVERTISEMENTS:
Sometimes, by retaining earned profits, lower dividends may be declared.
When the share values fall in the market, the management may purchase them
at lower prices. Later, they increase the dividend rate out of the past profits
and try to share the increased prosperity or gain by disposing off the shares at
a higher price.

3. Nis-utilisation of savings:
Management may not always use the retained earnings to the advantages of
the shareholders. Accumulated surpluses may be invested in other concerns
under the same management, bringing no gain to the shareholders.

4. Over-capitalisation:
If accumulated reserves are used for the issue of bonus shares, it may result in
over-capitalisation later on.
5. Interfering with the freedom of the investors:
Since the profits are retained in the same business the investors’ freedom
employing their savings in industries of their choice is restricted. This results
into the hindrance of natural growth of capital market.

6. Evasion of tax:
Sometimes earnings are retained to minimise the corporate profits so that the
tax liability may be reduced. Mow the Income-tax law has been amended in
such a way that evasion of tax may not be possible by the companies.

7. Dissatisfaction among the shareholders:

An over-enthusiastic policy of retaining profits into the business may lead to
dissatisfaction among the shareholders. They may feel that the directors are
ignoring their interest, by paying them a rate of dividend lower than that can
be paid out of the available profits.

Conclusion:

However, the Government should regulate internal financing with a view to

maintain a proper balance between the old and new enterprises. Viable
projects should not be allowed to go unimplemented due to lack of funds.
Thus, to conclude, in the words of Pigor, “Excessive ploughing back entails
social waste, because the money is not made available to those who can use
it to the best advantage for the community but is retained by those who have
earned it.”
 Module: 3
Investment Decisions

InvestmentDecisions:-Capitalbudgeting–processofcapitalbudgeting-
selection of projects - estimation of cash flows - payback and discounted
payback period – ARR, NPV, PI and IRR. Capital budgeting decisions
Module 3
under risk - capital rationing - project selection under rationing. Cost of
capital , cost of equity, cost of debt and overall cost of capital, calculation
of WACC

Investment Decision

One of the major decisional areas of financial management is investment decision. “The
investment decision is concerned with how the firm’s funds are to be invested in different
assets”. It can be long-term or short-term.

Capital Budgeting

Meaning: Capital budgeting is the firm’s decision to invest its funds most efficiently in long
term activities against an anticipated flow of future benefits over a number of years.

Definition: According to Lawrence. J. Gitman “Capital budgeting refers to the total process of
generating, evaluating, selecting and following up on capital expenditure alternatives”.

Importance of Capital Budgeting

 Large investment of funds

 Long-term commitment of funds
 Irreversible nature of expenditure

1
  Long-term effect on profitability
 Risk of obsolescence
 Loss of flexibility
 Impact on cost structure
 National importance

Process/Steps of Capital Budgeting

Conception of ideas

Preliminary Project Proposal

Feasibility Reports

Evaluation and Ranking

Acceptance or Rejection

Follow up

2
 I. Conception of Ideas: At any time a firm may have several investment proposals and
they may come from different levels, i.e. from operator’s level to top management’s level
and may also come from consultants.
II. Preliminary Project Proposal: The heads of the department or branches may make a
study of the idea coming up and submit the proposals to the higher authorities. The higher
authorities will consider all such proposals and select the sound proposals for detailed
analysis.
III. Feasibility Reports: The higher authorities seek the assistance of experts to prepare
feasibility reports in respect of the selected proposals. The feasibility reports discuss the
economic, commercial, technical, financial and managerial aspects of the proposals.
IV. Evaluation and Ranking: The proposals which are found feasible are selected for
evaluation and ranking. It is done on the basis of two aspects;
i. Liquidity
ii. Profitability
There are different methods like payback period method, average rate of return method
etc., for evaluating and ranking investment proposals.
V. Acceptance or Rejection: On the basis of set criteria top ranking proposals may be
accepted and the rest will be rejected. Funds are allocated for the projects accepted for
execution.
VI. Follow up: There is a follow up system to ensure that actual performance does not
deviate from the budgeted performance.

Capital Budgeting Methods

Capital budgeting methods are used for evaluating and ranking proposals.
Capital budgeting method is also known as methods of ranking investment proposal. There
are two types of ranking investment proposal;

 Traditional method
 Modern method

The following are the various investment evaluation methods for measuring profitability:

3
 Methods

Traditional Modern
Methods Methods

Payback Period Net Present Value

Method Method

Average Rate of Profitability Index

Return Method

Internal Rate of
Return

I. Traditional Method
1. Payback Period Method
Payback period refers to the time required for generating sufficient cash inflows for the
recovery of investment in a project.
The life period after the payback period is called post payback period.
The earnings in the post payback period are called post payback profit.

4
Decision Rule of Payback Period

The decision rule of payback period is that in accept or reject decisions. When the payback
period is lower than the standard payback period or cut-off period the project is to be accepted
and payback period is greater than the standard payback period the project is to be rejected.

i.e., Payback Period < Standard Payback Period = Accept

Payback Period > Standard Payback Period = Reject

Discounted Pay-Back Period Method (DPB method)

The discounted payback period is a capital budgeting procedure used to determine the
profitability of a project. A discounted payback period gives the number of years it takes to break
even from undertaking the initial expenditure, by discounting future cash flows and recognizing
the time value of money.

2. Average Rate of Return (Rate of Return Method)

Various projects are ranked on the basis of rate of return and the one with the highest
rate of return is accepted. If there is only one project in hand acceptance/rejection
decision is taken on the basis of cutoff rate or hurdle rate, i.e.., the minimum rate
specified by the management.
There are two approaches in the calculation of ARR and accordingly there are two
formulae.

Average annual earnings from the project

1) ARR = × 100
Original investment in the project

Average annual earnings from the project

2) ARR = × 100
Average investment in the project

5
 Where;

Total of expected annual earnings after depreciation and tax

Average annual earnings =
Number of years

Original investment = Total cost of the project till commissioning – Salvage value
Average investment means if there is;

Original cost of the project

No salvage value =
2

Any Salvage value = ½ (Original cost – Salvage value) + Salvage value

= ½ (Original cost + Salvage value)
Opening cost+Closing balance
i. e,
2

If additional working capital is required:

𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 + 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
𝑖. 𝑒, + 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
2

II. Modern Method (Discounted Cash Flow Methods)

An important feature of discounted cash flow method is time value. The concept of time value
of money is that a rupee received today is more valuable than a rupee received tomorrow. This is
because an amount invested today will grow to a larger sum in future. While adding up the cash
flows - both outflows and inflows at different points of time are adjusted for time value. This
process of adjustment is called discounting. Thus discounting is the process of finding out the
present value of money receivable at future dates.

Following are the Discounted Cash Flow Methods:

i. Net Present Value Method (NPV Method)

Net present value method is defined as the excess of discounted cash inflows over
discounted cash outflow of a project.

C1 C2 C3 Cn In
Mathematically NPV = ⌈1+r + (1+r)2 + (1+r)3 + ⋯ (1+r)n ⌉ − I + (1+r)n

6
Where; NPV = Net Present Value

C1, C2, C3…Cn = Cash inflows of 1st year, 2nd year and so on.
r = Rate of interest or discount rate
I = Initial investment, In investment in the nth period.

Decision Rule of NPV Method

NPV > 0 or +ve = Accept the proposal

NPV < 0 or –ve = Reject the proposal

In investment ranking project having greater NPV is ranked first.

ii. Profitability Index Method (Benefit/Cost Ratio)

This is a variant of the net present value method. Profitability index is the ratio of present
value of cash inflows to the present value of cash outflows. This method is superior to
NPV method.

Present value of cash inflows

Profitability index =
Present value of cash outflows

[OR]

Present value of cash inflows

Profitability index =
Initial investment

[OR]

Present value of cash inflows

Profitability index = × 100
Initial investment

[OR]

C1 C2 C3 Cn
1 + r + (1 + r)2 + (1 + r)3 + ⋯ + ( 1 + r)n
Profitability index = × 100
I

7
Where, C1, C2….. Etc. denotes cash inflows of various years

I = Investment

r = Rate of interest or cost of capital

Decision Rule of Profitability Index Method

PI > 100% (or 1) = Accept the proposal

PI < 100% = Reject the proposal

iii. Internal Rate of Return Method (IRR)

Internal rate of return is that discount rate which equates the present value of cash inflows
with the present value of cash outflows. It is a rate of discount at which the net present
value becomes zero. This method is also known as time adjusted rate of return method,
project rate of return, yield method, etc.

For evaluation of investment proposals a cut-off rate or hurdle rate is fixed. A cut-off rate or
hurdle rate is the minimum rate of return on investment.

Decision Rule of IRR

IRR > Cost of capital = Accept the proposal

IRR < Cost of capital = Reject the proposal

In investment ranking project having greater IRR is ranked first.

C
IRR = A + (B − A)
(C − D)

Where, A = Lower rate

B = Higher rate

C = NPV at lower rate

D = NPV at higher rate

8
Comparison between NPV and IRR

NPV IRR
NPV is expressed in amount IRR is expressed in percentage

May be positive or negative Always positive

The interest rate is a known factor The interest rate is an unknown factor

It can be computed only if interest rate To compute IRR no need of interest rate

is given

For accept or reject decisions: For accept or reject decisions:

Decision rule is Decision rule is

NPV > 0 = Accept IRR > K = Accept the proposal

NPV < 0 = Reject IRR < K = Reject the proposal

For investment ranking project having For investment ranking project having

greater NPV is ranked first. greater IRR is ranked first.

Capital Budgeting Decisions under Risk and Uncertainty

Risk: It is variability between actual return and estimated return in a certain future. The decision
maker draws a probability of certain return based on historical data.

Uncertainty: The decision makers are not able to draw probability of an outcome in uncertain
future. The facts are unknown in uncertain future.

9
 Various evaluation methods are used for risk and uncertainty in capital budgeting is as
follows:

 Risk-adjusted discount rate

 Certainty Equivalent Method.
 Sensitivity Technique.
 Probability Technique.
 Standard Deviation Method.
 Co-efficient of Variation Method.
 Decision Tree Analysis.

i. Risk-adjusted discount rate

While calculating the risk in capital budgeting, increase cut of rate or discount factor by
certain percentage an account of risk. This is one of the simplest methods.
ii. Certainty Equivalent Method
Certainty Equivalent is essential for evaluating risk. It is evident that investors expect the
return on their investment equivalent to the risk she/he takes, which means, higher the
risk, equivalent is the expected return on that investment. It deals with risk factors
involved where risky future cash flows are expressed in terms of the certain cash flows
investors will accept today. Uncertain cash flows are converted into certain cash flows by
multiplying it with probability of occurrence i.e., certainty coefficient.
.
Certainty coefficient lies between 0 and 1

iii. Sensitivity Technique

When cash inflows are sensitive under different circumstances more than one forecast of
the future cash inflows may be made. These inflows may be regarded on:
 Optimistic
 Most likely
 Pessimistic
Further cash inflows may be discounted to find out the net present values under these
three different situations. If the net present values under the three situations differ widely.

10
 It implies that there is a great risk in the project and the investor’s decision to accept or
reject a project will depend upon its risk bearing activities.
iv. Probability Technique
Probability technique refers to each event of future happenings are assigned with relative
frequency probability. Probability means the likelihood of future event. The cash inflows
of the future years further discounted with the probability. The higher present value
may be accepted.
v. Standard Deviation Method
Two Projects have the same cash outflow and their net values are also the same, standard
deviation of the expected cash inflows of the two Projects may be calculated to measure
the comparative and risk of the Projects. The project having a higher standard deviation
in said to be riskier as compared to the other.
vi. Co-efficient of Variation Method
Co-efficient of variation is a relative measure of dispersion. If the projects have the same
cost but different net present values, relatives measure, i.e., Co-efficient of variation
should be risk induced. It can be calculated as:

𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝒅𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏
𝑪𝒐𝒆𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒕 𝒐𝒇 𝒗𝒂𝒓𝒊𝒂𝒕𝒊𝒐𝒏 = × 𝟏𝟎𝟎
𝒎𝒆𝒂𝒏

vii. Decision Tree Analysis

In the modern business world, putting the investments are become more complex and
taking decisions in the risky situations. So, the decision tree analysis helpful for taking
risky and complex decisions, because it considers all the possible event’s and each
possible events are assigned with the probability

Risks Associated with Projects

 Stand-Alone risk: It is a risk associated with single project alone.

 Corporate risk: It is a risk of choosing a project which affects the overall company profits
or positions.

11
 Market risk: It is a risk of choosing a project which affects the shareholders position in
company.
 Liquidity risk: To face difficulty in converting an investment into cash. It means investors
are not able to get fair value on selling its investment when they need cash immediately.
 Inflation risk: It is a loss of purchasing power. It means the quantity of goods you bought in
Rs.5 now you can buy in Rs.8. due to the time variation the value of money decrease this is
known as inflation.

Capital Rationing

The process of selection of profitable proposals from among the various alternatives and
distribution of available resources among them is called capital rationing. It has to select the
combination of proposals which will yield maximum returns.

Methods of Capital Rationing

Methods

Hard Capital Soft Capital

a. Hard Capital
This occurs when a company has issues raising additional funds, either through equity or
debt. The rationing arises from an external need to reduce spending and can lead to a
shortage of capital to finance future projects.
E.g.: A company may be restricted from borrowing money to finance new projects
because it has suffered a downgrade in its credit rating.

12
b. Soft Capital
Soft Capital is also known as Internal Rationing. This type of rationing comes about due
to the internal policies of a company. A situation where a company has freely chosen to
impose some restrictions on its capital expenditures, even though it may have the ability
to make much higher capital investments than it chooses to.
E.g.: The Company may simply impose a limit on the number of new projects that it will
take on during the next 12 months.

Cost of Capital

Cost of capital is one of the most important techniques employed by financial managers to
evaluate the profitability of capital investment proposals. It helps the management to determine
the alternative sources of capital.

Meaning: Cost of capital is the rate of return which one may receive for lending the funds.

Definition: According to Solomon Ezra- “Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditures”

Other Concepts of Cost of Capital

 Explicit Cost
The rate of discount that equated the present value of cash inflows with the present value
of future cash outflows.
 Implicit Cost
The rate of return associated with the best investment opportunity forgone by the firm
while investing in the present project.
 Historical Cost
The costs which are incurred for the procurement of funds based upon the existing capital
structure of the firm.
 Future Cost
The expected cost of raising funds

13
 Specific Cost
Specific cost is also known as the component cost. It refers to the cost which is associated
with the particular source of capital.
 Weighted Cost
Weighted cost is also known as the composit cost. It is the combined cost of different
sources of capital taken together i.e., cost of debt, cost of equity and cost of preference
capital
 Average Cost
Average cost of capital is the weighted average cost of all components if components of
funds are made use of.
 Marginal Cost
The average cost of capital which is to be incurred due to new or additional funds raised
by the company to meet their financial requirements.

Overall Cost of Capital

Overall cost of capital of the firm is also an important factor that influences
the capital structure decision. If the existing cost of capital is already high then the firm will go
for low cost sources of funds; otherwise it can generate funds from high cost sources.

Cost of Equity Capital

Cost of equity capital may be defined as –

“The minimum rate of return that a firm must earn on the equity finances the portion of an
investment project in order to live and changed the market price of the shares”.

There are four approaches for the computation of cost of equity capital

1) Dividend price approach

2) Dividend + growth approach
3) Earning price approach
4) Capital Asset Price Model Approach (CAPM Approach)

14
1. Dividend Price Approach
The cost of new equity share is considered to be equal to the current rate of dividend in
relation to current market price.

𝑫𝑷
𝑲𝒆 =
𝑴𝑷

Where: Ke = Cost of new equity shares

DP = Dividend per share

MP = Market price per share

2. Dividend + Growth Approach

The computation of cost of capital on the basis of current dividend is inappropriate. The
motive of investors while making an investment in new issues is not to earn divided at the
current rate, but future dividends at enhanced rates. Thus the twin elements to be taken
into account for the computation of cost of capital are:
 The expected dividends and capital gains.
 Net proceeds from the sale of a share or current market price of a share.

𝑫𝑷
𝑲𝒆 = +𝒈
𝑴𝑷

Where ‘g’ stands for growth rate

Ke = Cost of new equity shares

DP = Dividend per share

MP = Market price per share

15
3. Earnings price approach
According to this approach, earnings rather than dividends, per share are compared with
the current price per share to find out the cost of equity capital. This method is superior to
dividend approach.

𝑬𝑷
𝑲𝒆 =
𝑴𝑷

Where: Ke = Cost of equity capital

EP = Earnings per share

MP = Market price per share

4. Capital Asset Price Model Approach (CAPM Approach)

This approach is also known as Security Market Line (SML) Approach. Under CAPM
approach, the expected return on an investment depends on three factors.
 Risk free rate (Rf)
 Market risk premium = Market rate of return – risk free rate or Rm - Rf
Market risk premium (Rm): It is a reward that market offers for bearing a risk.
 Systematic risk (β): It is the amount of risk present in a particular portfolio of
investment, which is called β.

𝑹𝒆 = 𝑹𝒇 + 𝜷 (𝑹𝒎 − 𝑹𝒇)

Where, Re = Expected return or cost of equity

Rf = Risk free rate

β= Beta co-efficient of risk

Rm = Market rate of return

16
 Cost of Debt

Cost of debt is the after-tax cost of long-term funds through borrowing. Calculating the cost of
debt involves finding the average interest paid on all of a company’s debts. The cost of debt
measure is helpful in understanding the overall rate being paid by a company to use these types
of debt financing. Debt may be issued;

 At par
 At premium or discount
 Perpetual or redeemable.
i. Debt Issued at Par

Debt issued at par means, debt is issued at the face value of the debt.

𝑲𝒅 = (𝟏 − 𝒕)𝑹

Where, Kd = Cost of debt capital

t = Tax rate

R = Debenture interest rate.

ii. Debt Issued at Premium or Discount

If the debt is issued at premium or discount, the cost of debt is calculated with the help of the
following formula:
𝑰
𝑲𝒅 = (𝟏 − 𝒕)
𝑵𝑷
Where, Kd = Cost of debt capital

I = Annual interest payable

Np = Net proceeds of debenture

t = Tax rate.

17
iii. Cost of Perpetual Debt and Redeemable Debt

It is the rate of return which the lenders expect. The debt carries a certain rate of interest.

𝟏
𝐈 + (𝑷 − 𝑵𝒑)
𝑲𝒅𝒃 = 𝒏
𝟏
(𝑷 + 𝑵𝒑)
𝟐

Where, I = Annual interest payable

P = Par value of debt

Np = Net proceeds of the debenture

n = Number of years to maturity

Kdb = Cost of debt before tax.

Cost of Preference Share

Cost of preference share capital is the annual preference share dividend by the net proceeds from
the sale of preference share. There are two types of preference shares irredeemable and
redeemable.

Cost of irredeemable preference share capital is calculated with the help of the following
formula:

𝑫𝑷
𝑲𝑷 =
𝑵𝑷

Where; Kp = Cost of preference share

Dp = Fixed preference dividend

Np = Net proceeds of an equity share

18
Cost of Retained Earning

Retained earnings are one of the sources of finance for investment proposal. It is different from
other sources like debt, equity and preference shares. Cost of retained earnings is the same as the
cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost
of equity capital.

𝑲𝒓 = 𝑲𝒆(𝟏 − 𝒕)(𝟏 − 𝒃)

Where; Kr = Cost of retained earnings

Ke = Cost of equity

t = Tax rate

b = Brokerage cost

Weighted Average Cost of Capital [Ko]

Weighted average cost of capital is the expected average future cost of funds over the long run
found by weighting the cost of each specific type of capital by its proportion in the firm’s capital
structure. It is also called as composite cost of capital.

𝑾𝟏𝑲𝒅 + 𝑾𝟐𝑲𝒑 + 𝑾𝟑𝑲𝒆 + 𝑾𝟒𝑲𝒓

𝑲𝒐 =
𝑾𝟏 + 𝑾𝟐 + 𝑾𝟑 + 𝑾𝟒

Where, W1, W2…= Weight of specific source

Kd = Cost of debt

Kp = Cost of preference shares

Ke = Cost of equity

Kr = Cost of retained earnings

19
 [OR]

𝑬 𝑫
𝑾𝑨𝑨𝑪 = ( × 𝑹𝒆) + ( × 𝑹𝒅 × (𝟏 − 𝑻𝒄))
𝑽 𝑽

Where; E = Market value of the firm’s equity

D = Market value of the firm’s debt

V = E+D

Re = Cost of equity

Rd = Cost of debt

Tc = Corporate tax rate

-----------------------------------------------------------------------------------------------

20
 MODULE 4
WORKING CAPITAL

Working Capital is basically an indicator of the short-term financial

position of an organization and is also a measure of its overall efficiency.
Working Capital is obtained by subtracting the current liabilities from the
current assets. Cash and cash equivalents—including cash, such as funds
in checking or savings accounts, while cash equivalents are highly-liquid
assets, such as money-market funds and Treasury bills. Marketable
securities—such as stocks, mutual fund shares, and some types of bonds.

Concept of Working Capital

There are two concepts or senses used for working capital.

These are:

1. Gross Working Capital

2. Net working Capital

Let us explain what these two concepts mean.

1. Gross Working Capital:

The concept of gross working capital refers to the total value of current
assets. In other words, gross working capital is the total amount available
for financing of current assets. However, it does not reveal the true financial
position of an enterprise. How? A borrowing will increase current assets
and, thus, will increase gross working capital but, at the same time, it will
increase current liabilities also.

As a result, the net working capital will remain the same. This concept is
usually supported by the business community as it raises their assets
(current) and is in their advantage to borrow the funds from external
sources such as banks and the financial institutions.

In this sense, the working capital is a financial concept. As per this concept:

Gross Working Capital = Total Current Assets

2. Net Working Capital:

The net working capital is an accounting concept which represents the
excess of current assets over current liabilities. Current assets consist of
items such as cash, bank balance, stock, debtors, bills receivables, etc.
and current liabilities include items such as bills payables, creditors, etc.
Excess of current assets over current liabilities, thus, indicates the liquid
position of an enterprise.

The ratio of 2:1 between current assets and current liabilities is considered
as optimum or sound. What this ratio implies is that the firm/ enterprise
have sufficient liquidity to meet operating expenses and current liabilities. It
is important to mention that net working capital will not increase with every
increase in gross working capital. Importantly, net working capital will
increase only when there is increase in current assets without
corresponding increase in current liabilities.

Thus, in the form of a simple formula:

Net Working Capital = Current Assets-Current Liabilities

After subtracting current liabilities from current assets what is left over is
net working capital.

Working capital normally refers to net working capital. The banks and
financial institutions do also adopt the net working capital concept as it
helps assess the requirement of the borrower. Yes, if in any particular case,
the current assets are less than the current liabilities, then the difference
between the two will be called ‘Working Capital Deficit.’

What this deficit in working capital indicates is that the funds from current
sources, i.e., current liabilities have been diverted for acquiring fixed
assets. In such case, the enterprise cannot survive for a long period
because current liabilities are to be paid out of the realisation made through
current assets which are insufficient.

working capital management

Working capital management is a business tool that helps companies

effectively make use of c urrent assets, helping companies to maintain
sufficient cash flow to meet short term goals and obligations. By effectively
managing working capital, companies can free up cash that would
otherwise be trapped on their balance sheets. As a result, they may be able
to reduce the need for external borrowing, expand their businesses, fund
mergers or acquisitions, or invest in R&D.

Working capital is essential to the health of every business, but managing it

effectively is something of a balancing act. Companies need to have
enough cash available to cover both planned and unexpected costs, while
also making the best use of the funds available. This is achieved by the
effective management of accounts payable, accounts receivable, inventory
and cash.

Need And Importance 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 fro 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

Sources of Working Capital

Sources of working capital can be spontaneous, short term and long term.
Spontaneous working capital includes mainly trade credit such as the
sundry creditor, bills payable, and notes payable. Short term sources are
tax provisions, dividend provisions, bank overdraft, cash credit, trade
deposits, public deposits, bills discounting, short-term loans, inter-corporate
loans, and commercial paper. Long-term sources are retained profits,
provision for depreciation, share
Factors 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.

Consequently, more working capital is required. On the contrary, in case of

trading business the goods are sold immediately after purchasing or
sometimes the sale is affected even before the purchase itself. Therefore,
very little working capital is required. Moreover, in case of service
businesses, the working capital is almost nil since there is nothing in stock.

(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.

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.

Therefore, it requires less working capital, while the case is different in

respect of companies with less operating efficiency.

(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

INVENTORY MANAGEMENT

refers to the process of ordering, storing, using, and selling a company's

inventory. This includes the management of raw materials, components,
and finished products, as well as warehousing and processing of such
items.

KEY TAKEAWAYS
Inventory management is the entire process of managing inventories from
raw materials to finished products.
Inventory management tries to efficiently streamline inventories to avoid
both gluts and shortages.
Two major methods for inventory management are just-in-time (JIT) and
materials requirement planning (MRP).

Understanding Inventory Management

A company's inventory is one of its most valuable assets. In retail,
manufacturing, food services, and other inventory-intensive sectors, a
company's inputs and finished products are the core of its business. A
shortage of inventory when and where it's needed can be extremely
detrimental.

At the same time, inventory can be thought of as a liability (if not in an

accounting sense). A large inventory carries the risk of spoilage, theft,
damage, or shifts in demand. Inventory must be insured, and if it is not sold
in time it may have to be disposed of at clearance prices—or simply
destroyed.

For these reasons, inventory management is important for businesses of

any size. Knowing when to restock inventory, what amounts to purchase or
produce, what price to pay—as well as when to sell and at what price—can
easily become complex decisions. Small businesses will often keep track of
stock manually and determine the reorder points and quantities using
spreadsheet (Excel) formulas. Larger businesses will use specialized
enterprise resource planning (ERP) software. The largest corporations use
highly customized software as a service (SaaS) applications.

Appropriate inventory management strategies vary depending on the

industry. An oil depot is able to store large amounts of inventory for
extended periods of time, allowing it to wait for demand to pick up. While
storing oil is expensive and risky—a fire in the UK in 2005 led to millions of
pounds in damage and fines—there is no risk that the inventory will spoil or
go out of style. For businesses dealing in perishable goods or products for
which demand is extremely time-sensitive—2021 calendars or fast-fashion
items, for example—sitting on inventory is not an option, and misjudging
the timing or quantities of orders can be costly.

For companies with complex supply chains and manufacturing processes,

balancing the risks of inventory gluts and shortages is especially difficult.
To achieve these balances, firms have developed several methods for
inventory management, including just-in-time (JIT) and materials
requirement planning (MRP).

Some firms like financial services firms do not have physical inventory and
so must rely on service process management.
Accounting for Inventory
Inventory represents a current asset since a company typically intends to
sell its finished goods within a short amount of time, typically a year.
Inventory has to be physically counted or measured before it can be put on
a balance sheet. Companies typically maintain sophisticated inventory
management systems capable of tracking real-time inventory levels.

Inventory is accounted for using one of three methods: first-in-first-out

(FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average costing.
An inventory account typically consists of four separate categories:

Raw materials — represent various materials a company purchases for its

production process. These materials must undergo significant work before
a company can transform them into a finished good ready for sale.
Work in process (also known as goods-in-process) — represents raw
materials in the process of being transformed into a finished product.
Finished goods — are completed products readily available for sale to a
company's customers.
Merchandise — represents finished goods a company buys from a supplier
for future resale.
Inventory Management Methods
Depending on the type of business or product being analyzed, a company
will use various inventory management methods. Some of these
management methods include just-in-time (JIT) manufacturing, materials
requirement planning (MRP), economic order quantity (EOQ), and days
sales of inventory (DSI).

Just-in-Time Management (JIT) — This manufacturing model originated in

Japan in the 1960s and 1970s. Toyota Motor (TM) contributed the most to
its development.1 The method allows companies to save significant
amounts of money and reduce waste by keeping only the inventory they
need to produce and sell products. This approach reduces storage and
insurance costs, as well as the cost of liquidating or discarding excess
inventory. JIT inventory management can be risky. If demand unexpectedly
spikes, the manufacturer may not be able to source the inventory it needs
to meet that demand, damaging its reputation with customers and driving
business toward competitors. Even the smallest delays can be problematic;
if a key input does not arrive "just in time," a bottleneck can result.
Materials requirement planning (MRP) — This inventory management
method is sales-forecast dependent, meaning that manufacturers must
have accurate sales records to enable accurate planning of inventory
needs and to communicate those needs with materials suppliers in a timely
manner. For example, a ski manufacturer using an MRP inventory system
might ensure that materials such as plastic, fiberglass, wood, and
aluminum are in stock based on forecasted orders. Inability to accurately
forecast sales and plan inventory acquisitions results in a manufacturer's
inability to fulfill orders.
Economic Order Quantity (EOQ) — This model is used in inventory
management by calculating the number of units a company should add to
its inventory with each batch order to reduce the total costs of its inventory
while assuming constant consumer demand. The costs of inventory in the
model include holding and setup costs. The EOQ model seeks to ensure
that the right amount of inventory is ordered per batch so a company does
not have to make orders too frequently and there is not an excess of
inventory sitting on hand. It assumes that there is a trade-off between
inventory holding costs and inventory setup costs, and total inventory costs
are minimized when both setup costs and holding costs are minimized.
Days sales of inventory (DSI) — is a financial ratio that indicates the
average time in days that a company takes to turn its inventory, including
goods that are a work in progress, into sales. DSI is also known as the
average age of inventory, days inventory outstanding (DIO), days in
inventory (DII), days sales in inventory or days inventory and is interpreted
in multiple ways. Indicating the liquidity of the inventory, the figure
represents how many days a company’s current stock of inventory will last.
Generally, a lower DSI is preferred as it indicates a shorter duration to clear
off the inventory, though the average DSI varies from one industry to
another.
There are other methods to analyze inventory. If a company frequently
switches its method of inventory accounting without reasonable
justification, it is likely its management is trying to paint a brighter picture of
its business than what is true. The SEC requires public companies to
disclose LIFO reserve that can make inventories under LIFO costing
comparable to FIFO costing.

Frequent inventory write-offs can indicate a company's issues with selling

its finished goods or inventory obsolescence. This can also raise red flags
with a company's ability to stay competitive and manufacture products that
appeal to consumers going forward.
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Related Terms
Material Requirements Planning (MRP) Definition
Material requirements planning is among the first software-based
integrated information systems designed to improve productivity for
businesses. more
Understanding Economic Order Quantity (EOQ)
Economic order quantity (EOQ) is the ideal order quantity that a company
should make for its inventory given a set cost of production, demand rate,
and other variables. more
Inventory
Inventory is the term for merchandise or raw materials that a company has
on hand. more
What Is Just in Time (JIT)?
A just-in-time (JIT) inventory system is a management strategy that aligns
raw-material orders from suppliers directly with production schedules. more
Raw Materials Definition and Accounting
Raw materials are commodities companies use in the primary production or
manufacturing of goods. more
Ending Inventory
Ending inventory is a common financial metric measuring the final value of
goods still available for sale at the end of an accounting period.
 MODULE 5

DIVIDEND DECISIONS

Dividend Decisions: Dividend policy and factors affecting dividend policy – dividend and its
forms – relevance and irrelevance. An overview of theories of dividend (Gordon Model, Walter
Model, MM Model) - forms of dividend – cash dividend, bonus shares, share split and stock
repurchase.

Other Sources of Finance: Leasing, Hire Purchase and Venture capital funding-emerging areas
in finance-merger –acquisition-takeover – financial engineering

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 DIVIDEND POLICY

• A company’s dividend policy dictates the amount of dividends paid out by the company to its
shareholders and the frequency with which the dividends are paid out.
• When a company makes a profit, they need to make a decision on what to do with it.
• They can either retain the profits in the company (retained earnings on the balance sheet), or
they can distribute the money to shareholders in the form of dividends.

Example of a Dividend Policy

Kinder Morgan (KMI) shocked the investment world when in 2015 they cut their dividend payout
by 75%, a move that saw their share price tank. However, many investors found the company on
solid footing and making sound financial decisions for their future. In this case, a company cutting
their dividend actually worked in their favor, and six months after the cut, Kinder Morgan saw its
share price rise almost 25%. In early 2019, the company again raised its dividend payout by 25%,
a move that helped to reinvigorate investor confidence in the energy company.

TYPES OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and profitable position.

On the basis of the dividend declaration by the firm, the dividend policy may be classified under
the following types:

1) Regular dividend policy

2) Stable dividend policy
3) Irregular dividend policy
4) No dividend policy.

1. Regular Dividend Policy

 When dividend payable at the usual rate is called as regular dividend policy.
 This type of policy is suitable to the small investors, retired persons and others.

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  It establishes a profitable record of the company and confidence of the shareholders
increases.
2. Stable Dividend Policy
 Stable dividend policy means payment of certain minimum amount of dividend regularly.
 There shall be a steady dividend payout every year irrespective of change in income.
 Once the stable dividend policy is paid by the company, it is difficult to change the same.
 If the company fails to pay stable dividend, then the financial standing of the company in
the minds of investors get damaged.

3. Irregular Dividend Policy

 When the companies are facing constraints of earnings and unsuccessful business
operation, they may follow irregular dividend policy.
 It is one of the temporary arrangements to meet the financial problems.
 Here, the company does not pay fixed dividend regularly rather it changes yearly depending
on the earnings.

4. No Dividend Policy
 Sometimes the company may follow no dividend policy because of its unfavorable working
capital position of the amount required for future growth of the concerns.
 No dividends will be issued rather the profits shall be retained for business growth.

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FACTORS AFFECTING DIVIDEND POLICY

A company needs to analyze certain factors before framing their dividend policy.

The following are the various factors/determinants that impact the dividend policy of a company:

1. Profitable Position of the Firm - Dividend decision depends on the profitable position of the
business concern. When the firm earns more profit, they can distribute more dividends to the
shareholders.
2. Uncertainty of Future Income - Future income is a very important factor, which affects the
dividend policy. When the shareholder needs regular income, the firm should maintain regular
dividend policy.
3. Legal Constrains - The Companies Act 2013 has put several restrictions regarding payments
and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down certain
restrictions on payment of dividends.
4. Liquidity Position - Liquidity position of the firms leads to easy payments of dividend. If the
firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay
stock dividend.
5. Sources of Finance - If the firm has finance sources, it will be easy to mobilize large finance.
The firm shall not go for retained earnings.

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 6. Growth Rate of the Firm - High growth rate implies that the firm can distribute more
dividend to its shareholders.
7. Tax Policy - Tax policy of the government also affects the dividend policy of the firm. When
the government gives tax incentives, the company pays more dividend.
8. Capital Market Conditions - Due to the capital market conditions, dividend policy may be
affected. If the capital market is prefect, it leads to improve the higher dividend.

DIVIDEND AND FORMS OF DIVIDEND

DIVIDEND – Meaning

• Dividend refers to the business concerns net profits distributed among the shareholders.
• It may also be termed as the part of the profit of a business concern, which is distributed
among its shareholders.
• Dividend is defined as “a distribution to shareholders out of profits or reserves available
for this purpose”

TYPES/FORMS OF DIVIDEND

A dividend is generally considered to be a cash payment issued to the holders of

company stock. However, there are several types of dividends, some of which do not involve the
payment of cash to shareholders. These dividend types/forms are:

Hence, Dividends are classified into:

1. Cash dividend
2. Stock dividend
3. Bond dividend
4. Property dividend

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1. Cash Dividend

The cash dividend is by far the most common of the dividend types used. On the date of
declaration, the board of directors resolves to pay a certain dividend amount in cash to those
investors holding the company’s stock on a specific date. The date of record is the date on which
dividends are assigned to the holders of the company’s stock. On the date of payment, the company
issues dividend payments.

• If the dividend is paid in the form of cash to the shareholders, it is called cash
dividend.

• It is paid periodically out the business concerns EAIT (Earnings after interest
and tax).

• Cash dividends are common and popular types followed by majority of the
business concerns.

2. Stock Dividend

A stock dividend is the issuance by a company of its common stock to its common
shareholders without any consideration. If the company issues less than 25 percent of the total
number of previously outstanding shares, then treat the transaction as a stock dividend. If the
transaction is for a greater proportion of the previously outstanding shares, then treat the
transaction as a stock split.

• Stock dividend is paid in the form of the company stock due to raising of more
finance.

• Under this type, cash is retained by the business concern.

• Stock dividend may be bonus issue. This issue is given only to the existing
shareholders of the business concern.

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3. Property Dividend

A company may issue a non-monetary dividend to investors, rather than making a cash or
stock payment. Record this distribution at the fair market value of the assets distributed. Since the
fair market value is likely to vary somewhat from the book value of the assets, the company will
likely record the variance as a gain or loss. This accounting rule can sometimes lead a business to
deliberately issue property dividends in order to alter their taxable and/or reported income.

• Property dividends are paid in the form of some assets other than cash.

• It will be distributed under the exceptional circumstance.

• This type of dividend is not published in India.

3.Bond Dividend

• Bond dividend is also known as “script dividend”.

• If the company does not have sufficient funds to pay cash dividend, the
company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes or scrips.

• Bonds are issued promising to pay in a longer maturity period and bears
interest. While scrips are issued promising to pay in a shorter maturity
period.

The dividends and dividend policy of a company are important factors that many investors
consider when deciding what stocks to invest in. Dividends can help investors earn a high return
on their investment, and a company’s dividend payment policy is a reflection of its financial
performance.

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Bonus Shares

 Bonus shares are an additional number of shares given by the company to its existing
shareholders as “BONUS” when they are not in the position to pay a dividend to its
shareholders despite earning decent profits for that quarter.
 Only a company has the right to issue bonus shares to their shareholders, which has earned
massive profit or large free reserves that cannot be utilized for any particular purpose and
can be distributed as dividends.
 However, these bonus shares are given to the shareholders according to their existing
stake in the company.
 Example: If a company declares one for two bonus shares, it would mean that an existing
shareholder would get one additional share for two existing shares. Suppose a shareholder
holds 2,000 shares of the company. When the company issues bonus shares, he will receive
1000 bonus shares, i.e. (2000 *1/2 = 1,000).
 When the company issue bonus shares to its shareholders, the term “record date” and
“ex-date” are very important.

What is Record date and Ex-date????

 The record date is the cut-off date decided by the company to be eligible for bonus shares. All
shareholders who have shares in their Demat account on the record date will be eligible to receive
bonus shares from the company.
 The ex-date is one day before the record date. Here an investor has to buy the shares at least one
day before the ex-date to become eligible for the bonus shares.

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Share Split

 It is when a company divides the existing shares of its stock into multiple new shares to
boost the stock's liquidity.
 The most common split ratios are 2-for-1 or 3-for-1, which means that the stockholder will
have two or three shares, respectively, for every share held earlier.
 Basically, companies choose to split their shares so they can lower the trading price of
their stock to a range deemed comfortable by most investors and increase the liquidity of
the shares.
 Most investors are more comfortable purchasing, say, 100 shares of Rs.10 stock as opposed
to 10 shares of Rs.100 stock. Thus, when a company's share price has risen substantially,
they go for share split.

Stock Repurchase

 A share repurchase is a transaction whereby a company buys back its own shares from
the marketplace.
 The company buys shares directly from the market or offers its shareholders the option
of tendering their shares directly to the company at a fixed price.
 It is also known as “Share Buyback”.
 Common reasons for a stock buyback include signaling that the company’s stock is
undervalued, leveraging tax efficiency, absorbing the excess of the shares outstanding, and
defending from a hostile takeover.

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DIVIDEND DECISIONS

Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long-term growth.

Hence, dividend decision plays very important part in the financial management.

Dividend theories are classified into two:

(a) Irrelevance of Dividend

(b) Relevance of Dividend.

A. IRRELEVANCE OF DIVIDEND

 According to professors Solomon, Modigliani and Miller, dividend policy has no effect
on the share price of the company.
 There is no relation between the dividend rate and value of the firm. Dividend decision
is irrelevant of the value of the firm.
 According to Ezra Solomon, the dividend policy of a firm is a residual decision and
dividend is a passive residual.
 Modigliani and Miller contributed a major approach to prove the irrelevance dividend
concept.

B. RELEVANCE OF DIVIDEND

 According to this concept, dividend policy is considered to affect the value of the firm.
 Dividend relevance implies that shareholders prefer current dividend and proposes that
dividend policy affect the share price.
 Therefore, according to this theory, optimal dividend policy should be determined which
will ensure maximization of the wealth of the shareholders.
 Relevance of dividend concept is supported by two eminent persons like Walter and
Gordon.

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AN OVERVIEW OF THEORIES OF DIVIDEND

MODIGLIANI AND MILLER’S APPROACH

According to MM, under a perfect market condition, the dividend policy of the company is
irrelevant and it does not affect the value of the firm.

MM approach is based on the following important assumptions:

1) Perfect capital market.

2) Investors are rational.
3) There is no tax.
4) The firm has fixed investment policy.
5) No risk or uncertainty.

According to this approach, the market price of a share is dependent on the earnings of the firm on
its investment and not on the dividend paid by it. Earnings of the firm which affect its value, further
depends upon the investment opportunities available to it.

Modigliani – Miller’s model can be used to calculate the market price of the share at the end
of a period, if the share price at the beginning of the period, dividends and the cost of capital
are known.

Po = (D1 + P1)/ (1 + Ke)

Where; Po = Prevailing market price of share

D1 = Dividend to be received at the end

P1 = Market price of share at the end

Ke = Cost of equity capital

From the above formula, we can find the value of P1 i.e., market price of share at the end which
is as follows:

P1 = Po * (1 + Ke) – D1

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In MM Approach, the value of the firm will be unchanged by the dividend decisions. The value
of the firm can be calculated using the following formula:

V = (n + Δn) p1 – I – E

(1+Ke)
Where;

V = Value of firm

n = number of shares in the beginning of the period

Δn = number of shares issued to raise the funds required

I = Amount required for investment

E = total earnings during the period.

Criticism of MM Approach

MM approach consists of certain criticisms also. The following are the major criticisms of MM
approach:
 MM approach assumes that tax does not exist. It is not applicable in the practical
life of the firm.
 MM approach assumes that, there is no risk and uncertain of the investment. It is
also not applicable in present day business life.
 MM approach does not consider floatation cost and transaction cost. It leads to
affect the value of the firm.
 MM approach considers only single decrement rate, it does not exist in real
practice.
 MM approach assumes that, investor behaves rationally. But we cannot give
assurance that all the investors will behave rationally.

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 Example:
X Company Ltd., has 100000 shares outstanding the current market price of the shares Rs.
15 each. The company expects the net profit of Rs. 2,00,000 during the year and it belongs to
a rich class for which the appropriate capitalization rate has been estimated to be 20%. The
company is considering dividend of Rs. 2.50 per share for the current year. What will be the
price of the share at the end of the year (i) if the dividend is paid and (ii) if the dividend is
not paid

Solution:

Po = (D1 + P1)/(1 + Ke)

(i) If the dividend is paid:

Po = Rs.15, Ke = 20%, D1 = 2.50, P1 =?

15 = 2.50 + P1
1 + 20%
15 = 2.50 + P1
1.2
2.50 + P1 = 15 * 1.2
P1 = 18 – 2.50 = 15.50
(ii) If the dividend is not paid:
Po = 15, Ke = 20%, D1 = 0
P1 =?
15 = 0 + P1
1 + 20%
15 = 0 + P1
1.2
0 + P1 = 15 * 1.20
P1 = 18.

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Example:

AB Engineering Ltd. belongs to a risk class for which the capitalization rate is 10%. It
currently has outstanding 10,000 shares selling at Rs.100 each. The firm is contemplating the
declaration of dividend of a dividend of Rs. 5/share at the end of the current financial year.
It expects to have a net income of Rs.1,00,000 and has a proposal for making new investments
of Rs. 2,00,000. Calculate the value of the firms when dividends (i) are not paid and (ii) are
paid.

Solution:
VALUE OF FIRM WHEN DIVIDENDS ARE NOT PAID
Calculation of P1 (Price at the end) ----
Ke = 10%, Po = 100 and D1 = 0
Po = (D1 + P1)/(1 + Ke)
100 = (P1 + 0) / (1 + 0.10) = 110.
Calculation of funds required for investment ----
Earning = 1,00,000
No dividend so, 1,00,000 available for investment.
Total investment amount required = 2,00,000
Balance funds required = 2,00,000 – 1,00,000 = 1,00,000
No. of shares required to be issued for balance fund (Δn) -------
Δn = Funds require / P1 = 1,00,000/110
Calculation of value of firm -----

V = (n + Δn) p1 – I – E

(1+Ke)

= (10,000 + 1,00,000/110) * 110 – 2,00,000 – 1,00,000

(1 + 0.10)

= 10,00,000.

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VALUE OF FIRM WHEN DIVIENDS ARE PAID

Step 1 – Calculate price at the end of the period:

Ke = 10%, Po = 100 and D1 = 5
P0 = (P1 + D1) / (1 +Ke)
100 = (P1 + 5)/ (1 + 0.10)
P1 = 105.

Step 2 – Calculating fund required for investment:

Earnings = 1,00,000
Dividends to be paid = 50,000
Fund available = 1,00,000 – 50,000 = 50,000
Total investment = 2,00,000
Balance fund required = 2,00,000 – 50,000 = 1,50,000.

Step 3 – Number of shares to be issued for balance amount:

No. of shares (Δn) = Funds required/Price at end (P1) = 1,50,000/105

Step 4 – Calculation of value of firm:

V = (n + Δn) p1 – I – E

(1+Ke)
= (10,000 + 1,50,000/105) 105 – 2,00,000 – 1,00,000
(1 + 0.10)
= 10,00,000.
Thus, it could be seen that the value of firm remains the same i.e., 10,00,000 whether dividend is
given or not. Thus, the dividend policy is irrelevant and do not affect the value of firm.

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WALTER’S MODEL

 Prof. James E. Walter argues that the dividend policy almost always affects the value of
the firm.

 Walter model is based in the relationship between the following important factors: Rate of
return on retained earnings (r) and Cost of capital (k).

 According to the Walter’s model, if r > k, i.e., rate of return that the company may earn on
retained earnings, is higher than cost of equity (rate of return of the shareholders), then it
would be in the interest of the firm to retain the earnings.

 If the firm has r = k, it is a matter of indifferent whether earnings are retained or distributed.

 On other hand if r < k, i.e., if the company’s reinvestment rate on retained earnings is the
less than shareholders’ rate of return, the company should not retain earnings.

Assumptions of Walter Model

Walters model is based on the following important assumptions:

1. The firm uses only internal finance.
2. The firm does not use debt or equity finance.
3. The firm has constant return and cost of capital.
4. The firms’ earnings are either distributed as dividends or reinvested internally.
5. The firm has constant EPS and dividend.
6. The firm has a very long life.

Walter has evolved a mathematical formula for determining the value of market share which is
as follows:
P = D + (r/Ke) * (E-D)
Ke
Where;
P = Market price of equity share

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D = Dividend per share
r = rate of return
E = Earnings per share
Ke = Cost of equity share

Criticisms of Walter’s Model

The following are some of the important criticisms against Walter model:
 Walter model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
 There is no possibility of constant return. Return may increase or decrease, depending
upon the business situation. Hence, it is also not applicable.
 According to Walter model, it is based on constant cost of capital. But it is not
applicable in the real life of the business.

Question:
From the following information supplied to you, ascertain whether the firm is following an optional
dividend policy as per Walter’s Model?
Total earnings of the firm = Rs. 2,00,000
Number of equity shares is 20,000 at Rs.100 each.
Dividend paid = Rs. 1,00,000
P/E ratio (Price- earnings ratio) = 10
Return on investment = 15%
The firm is expected to maintain its rate on return on fresh investments. Also find out what
should be the E/P ratio at which the dividend policy will have no effect on the value of the
share? Will your decision change if the P/E ratio is 7.25 and return on investment of 10 %?

Solution:

(a) EPS = Total earnings/no. of shares = 2,00,000/20,000 = Rs.10

P/E ratio = 10
Ke = 1

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 P/E ratio
= 1/10 = 0.10
DPS (Dividend per share) = Total dividend paid/number of shares = 1,00,000/20,000 = 5
Value of share as per Walters’ Model –
P = D + (r/Ke) * (E-D)
Ke
= 5 + 0.15/0.10 * (10-5)
0.10
= 12.5
Dividend pay-out ratio = DPS/EPS * 100 = 5/10 * 100 = 60%
r >Ke (15% >10%) therefore by distributing 60% of earnings, the firm is not following an optional
dividend policy.

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GORDON’S MODEL

Myron Gorden suggests one of the popular model which assume that dividend policy of a firm
affects its value, and it is based on the following important assumptions:
1) The firm is an all-equity firm.
2) The firm has no external finance.
3) Cost of capital and return are constant.
4) The firm has perpetual life.
5) There are no taxes.
6) Constant relation ratio (g=br).
7) Cost of capital is greater than growth rate (Ke >br).

Gordon contended that the payment of current dividends “resolves investor uncertainty”.
Investors have a preference for a certain level of income now rather that the prospect of a higher,
but less certain, income at some time in the future.

P = E (1 – b)
Ke – br

Where;
P = Price of a share
E = Earnings per share
1-b = D/P ratio i.e., percentage of earnings distributed as dividend
Ke = Cost of equity
br = Growth rate i.e., rate of return in investment of an all-equity firm

Criticisms of Gordon’s Model

Gordon’s model consists of the following important criticisms:

 Gordon model assumes that there is no debt and equity finance used by the firm. It is
not applicable to present day business.

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  Ke and r cannot be constant in the real practice.
 According to Gordon’s model, there are no tax paid by the firm. It is not practically
applicable.

Question:
Raja company earns a rate of 12% on its total investment of Rs. 6,00,000 in assets. It has 6,00,000
outstanding common shares at Rs. 10 per share. Discount rate of the firm is 10% and it has a policy of
retaining 40% of the earnings. Determine the price of its share using Gordon’s Model.

Solution:
P = E (1 – b)
Ke – br

Where;
E = Earnings per share = 12% of Rs. 10 = Rs. 1.20
r = 12% = 0.12
Ke = 10% = 0.10
b = 40% = 0.40
1 – b = percentage of earnings distributed as dividend = 1 – 0.40
br = rate of return on investment = 40%*12% = 0.40*0.12
P = 1.20 (1-0.40)
0.10 – (0.40*0.12) = Rs. 13.85
In this case, the optional dividend policy for the firm would be to pay zero dividend and the
Market Price would be:
P = D + (r/Ke) * (E-D)
Ke
= 5 + 0.15/0.10 * (10-0)
0.10
= Rs. 200
So, the MP of the share can be increased by following a zero payout.

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(b) If P/E is 7.25 instead of 10 then the Ke =1/7.25=0.138 and return on investment is 10%. Here,
as the Ke > r (13.8%>10%), the firm should not retain rather can give dividend. The market price
of equity share in this case shall be as follows:
P = D + (r/Ke) * (E-D)
Ke
= 5 + 0.10/0.138 * (10 – 5)
0.138
= 62.48

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 II.OTHER SOURCES OF FINANCE

The major other source of financing are as follows:

• Leasing
• Hire purchase
• Venture Capital

1. LEASING
 Lease financing is one of the important sources of medium- and long-term financing
where the owner of an asset gives another person, the right to use that asset against
periodical payments.
 The owner of the asset is known as lessor and the user is called lessee.
 The periodical payment made by the lessee to the lessor is known as lease rental.
 Under lease financing, lessee is given the right to use the asset but the ownership lies
with the lessor and at the end of the lease contract, the asset is returned to the lessor or
an option is given to the lessee either to purchase the asset or to renew the lease
agreement.
 Depending upon the transfer of risk and rewards to the lessee, the period of lease and
the number of parties to the transaction, lease financing can be classified into two
categories. Finance lease and Operating lease.

A. Finance Lease (Capital Lease)

 It is the lease where the lessor transfers substantially all the risks and rewards of
ownership of assets to the lessee for lease rentals.

 In other words, it puts the lessee in the same condition as he/she would have been if he/she
had purchased the asset.

 Finance lease has two phases:

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 1. The first one is called primary period. This is non-cancellable period and, in this period,
the lessor recovers his total investment through lease rental. The primary period may last
for indefinite period of time.

2. The lease rental for the secondary period is much smaller than that of primary period.

Features of Finance lease

1. A finance lease is a device that gives the lessee a right to use an asset.

2. The lease rental charged by the lessor during the primary period of lease is sufficient to recover
his/her investment.

3. The lease rental for the secondary period is much smaller. This is often known as peppercorn
rental.

4. Lessee is responsible for the maintenance of asset.

5. No asset-based risk and rewards is taken by lessor.

6. Such type of lease is non-cancellable; the lessor’s investment is assured.

7. The lessee shall be given an option to buy the asset after the lease period.

8. The P.V of all lease rental receivable shall exceeds the initial fair value of the lease assets.

9. Lease assets must be a specialized purpose asset and used for that special purpose itself.

Example of Finance lease:

Jet Aviation Ltd, an Indian airline company, requires passenger planes for its operations. Jet enters
into a legal lease agreement with Boeing (an American based plane manufacturing company) to
lease out airplanes. Boeing supplies planes to Jet on January 1, 2019, on a 5-year term against
which Jet will pay an annual lease rental of $500,000 at the end of each year. Assume the implicit

23
rate of interest is 10%. The useful life of the plane is 6 years. Jet has the option to buy the planes
at the termination of the lease period.

1. The lease is allowed to purchase the leased asset at the end of the lease period.
2. The lease term is 83.33% (5/6), which is more than 75% of the leased asset’s useful life.
3. The lease satisfies the majority of the conditions; hence it is classified as a finance lease.

B. Operating Lease

 Lease other than finance lease is called operating lease. Here risks and rewards incidental
to the ownership of asset are not transferred by the lessor to the lessee.
 The term of such lease is much less than the economic life of the asset and thus the total
investment of the lessor is not recovered through lease rental during the primary period of
lease.
 In case of operating lease, the lessor usually provides advice to the lessee for repair,
maintenance and technical knowhow of the leased asset and that is why this type of lease
is also known as service lease.

Features of Operating Lease

1.The lease term is much lower than the economic life of the asset.

2. The lessee has the right to terminate the lease by giving a short notice and no penalty is
charged for that.

3. The lessor provides the technical knowhow of the leased asset to the lessee.

4. Risks and rewards incidental to the ownership of asset are borne by the lessor.

5. Lessor has to depend on leasing of an asset to different lessee for recovery of his/her
investment.

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2. HIRE PURCHASE

• Hire purchase is an arrangement for buying expensive consumer goods, where the buyer
makes an initial down payment and pays the balance plus interest in installments.
• In a hire purchase agreement, ownership is not transferred to the purchaser until all
payments are made.
• The seller can repossess the goods in case of default in payment of any installment
and each installment is treated as hire charges till the last installment is paid.

Features of Hire purchase

 The payment is to be made by the hirer (buyer) to the Hiree, usually the vendor, in
installments over a specified period of time.
 The possession of the goods is transferred to the buyer immediately.
 The property in the goods remains with the vendor (hiree) till the last installment is paid.
The ownership passes to the buyer (hirer) when he pays all installments.

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  The Hiree or the vendor can repossess the goods in case of default and treat the amount
received by way of installments as hire charged for that period.
 The installments in hire purchase include interest as well as repayments of principal.
 Usually, the hiree charges interest on flat rate.

Example to understand the concept of Hire Purchase

An equipment costing Rs. 1,00,000 is sold on hire purchase on the terms that interest will be
charged at 15% p.a. on flat rate basis and the payment is to be made in 5 equal year-end
installments.

The total Interest burden shall be Rs. 75,000 i.e., 1,00,000 × 15/100 × 5 and

The yearly installment shall be (1,00,000 + 75,000)/5 = Rs. 35,000.

3.VENTURE CAPITAL FUNDING

 Venture capital funds (VCFs) are investment instruments through which individuals can
park their money in newly-formed start-ups as well as small and medium-sized
companies. These are types of investment funds that primarily target firms that have the
potential to deliver high returns. Nonetheless, investing in these companies also involves
considerable risk.
 VCFs are somewhat similar to mutual funds – these constitute a pool of money collected
from several investors. Here investors can refer to individuals with high net worth,
companies, or even other funds.

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  VCF will only invest in firms that project significant growth potential and the ability to
generate high ROI in the long run. As investments are made in new ventures, the risk
associated is also comparatively high.
 The venture capital funding firms provide the funds to start ups in exchange for the equity
stake.
 A venture capital firm performs a dual role in the fund, serving as both an investor and a
fund manager. As an investor, they usually put in 1%-2% of their own money, which
demonstrates to other investors that they are committed to the success of the fund. As the
fund manager, they are responsible for identifying investment opportunities, innovative
business models, or technologies, and those with the potential to generate high returns on
investment for the fund.

EMERGING AREAS IN FINANCE

1. Digital Transformation

 In the era of digitalization, the financial management sector has also been adoption of
new and emerging technologies to bring in operational efficiencies, enhance superior
customer experiences.
 Artificial Intelligent, Big Data Analytics, Machine learning application to finance is
transforming the financial management domain.
 Automation and robotics, which helps in improving processes; Data visualization,
which gives end users real-time easy to understand financial information; basic
analytics, which helps in efficient decision support; and advanced analytics, which
can help business to uncover hidden shareholder value and growth opportunities are
reshaping the concept of financial management.

2. Digital Finance and Money

 It includes a variety of products, applications, processes and business models that have
transformed the traditional way of providing banking and financial services.

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  New entrants, such as mobile network operators (MNOs), payment service providers
(PSPs), merchant aggregators, retailers, FinTech companies, neo-banks, and super
platforms, are leveraging these technologies and altering the competitive landscape for
financial services.
 They offer innovative and sustainable financial services.

3. Cryptocurrency

 Cryptocurrency -- a digital or virtual currency that is secured by cryptography, which

makes it nearly impossible to counterfeit or double-spend is also mandatory for the
workforce of the future.
 They are decentralized networks based on blockchain technology—a distributed ledger
enforced by a disparate network of computers.
 However, it is generally not issued by any central authority.
 It doesn't rely on banks to verify transactions. It's a peer-to-peer system that can enable
anyone anywhere to send and receive payments. Instead of being physical money
cryptocurrency payments exist purely as digital entries to an online database that describe
specific transactions. When you transfer cryptocurrency funds, the transactions are
recorded in a public ledger. You store your cryptocurrency in a digital wallet.
 Cryptocurrency got its name because it uses encryption to verify transactions. This means
advanced coding is involved in storing and transmitting cryptocurrency data between
wallets and to public ledgers.

4.Data Analytics

 Data analytics helps individuals and organizations make sense of data. Data analysts
typically analyze raw data for insights and trends.
 Data analytics techniques can reveal trends and metrics that would otherwise be lost
in the mass of information. This information can then be used to optimize processes to
increase the overall efficiency of a business or system.
 It is very important in the field of finance as Financial augmented analytics helps
finance executives to convert a huge amount of structured and unstructured data into

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 useful insights that facilitate competent decision-making. It eliminates human errors
from the financial transactions/processes.
 With the help of augmented analytics, the finance teams can easily get all the
information that they need to provide detailed view of various key performance
indicators (KPIs).
 It helps in closely examining and understanding important metrics, detect
parameters like fraud and manipulation in revenue turnover. It also allows the
executives to take crucial actions and decisions to prevent/manage the same.

MERGER VS ACQUISITION

MERGER

 A merger is the combination of two firms, which subsequently form a new legal entity
under the banner of one corporate name.
 In a merger, the boards of directors for two companies approve the combination and
seek shareholders' approval.
 Mergers can be structured in a number of different ways, based on the relationship
between the two companies involved in the deal:
1) Horizontal merger: Two companies that are in direct competition and share the same
product lines and markets.
2) Vertical merger: A customer and company or a supplier and company. Think of an ice
cream maker merging with a cone supplier.
3) Congeneric mergers: Two businesses that serve the same consumer base in different
ways, such as a TV manufacturer and a cable company.
4) Market-extension merger: Two companies that sell the same products in different
markets.
5) Product-extension merger: Two companies selling different but related products in the
same market.
6) Conglomeration: Two companies that have no common business areas.

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ACQUISITIONS
 In an acquisition, one company purchases another outright.
 When one company takes over another and establishes itself as the new owner, the
purchase is called an acquisition.
 In a simple acquisition, the acquiring company obtains the majority stake in the acquired
firm, which does not change its name or alter its organizational structure.
 A company can buy another company with cash, stock, assumption of debt, or a
combination of some or all of the three. In smaller deals, it is also common for one
company to acquire all of another company's assets.
 Acquisitions can be as follows:
1) Hostile Acquisition – A hostile takeover is the acquisition of one company by
another without approval from the target company's management.
2) Friendly Acquisition –A friendly takeover is a scenario in which a target
company is willingly acquired by another company
3) Buyouts - A buyout is the acquisition of a company's controlling interest. When
the company's management buys the shares, it is known as a management
buyout. Leveraged buyouts (LBO) use large sums of borrowed money, with the
company's purchased assets being used as collateral for the loans.

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 FINANCIAL ENGINEERING

 Financial engineering is the use of mathematical techniques to solve financial problems.

 Financial engineering uses tools and knowledge from the fields of computer science,
statistics, economics, and applied mathematics to address current financial issues as
well as to devise new and innovative financial products.

 It test and issue new investment tools and methods of analysis.

 Financial engineering is used in a wide variety of areas in the financial services industry,
including corporate finance, risk management, and the creation of financial derivative
products.

 Environmental and intra-firm factors influence financial engineering.

 The steps of financial engineering are

Need identification ---- create minimum viable product and get feedbacks ---- brainstorm
and discussions to develop complex model ---- quality assurance ---- perfect model ----
pricing ---- marketing ---- launching.

END MODULE 5

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