JSNR Financial Managment Text (BBA)

FINANCIAL MANAGEMENT
(FOR PRIVATE CIRCULATION ONLY)

2023
COURSE DESIGN AND REVIEW COMMITTEE
Dr. Shirish Limaye Dr. N.M. Vechlekar
Prof. Alaka Yeravadekar Prof. Abhinav D. Jog
Dr. Bhama Venketraman Prof. Arun Vartak
Prof. Sudhir Gijre Prof. Priyanka Meshram
Dr. Ravi Chitnis
COURSE WRITERS
Dr. Satish Inamdar Prof. Anil Agashe
EDITOR
Mr. Yogesh Bhosle
Published by Symbiosis Skills and Professional University (SSPU), Pune 2023
Copyright © 2023 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.
Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SSPU apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
PREFACE
Finance is the most basic and the most significant function in virtually every business activity. The
success of business activity depends upon the success of its finance function. From academic point of
view, finance is the subject, which is considered to be one of the most technical ones, having a very
wide scope and having constantly changing rules and regulations. This is the reason a normal student
attempts to keep himself away from the subject of finance. This aggravates the problems for the
students. One cannot afford to ignore the function of finance. The ultimate evaluation of any business
activity is profit-based evaluation and the term profit itself is a financial phenomenon. As such, one
needs to be acquainted with the basics of finance, despite the hardships involved in the process.
My objective of writing this book is to introduce the basic principles of finance to a non-technical
student in the simplest possible language. As such, I have deliberately avoided too much of quantitative
or mathematical elaboration or explanation to any of the basic concepts or principles. I have attempted
to explain the basic concepts with the help of examples and illustrations. Good numbers of problems
have been incorporated for self study.
I am thankful to SSOU for providing me this opportunity to reach out to a very wide spectrum of
readership. Maximum efforts have been made to incorporate the latest status of the subject and to make
the text free of errors. Still, if any omissions are pointed out and intimated, necessary modifications
can be made in the subsequent editions.
Dr. Satish Inamdar

Prof. Anil Agashe
iii
ABOUT THE AUTHOR
Dr. Satish Inamdar holds a Master’s Degree in Commerce and Bachelor’s Degree in Law. He has
completed his Ph.D. in Management. He has done his research in the subject of Urban Co-operative
Banks. He is Fellow Member of the Institute of Chartered Accountants of India, Associate Member
of The Institute of Cost and Works Accountants of India and Associate Member of The Institute of
Company Secretaries of India. He is associated with the industry for almost three decades in various
senior capacities.
He has been working as the Director at Balaji Institute of international Business since 2007. Before that,
he was associated with Symbiosis Institute of Business Management as a Faculty of Finance for close
to two decades. He has conducted Management Development Programmes and Executive Development
Programmes for various private sector and public sector organisations. He has authored six books on
the subjects like Cost and Management Accounting, Financial Management and Management Control
Systems. He is the Charter Member of Rotary Club of Pune, Kothrud.
Prof. Anil Agashe has a Master’s degree in Political Science and Public Administration from Pune
University, and a certificate in Foreign Exchange from Bankers’ Training College of Reserve Bank
of India. He has been a banker and has also worked in Corporates with an experience in the field of
Finance and Project Management. He has been associated with the most prominent leasing companies
of the country for the past sixteen years. For the past ten years he is associated as faculty to many
management institutes in Pune. He has conducted management training programs for the corporates.
iv
CONTENTS
Unit No. TITLE Page No.

1 Introducation to Finance 1 - 18
1.1 Introduction
1.2 Approaches to the Term Finance
1.3 Scope of Finance Function
1.4 Goals/Objectives of Finance Function
1.5 Organisation of Finance Function
1.6 Duties and Responsibilities of Finance Executive
1.7 The Fields of Finance
1.8 Finance Function in Relation with Other Functions
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
2 Forms of Business Organisations 19 - 32
2.1 Introduction
2.2 Proprietary Firms
2.3 Partnership Firms
2.4 Joint Stock Companies
Summary
Keywords
Suggested Reading
3 Capitalisation 33 - 46
3.1 Introduction
3.2 Theories of Capitalisation
3.3 Overcapitalisation
3.4 Undercapitalisation
3.5 Overcapitalisation vs. Undercapitalisation
3.6 Watered Stock/Watered Capital
3.7 Watered Capital vs. Overcapitalisation
Summary
Keywords
Suggested Reading
v
4 Sources of Long-Term and Medium-Term Finance 47 – 68
4.1 Introduction
4.2 Shares
4.3 Debentures
4.4 Term Loans
4.5 Public Deposits
4.6 Lease Financing
4.7 Hire Purchasing
4.8 Retained Earnings
Summary
Keywords
Suggested Reading
5 Capital Structure 69 – 92
5.1 Introduction
5.2 Goals/Principles of Capital Structure Management
5.3 Factors affecting Capital Structure
5.4 Cost of Capital
5.5 Composite Cost of Capital
5.6 Illustrative Problems
Summary
Keywords
Problems
Suggested Reading
6 Leverages and Theories of Capital Structure 93 – 114
6.1 Introduction
6.2 Concept of Leverages
6.3 Leverages
6.4 Theories of Capital Structure
Summary
Keywords
Problems
Suggested Reading
vi
7 Capital Budgeting 115 – 158
7.1 Introduction
7.2 The Process of Capital Budgeting
7.3 How to Compute Cash Flows
7.4 Time Value of Money
7.5 Techniques for Evaluation of Capital Expenditure Proposals
7.6 Limitations of Capital Budgeting
7.7 Evaluation Criteria in Certain Typical Situations
7.8 Planning, Organisation and Control of Capital Expenditure
7.9 Capital Rationing
7.10 Capital Budgeting and Risk
Summary
Keywords
Problems
Suggested Reading
8 Working Capital Management 159 – 194
8.1 Introduction
8.2 Working Capital – The Term
8.3 Principles of Working Capital Management
8.4 Factors affecting Working Capital Requirement
8.5 Financing of Working Capital Requirement
8.6 Control over Working Capital
Summary
Keywords
Problems
Suggested Reading
vii
viii
Introduction to Finance
UNIT
1
Structure:
1.1 Introduction
1.2 Approaches to the Term Finance
1.3 Scope of Finance Function
1.4 Goals/Obectives of Finance Function
1.5 Organisation of Finance Function
1.6 Duties and Responsibilities of Finance Executive
1.7 The Fields of Finance
1.8 Finance Function in Relation with Other Functions
Summary
Keywords
Suggested Reading
Introduction to Finance 1
Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Define the concept and purpose of financial management
----------------------
• Explain scope and role of finance function in a business organisation
---------------------- • Underline various activities that come under the ambit of finance
function
----------------------
• Identify the goals of financial management
----------------------
---------------------- 1.1 INTRODUCTION

---------------------- A business is an activity, which is carried on with the intention of earning
profits. If the operations of a typical manufacturing organisation are considered,
---------------------- it involves the purchasing of raw material, processing the same with the help
---------------------- of various factors of production like labour and machinery, manufacturing the
final product and selling the finished product in the market to earn the profits.
---------------------- Thus, production, marketing and finance are the key operational areas in case of
a manufacturing organisation, out of which finance, is the most crucial one. This
---------------------- is so, as the functions of production and marketing are related with the function
---------------------- of finance. If the decisions relating to money or funds fail, it may result into the
failure of the business organisation as a whole. Hence, it is utmost important
---------------------- to take the proper financial decisions and that too at a proper point of time.
In practical situations, in order to overcome temporary financial problems, the
---------------------- organisations tend to take hasty decisions, which may prove to be fatal over a
---------------------- longer span of time.
---------------------- 1.2 APPROACHES TO THE TERM FINANCE

---------------------- The concept of finance has changed markedly with the change in times and
---------------------- circumstances. The various approaches on finance can be categorised as stated
below.
---------------------- 1. According to the first approach, the term finance was interpreted to mean
---------------------- the procurement of funds by corporate enterprises to meet their financing
needs. The term ‘procurement’ was used in a broad sense to include the
---------------------- whole gamut of raising the funds externally.
---------------------- This approach towards finance was criticised on various grounds.
a. It is too narrow and restrictive in nature. Procurement of the funds is
----------------------
only one of the functions of finance and other functions are ignored by
---------------------- this approach.
----------------------
----------------------
2 Financial Management
b. It considers the financial problems only of corporate enterprises. In Notes
that sense, it ignores the financial problems of non-corporate entities
like proprietary concerns, partnership firms etc. ----------------------
c. It considers only the basic and non-recurring problems relating to the ----------------------
business. Day-to-day financial problems of a normal company do not
receive any attention. ----------------------
d. It concentrates only on long-term financing. It means that the working ----------------------
capital management is out of the purview of finance function.
----------------------
2. The second approach holds that finance is concerned with cash. As all the
transactions are ultimately expressed in terms of cash, the term finance will ----------------------
be concerned with every activity of the enterprise. Thus, according to this
approach, the finance function is concerned with all the functional areas of ----------------------
the business for example, Production, Marketing, Purchasing, Personnel
----------------------
Administration, Research and Development and so on. Obviously, this
approach is too broad to be meaningful. ----------------------
3. The third approach, which is a more balanced one and hence the acceptable ----------------------
one to the modern scholars, interprets the term finance as being concerned
with procurement of funds and wise application of funds. This approach is ----------------------
supposed to be more acceptable as it gives equal weightage to procurement
of funds as well as utilisation of the funds. This approach is called the ----------------------
managerial approach to the term finance. ----------------------
In the light of the above discussions, it will be worthwhile to note some of the
definitions of the finance function given by some modern scholars. ----------------------
R.C. Osborn: The finance function is the process of acquiring and utilising ----------------------
funds of a business.
----------------------
Bonneville and Dewey: Financing consists of the raising, providing, managing
of all the money, capital or funds of any kind to be used in connection with the ----------------------
business.
----------------------
Prather and Wert: Business finance deals primarily with raising, administering
and disbursing funds by privately owned business units operating in non- ----------------------
financial fields of industry.
----------------------
Check your Progress 1 ----------------------
----------------------
Multiple Choice Single Response.
----------------------
1. Wrong decisions relating to finance adversely affect
i. Finance department ----------------------
ii. Marketing department ----------------------
iii. Production department ----------------------
iv. All the above departments
----------------------
Notes
2. According to the first approach to finance, which includes procurement
---------------------- of funds for
i. Corporate entities
----------------------
ii. Partnership firms
----------------------
iii. Sole trading organisations
---------------------- iv. None of the above
---------------------- v. i to iii above.
---------------------- 3. The first approach to finance concentrates on
i. Non-recurring problems
----------------------
ii. Day to day problems
----------------------
iii. Long-term problems
----------------------
iv. Short-term problems
---------------------- v. Working capital problems
---------------------- 4. The second approach to finance is concerned with cash. This approach is:
---------------------- i. Narrow
ii. Moderate
----------------------
iii. Broad
----------------------
iv. Too broad to be meaningful
---------------------- 5. The third approach to finance includes procurement and application of
funds. This approach is:
----------------------
i. Narrow
----------------------
ii. Moderate
---------------------- iii. Broad
---------------------- iv. Too broad to be meaningful
---------------------- v. Acceptable to the modern scholars
----------------------
Activity 1
----------------------
---------------------- Prepare a flow chart showing widening scope of finance function.
----------------------
---------------------- 1.3 SCOPE OF FINANCE FUNCTION

---------------------- According to the modern approach, the function of finance is concerned with
the following three types of decisions:
----------------------
Financing Decisions Notes
Financing decisions are the decisions regarding the process of raising the
----------------------
funds. This function of finance is concerned with providing the answers to the
various questions like: ----------------------
a. What should be the amount of funds to be raised? In simple words, the
----------------------
amount of funds to be raised by the organisation should not be more or less
than what is required as both the situations involve adverse consequences. ----------------------
b. What are the various sources available to the organisation for raising the
----------------------
required amount of funds? For raising the funds, the organisation can go
for internal sources as well as external sources. ----------------------
c. What should be the proportion in which the internal and external sources ----------------------
should be used by the organisation?
d. If the organisation, particularly the corporate form of organisation, wants ----------------------
to raise the funds from different sources, it is required to comply with ----------------------
various legal and procedural formalities. Earlier, these legal and procedural
formalities were prescribed and regulated by the Controller of Capital ----------------------
Issues (CCI). Since 1992, after the abolition of the office of CCI, these
formalities are prescribed and regulated by Securities and Exchange Board ----------------------
of India (SEBI). Though the intention of this subject is not to consider the ----------------------
SEBI regulations and guidelines in details, relevant SEBI guidelines are
discussed at the appropriate places. ----------------------
e. During the last decade of the twentieth century, many changes have taken ----------------------
place in the capital market, which refers to the market available to the
companies to raise the long-term requirement of funds. The question arises ----------------------
as to what is the nature of capital market operations. What kinds of changes
have taken place recently affecting the capital market in the country? ----------------------
Investment Decisions ----------------------

Investment Decisions are the decisions regarding the application of funds ----------------------
raised by the organisation. The investment decisions relate to the selection of
the assets in which the funds should be invested. ----------------------
The assets in which the funds can be invested are basically of two types: ----------------------
a. Fixed Assets – Fixed Assets indicate the infrastructural facilities and ----------------------
properties required by the organisation. Fixed Assets are the assets, which
bring the returns to the organisation over a longer span of time. The ----------------------
investment decisions in these types of assets are technically referred to as
‘Capital Budgeting Decisions.’ Capital Budgeting Decisions are concerned ----------------------
with the answers to the questions like: ----------------------
1 How should the fixed assets, proposals or projects be selected for
investment? What are the various methods available to evaluate the ----------------------
investment proposals in the fixed assets? ----------------------
2 How the decisions regarding the investment in fixed assets or proposals
----------------------
or projects should be made in the situations of risk and uncertainty?
Notes b. Current Assets – Current Assets are the assets, which are generated
during the course of operations and are capable of being converted in the
---------------------- form of cash or being utilised within a short span of time of one year.
Current Assets keep on changing the form and shape very frequently. The
---------------------- investment decisions in these types of assets are technically referred to as
---------------------- ‘Working Capital Management.’ Working Capital Management decisions
are concerned with the answers to the questions like:
----------------------
1. What is the meaning of working capital management? What are the
---------------------- objectives of working capital management?
2. Why the need for working capital arises?
----------------------
3. What are the factors affecting the requirement of working capital?
----------------------
4. How to quantify the requirement of working capital?
---------------------- 5. What are the sources available for financing the requirement of
---------------------- working capital?
6. Working capital management is concerned with the management of
---------------------- current assets on overall basis as well as on individual basis. In practical
---------------------- situations, current assets may be found in the form of cash and bank
balances, receivables and inventory. Working capital management is
---------------------- concerned with the management of these individual components of
current assets as well.
----------------------
Dividend Policy Decisions
----------------------
Profits earned by the organisation belong to the owners of the organisation.
---------------------- In case of the corporate form of organisation, shareholders are the owners and
they are entitled to receive the profits in the form of dividend. However, there
---------------------- is no specific law or statute, which specifies as to how much amount of profits
should be distributed by way of dividend and how much amount of profits should
----------------------
be retained in the business. The alternatives available to the organisation to
---------------------- distribute the profits in the form of dividend on one hand and retention of profits
in the business have reciprocal relationship with each other. If the dividends
---------------------- paid are higher, retained profits are less and vice versa. If the organisation
pays higher dividends, shareholders are very happy as they get more recurring
----------------------
income and the company may be able to gain the confidence of the shareholders.
---------------------- However, the organisation can be in financial problems as payment of dividend
results into the withdrawal of profits from the business. On the other hand, if
---------------------- the organisation pays less dividend, the organisation may be in a favourable
situation. However, the shareholders are likely to be offended. As such, the
----------------------
organisation is required to take the decisions regarding the payment of dividend
---------------------- in such a way that neither the shareholders are offended nor the organisation
is in financial problems. As such, dividend policy decisions are the strategic
---------------------- financial decisions and are concerned with the answers to the questions like:
---------------------- 1 What are the forms in which the dividends can be paid to the shareholders?
---------------------- 2 What are the legal and procedural formalities to be completed while paying
the dividend in different forms?
1.4 GOALS/OBJECTIVES OF FINANCE FUNCTION Notes
Profit Maximisation: ----------------------
As a basic principle, any business activity aims at earning profits. According ----------------------
to this principle, all the functions of the business will have the profit as the
main objective. Similarly, the finance function will also have the profits as the ----------------------
main objective. But this was only a traditional belief. Now, profit cannot be the
sole and only goal or objective of the finance function, due to the following ----------------------
problems connected with this objective. ----------------------
1. The term profit is an ambiguous concept, which is not having precise
connotation. For example, Profits can be long-term or short-term. Profits ----------------------
can be before tax or after tax and so on. If profit maximisation is accepted ----------------------
as the goal of finance function, the next question that arises is “Which
types of profits should be maximised?” ----------------------
2. The profits always go hand in hand with risks. The more profitable ventures ----------------------
necessarily involve more amount of risk. The owners of the business will
not like to earn more and more profits by accepting more risk. If profit ----------------------
maximisation is accepted as the goal of finance function, it totally ignores
----------------------
the risk factor.
3. Profit maximisation as the goal of financial function ignores the time ----------------------
pattern of returns. Consider the following two proposals A and B, which
----------------------
involve the same amount of returns.
A (Rs.) B (Rs.) ----------------------
Year I 70,000 – ----------------------
Year II 20,000 –
----------------------
Year III 10,000 1,00,000
1,00,000 1,00,000 ----------------------
Both the proposals A and B involve same amount of profits and hence ----------------------
ideally should be treated on par. But it will not be proper as proposal A
involves higher amount returns in the earlier years, while proposal B ----------------------
involves the returns in the later years. It makes proposal A more profitable
----------------------
ultimately, as the returns received earlier are more valuable than the returns
received later. The objective of profit maximisation does not differentiate ----------------------
between the returns received earlier and the returns received later.
----------------------
4. Profit maximisation as the objective does not take into consideration the
social considerations as well as the obligations to various interests of workers, ----------------------
consumers, society etc. and the ethical trade practices. If these factors are
ignored, the organisation cannot survive for long. Profit maximisation at the ----------------------
cost of social and moral obligations is a shortsighted policy.
----------------------
As such, profit maximisation cannot be a prime objective of the finance
function. The objective has to be one having more broad a base, which is more ----------------------
precise, which considers risk factor and time value of money and which gives ----------------------
Notes consideration to social and ethical elements also. The alternative is in the form
of wealth maximisation as the objective of the finance function.
----------------------
Wealth Maximisation:
---------------------- Due to the limitations attached with profit maximisation as an objective of
the finance function, it is no more accepted as the basic objective. As against it,
----------------------
it is now accepted that the objective of the business should be to maximise its
---------------------- wealth and value of the shares of the company. This object can also be stated as
maximisation of value.
----------------------
The value of an asset is judged not in terms of its cost but in terms of the
---------------------- benefit it produces. Similarly, the value of a course of action is judged in terms
of the benefits it produces less the cost of undertaking it. The benefits can be
---------------------- measured in terms of stream of future expected cash flows, but they must take
into consideration not only their magnitude but also the extent of uncertainty.
----------------------
Thus, wealth maximisation goal as a decision criteria suggests that, any
---------------------- financial action which creates wealth or which has discounted stream of future
---------------------- benefits exceeding its cost, is desirable and should be accepted and that which
does not satisfy this test should be rejected.
---------------------- The goal of wealth maximisation is supposed to be superior to the goal of
---------------------- profit maximisation due to following reasons:
1. It uses the concept of future expected cash flows rather than the ambiguous
---------------------- term of profits. As such, measurement of benefits in terms of cash flows
---------------------- avoids ambiguity.
2. It considers time value of money. It recognises that the cash flows generated
----------------------
earlier are more valuable than those generated later. That is why while
---------------------- computing value of total benefits, the cash flows are discounted at a certain
discounting rate. At the same time, it recognises the concept of risk also, by
---------------------- making necessary adjustments in discounting rate. As such, cash flows of
a project involving higher risk are discounted at a higher discounting rate
----------------------
and vice versa.
---------------------- Thus, the discounting rate used to discount future cash flows reflects the
concepts of both time and risk.
----------------------
Due to the above reasons, the wealth maximisation is considered superior
---------------------- to profit maximisation as an objective or goal of finance function. However, it
---------------------- should be noted that wealth maximization goal is only an extension of profit
maximization goal. If the time is too short and risk element is minimum, both
---------------------- wealth maximisation and profit maximisation will mean the same thing.
----------------------
----------------------
----------------------
----------------------
Notes
Check your Progress 2
----------------------
Multiple Choice Single Response. ----------------------
1. Investment decisions are decisions relating to the
----------------------
i. Procurement of funds
----------------------
ii. Application of funds
2. Investment decisions are technically referred to as ----------------------
i. Working capital management decisions ----------------------

ii. Current assets management decisions ----------------------
iii. Capital budgeting decisions
----------------------
iv. None of the above
----------------------
3. Profits of the company belong to the
i. Company ----------------------
ii. Employees ----------------------

iii. Directors ----------------------
iv. Shareholders
----------------------
4. The rate of profit to be distributed as dividend is declared by
----------------------
i. Legal provisions in Companies Act, 1956
ii. A director ----------------------
iii. Board of Directors ----------------------

iv. Shareholders in the general meeting ----------------------
5. Objective of business should be
----------------------
i. Profit maximisation
----------------------
ii. Wealth maximisation
iii. Goodwill maximisation ----------------------
iv. None of the above ----------------------

6. Wealth maximisation and profit maximisation would mean same thing ----------------------
i. If the time period is too short and the risk is minimum ----------------------
ii. If the time period is too long and the risk is maximum
----------------------
iii. If the time period is moderate and the risk is also moderate
----------------------
iv. All the above
----------------------
----------------------
Notes
Activity 2
----------------------
---------------------- Meet any businessman and discuss with him the factors he considers
challenges that he encountered while procuring and investing funds.
----------------------
---------------------- 1.5 ORGANISATION OF FINANCE FUNCTION

---------------------- At the outset, it must be cleared that there is no standard pattern for the
---------------------- organisation of finance function. It varies from enterprise to enterprise and its
characteristics vary in terms of nature, size, convention etc. In smaller concerns,
---------------------- where the operations are relatively less complicated and simple, there may not
be a separate executive to look after the finance function. In fact, the proprietor
---------------------- or partners only will be looking after all the functional areas like production,
---------------------- marketing, finance etc.
In bigger concerns, the execution of finance function becomes a specialised
----------------------
task and may be handled by an executive who may be the Treasurer, Finance
---------------------- Controller, Finance Manager, Vice-President (Finance) and so on. He is
generally given the charge of credit and collection accounting, investment and
---------------------- audit departments. He is responsible for preparing annual financial reports. He
reports directly to the President and Board of Directors.
----------------------
Secondly, it should be noted that generally the organisation of finance
---------------------- function is centralised one, unlike other business functions. Board of Directors
takes the main financial decisions. Board of Directors may delegate the powers
----------------------
to the executive committee, comprising of managing director, other one or
---------------------- two directors and finance officer of the company. This executive committee
takes all the financial decisions. Routine financial matters may be delegated to
---------------------- lower level officers. The reasons for finance function being a highly centralised
function are obvious.
----------------------
1. Financial decisions are the most crucial ones on which survival or failure
---------------------- of the organisation depends.
---------------------- 2. Financial decisions affect the solvency position of the organisation and a
wrong decision in this area may land the organisation into crisis.
----------------------
3. The organisation may gain economies of centralisation in the form of
---------------------- reduced cost of raising the funds, acquisition of fixed assets at competitive
prices etc.
----------------------
Though there is no standard pattern for organisation of the finance function, in
---------------------- general terms, the organisation of finance function takes the following form.
----------------------
----------------------
----------------------
Board of Directors Notes
----------------------
Executive Committee
----------------------
Vice President Vice President Vice President ----------------------
(Production) (Finance) (Marketing)
----------------------
Finance Controller Treasurer
----------------------
(1) Accounting and Costing (1) Receivables Management ----------------------
(2) Annual Reporting (2) Taxes and Insurance
----------------------
(3) Internal Auditing (3) Cost Management
----------------------
(4) Budgeting (4) Securities
(5) Statistics and Finance (5) Banking Relations ----------------------
(6) Record Keeping (6) Real Estates ----------------------
(7) Dividend Distribution ----------------------
----------------------
1.6 DUTIES AND RESPONSIBILITIES OF FINANCE
EXECUTIVE ----------------------
Based on the scope of the finance function, which has already been discussed, ----------------------
the various duties and responsibilities that a finance executive has to fulfill can
----------------------
be classified as below:
Recurring Duties ----------------------
a. Deciding the Financial Needs: In case of a newly started or growing ----------------------
concern, the basic duty of the finance executive is to prepare the financial
plan for the company. Financial plan decides in advance the quantum ----------------------
of funds required, their duration, etc. The funds may be needed by the
----------------------
company for initial promotional expenditure, fixed capital, working capital
or for dividend distribution. The finance executive should assess this need ----------------------
of funds properly.
----------------------
b. Raising the Funds Required: The finance executive has to choose the
sources of funds to fulfill financial needs. The sources may be in the form ----------------------
of issue of shares, debentures, borrowing from financial institutions or
general public, lease financing etc. The finance executive has also to decide ----------------------
the proportion in which the various sources should be raised. For this, he
may have to keep in mind basic three principles of cost, risk and control. ----------------------
If the company decides to go in for issue of securities say in the form of ----------------------
shares or debentures, he has to arrange for the underwriting or listing of
the same. If the company decides to go in for borrowed capital, he has to ----------------------
negotiate with the lenders of the funds.
----------------------
Notes c. Allocation of Funds: The financial executive has to ensure proper
allocation of funds. He can allocate the funds basically for two purposes.
----------------------
i. Fixed Assets Management: He has to decide in which fixed assets
---------------------- the company should invest the funds. He has to ensure that the fixed
assets acquired or to be acquired satisfy the present as well as future
---------------------- needs of the company. He has to ensure that the funds invested in
the fixed assets justify the investments in terms of the expected cash
----------------------
flows generated by them in future. If there are more than one proposal
---------------------- for making the investments in fixed assets, the finance executive has
to decide in which proposal the company should invest the funds.
---------------------- For this purpose, he may be required to take the help of various
techniques of capital budgeting to evaluate the various proposals, For
----------------------
example, Pay Back Period, Net Present Value, Internal Rate of Return,
---------------------- Profitability Index etc. If the outright purchases of fixed assets are not
useful, the finance executive has to ensure that in order to facilitate
---------------------- the replacement of fixed assets after their economic life is over, proper
depreciation policies are formulated. The wrong policies in the area
----------------------
of providing for the depreciation may result into over-capitalisation or
---------------------- under capitalisation.
ii. Working Capital Management: The finance executive has to ensure
----------------------
that sufficient funds are made available for investing in current assets,
---------------------- as it is the life¬blood of the business activity. Non-availability of
funds to invest in current assets in the form of say cash, receivable,
---------------------- inventory etc. may halt the business operations. At the same time, he
has to ensure that there is no blocking of funds in the current assets, as
----------------------
it may prove to be costly in terms of cost of these funds and in terms of
---------------------- opportunity cost of their use. Thus, the finance manager has to ensure
that investments in the current assets are minimum without affecting
---------------------- the operations of the company.
---------------------- d. Allocation of Income: Allocation of the income of the company is the
exclusive responsibility of the finance executive. For this purpose, basically
---------------------- the income may be distributed among the shareholders by way of dividend
or it may be retained in the business for future purpose like expansion.
----------------------
Decision in this regard may be taken in the light of financial position,
---------------------- present and future cash requirements, preferences of the shareholders etc.
---------------------- e. Control of Funds: The finance executive is responsible to control the use
of funds committed in the business so as to ensure that cash is flowing
---------------------- as per the plan and if there is any deviation between estimates and plans,
proper corrective action may be taken in the light of financial position of
---------------------- the company. For this purpose, he may be required to supervise the cash
---------------------- receipts and disbursements, ensure the safety of cash balances, expedite
receipts and delay the payments wherever possible etc.
----------------------
----------------------
f. Evaluation of Performance: The financial executive may be required Notes
to evaluate and interpret the financial statements, financial position and
operations of the company. For this purpose, he may be required to ----------------------
ensure that proper books and records are maintained in a proper way so
that whatever data is required of this purpose is available in time. For the ----------------------
evaluation and interpretation of the financial statements, financial executive ----------------------
may use the techniques like ratio analysis, funds flow statement etc.
----------------------
g. Corporate Taxation: As the company is a separate legal entity, it is
subjected to the various direct and indirect taxes like income tax, wealth ----------------------
tax, excise and customs duty, sales tax etc. The finance executive may be
expected to deal with the various tax planning and tax saving devices in ----------------------
order to minimise the tax liability.
----------------------
h. Other Duties: In addition to all the above duties the financial executive
may be required to prepare annual accounts, prepare and present financial ----------------------
reports to top management, carrying out internal audit, get done statutory
----------------------
and tax audit, safeguarding securities and assets of company by properly
insuring them etc. ----------------------
Non-recurring Duties:
----------------------
The non-recurring duties of the finance executive may involve preparation of
financial plan at the time of company promotion, financial readjustments in ----------------------
times of liquidity crisis, valuation of the enterprise at the time of acquisition ----------------------
and merger thereof etc.
----------------------
----------------------

1. In the organisational hierarchy of finance function, finance controller ----------------------
and treasure assist
----------------------
1. Board of Directors
2. Executive Committee ----------------------
3. Vice President Finance ----------------------

4. Vice President Production ----------------------
5. Vice President Marketing
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Notes
Activity 3
----------------------
---------------------- 1. Classify the following duties of finance executive into recurring or

non-recurring duties.
----------------------
Recurring /
---------------------- Duty Non-recurring
classification
---------------------- Allocation of income received from different sources
Financial plan at the time of company promotion
----------------------
Financial readjustment at the time of financial crises
---------------------- Corporate taxation
Evaluation of performance
---------------------- Valuation of enterprise at the time of acquisition and
mergers
----------------------
---------------------- 1.7 THE FIELDS OF FINANCE
---------------------- The finance function may operate in various fields. In each field, finance
---------------------- executives deal with the management of money and claims against money. The
distinctions arise due to variety of problems and variety of objects. The various
---------------------- fields of finance can be stated as below:
---------------------- 1. Business Finance: The term business and hence business finance is a
very broad term. It covers all the activities carried on with the intention of
---------------------- earning profits. Thus, business finance covers the study of finance function
in the area of business, which includes both trade as well as industry.
----------------------
2. Corporation Finance: Corporation finance is a part of business finance
---------------------- and deals with the financial practices, policies and problems of corporate
enterprises or companies to describe in simple words. The corporation
---------------------- finance studies the financial operations carried on by a corporate enterprise
---------------------- from the stage of its inception to the stage of its growth and expansion.
3. International Finance: International finance is the study of flow of funds
---------------------- between individuals and organisations beyond national boundaries and
developing the methods to handle these funds more effectively. This study
----------------------
may become crucial, as it involves exchange of currencies and also as the
---------------------- governments of either of the nations may have close watch and control on
these transactions involving foreign currencies.
---------------------- 4. Public Finance: It deals with the financial matters of the Governments.
---------------------- It becomes crucial as the Governments deal with huge sums of money,
which can be raised through the sources like taxes or other methods and are
---------------------- required to be utilised within the statutory and other limitations. Further, the
Government does not operate with objectives similar to that of the private
---------------------- organisations i.e. earning the profits is not the intention with which the
---------------------- Governments operate, but they operate with the intention of accomplishing
social or economic objectives.
5. Private Finance: It deals with the financial matters of non-government Notes
organisations.
----------------------
1.8 FINANCE FUNCTION IN RELATION WITH OTHER ----------------------
FUNCTIONS
----------------------
Other than finance, every business generally operates in three main
functional areas viz. Production, Marketing and Personnel. All these functions ----------------------
are closely related to finance function due to the simplest reason that for
----------------------
executing these functions, funds are required which is the area covered by
finance function. ----------------------
For example, to produce good quality of finished goods, the business needs
----------------------
good infrastructural facilities like building, machineries etc., a regular flow of
production facilities like quality, raw material, work in progress, consumable ----------------------
stores, quality control equipments, good maintenance facilities etc. All these
activities need the investment to be made in terms of either fixed capital and/or ----------------------
working capital, which is the area of finance function. To market the finished
----------------------
goods properly in the market, the business has to have a proper investment in
the finished goods to guarantee regular flow of goods in the market. It may be ----------------------
required to have good distribution systems, which may call for investment in
terms of fixed assets or labour force. All these activities need the investments ----------------------
to be made in terms of either fixed capital and/or working capital, which is
----------------------
the area of finance function. The personnel function deals with the availability
of proper kinds of labourers at proper time, training them properly and fixing ----------------------
their job responsibilities. All these activities need funds. For example, to pay
salaries, wages and other facilities to workers, funds are needed, to provide ----------------------
training facilities to workers, it may be necessary to invest in some fixed assets
----------------------
like building or equipments etc.
To conclude, it may be stated that all the functions or activities of the ----------------------
business are ultimately related to finance. The success of the business depends ----------------------
on how best all these functions can be coordinated.
----------------------
----------------------
Match the Following. ----------------------

i. Business finance a. Two nations, two currencies, two ----------------------
governments
ii. Corporation finance b. Financial matters of non-governmental ----------------------
organisations
----------------------
iii. International finance c. Financing of trade and financing of
industry ----------------------
iv. Public finance d. Financing from inception to growth and
development ----------------------
v. Private finance e. Collection of taxes and it’s utilisation
----------------------
Notes
Activity 4
----------------------
---------------------- Read job advertisements in newspapers and keep a record of the qualities
and qualifications required for a Finance Manager.
----------------------
---------------------- Summary
---------------------- l T
his unit introduces you the finance function in a business organisation.
Any business activity is carried out with the intention of earning profit.
----------------------
Finance function deals with the activities related to procurement of funds
---------------------- and deployment of funds in business.
l S
cope of finance function includes financing decisions, investment
----------------------
decisions and dividend policy decisions.
---------------------- l T
he main object of finance function is the wealth maximisation of the
---------------------- shareholders of the company.
l S
ome of the duties of finance executive consist of assessing the funds
---------------------- requirement for the business activity, procurement of funds, allocation of
---------------------- funds, allocation of income and control of funds.
l F
inance function is closely related to all main activities of the business
---------------------- such as Production, Marketing and Personnel since funds are required to
---------------------- carry out all these activities smoothly. A proper co-ordination between
finance function and all other business activities is a prerequisite to ensure
---------------------- the success of business.
----------------------
Keywords
----------------------
• Current Assets: Current Assets are the assets, which are generated during
---------------------- the course of operations and are capable of being converted in the form of
cash or being utilised within a short span of time of one year.
----------------------
• Fixed Assets: Fixed Assets indicate the infrastructural facilities and
---------------------- properties required by the organisation. Fixed Assets are the assets, which
---------------------- bring the returns to the organisation over a longer span of time.
• Allocation of Income: Allocation of the income of the company is the
----------------------
exclusive responsibility of the finance executive.
----------------------
----------------------
---------------------- 1. Describe the scope and importance of the finance function in the
management of a corporation.
----------------------
2. Explain the meaning, nature and scope of Business Finance.
----------------------
3. Explain the organisational framework of finance function. State the relation Notes
of finance function to other functions of a business enterprise.
----------------------
4. What are the duties discharged by the financial executives in a large
business organisation? ----------------------
5. Explain the traditional and modern concept of finance function.
----------------------
6. State the relation of finance function to other functions of a business
enterprise. ----------------------
7. Describe the organisational structure of finance department of a large ----------------------
business concern.
----------------------
8. How is finance function organised in business firms?
----------------------
9. Explain the internal structure of the finance department in medium and
large business enterprises with a suitable chart. ----------------------
Answers to Check your Progress ----------------------

1. Wrong decisions relating to finance adversely affect ----------------------
iv. All the above departments
----------------------
2. According to the first approach to finance, which includes procurement of
funds for ----------------------
i. Corporate entities ----------------------
3. The first approach to finance concentrates on ----------------------
iii. Long-term problems
----------------------
4. The second approach to finance is concerned with cash. This approach is:
----------------------
iv. Too broad to be meaningful
5. The third approach to finance includes procurement and application of ----------------------
funds. This approach is: ----------------------
v. Acceptable to the modern scholars
----------------------
----------------------
1. Investment decisions are decisions relating to the ----------------------
ii. Application of funds ----------------------

2. Investment decisions are technically referred to as ----------------------
iii. Capital budgeting decisions
----------------------
----------------------
Notes 3. Profits of the company belong to the
iv. Shareholders
----------------------
4. The rate of profit to be distributed as dividend is declared by
----------------------
iv. Shareholders in the general meeting
---------------------- 5. Objective of business should be
---------------------- ii. Wealth maximisation
---------------------- 6. Wealth maximisation and profit maximisation would mean same thing
i. If the time period is too short and the risk is minimum
----------------------
----------------------
---------------------- 1. In the organisational hierarchy of finance function, finance controller and
---------------------- treasure assist
iii. Vice president finance
----------------------
----------------------
Match the Following.
---------------------- i. c
---------------------- ii. d
---------------------- iii. a
iv. e
----------------------
v. b
----------------------
---------------------- Suggested Reading

---------------------- 1. Ainapure & Ainapure. Auditing and Assurance.
---------------------- 2. Kaplan & Atkinson. Advanced Management Accounting Book.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Forms of Business Organisations
UNIT
2
Structure:
2.1 Introduction
2.2 Proprietary Firms
2.3 Partnership Firms
2.4 Joint Stock Companies
Summary
Keywords
Suggested Reading
Forms of Business Organisations 19

Notes
Objectives
----------------------
----------------------
• Define various forms of business organisations
----------------------
• Differentiate between various forms of business organisations
---------------------- • Evaluate the advantages and disadvantages of each type of business
organisation
----------------------
• Distinguish between private and public limited company
----------------------
• Generalise the mode of operations of each type of business
---------------------- organisation
----------------------
2.1 INTRODUCTION
----------------------
The finance function of the organisation is greatly affected by the forms of
---------------------- organisation. The form of business organisation means the basic constitution of
the organisation in which it is set. It is generally defined by its ownership. The
---------------------- owners are persons who own the business organisation and they are a major
source of finance for the organisation. The various laws applicable to business
----------------------
entities as well as the mode of conducting business depend upon the form of
---------------------- business organisation. In practical circumstances, we come across basically
three forms of business organisations viz. Proprietary Firms, Partnership Firms
---------------------- and Joint Stock Companies.
----------------------
2.2 PROPRIETARY FIRMS
----------------------
In this case, only one person is the owner of the business who is called as the
---------------------- ‘Proprietor’ and the same person is the manager. All the profits earned by the
business belong to the proprietor and he is liable for the losses and liabilities of
----------------------
the business.
---------------------- Advantages:
---------------------- a. Proprietary Firm is the easiest and most economical form of business
organisation to form and operate. Not many of the government regulations
---------------------- are applicable to the Proprietary Firms.
---------------------- b. This form of organisation is very suitable where the size of the business
is small and the complexities involved in the business are comparatively
---------------------- less. However, if the size of the business increases or the complexities in
---------------------- the business operations grow, this form may prove to be insufficient.
Disadvantages:
----------------------
a. This form of organisation does not have any legal status. The proprietary
---------------------- firms exist due to the existence of the proprietor. If the proprietor ceases to
be in existence, the firm ceases to be in existence.
----------------------
b. As only one person is the owner and the manager, the capacity of the Notes
business to raise funds and to cope up with complex business operations is
comparatively limited. ----------------------
----------------------
----------------------
State True or False.
----------------------
1. The forms of business organisation means the basic constitution of the
organisation in which it is set. ----------------------
2. Proprietary is a difficult and expensive form of business organisation. ----------------------

3. Sole trading form of business organisation has no separate legal status. ----------------------
4. When scale of operation increases, sole trading form of business
----------------------
organisation is not suitable.
5. Proprietor’s liability is always limited to his capital investments. ----------------------
6. Income of the proprietary firm and the proprietor is combined. ----------------------
7. Liabilities of the proprietary firm cannot be paid by the proprietor out ----------------------
of his personal assets.
8. When the proprietor transfers his business to another person, the basic ----------------------
constitution of business is affected. ----------------------
----------------------
Activity 1
----------------------
Read financial statements of any two sole proprietors and compare their ----------------------
a. The sources of finance
----------------------
b. The application of finance
----------------------
c. Amount of profit earned
d. Amount of profits ploughed back ----------------------
----------------------
2.3 PARTNERSHIP FIRMS ----------------------
In this case, more than two persons but less than twenty persons come ----------------------
together and form a partnership firm. Each of these partners is the owner of the
business in the proportion decided among themselves. Partnership is a contract ----------------------
among the partners and the relationship among the partners is governed on the ----------------------
basis of terms and conditions laid down in an official and written document
called as ‘partnership deed’ or ‘partnership agreement’. ----------------------
----------------------
----------------------

Notes Advantages:
a. This form of organisation is also reasonably easy and economical to
----------------------
form and operate.
---------------------- b. As resources of more than one person are pooled together, capacity
---------------------- of the business to handle more complex business operations or
operations requiring more amounts of funds is better as compared to
---------------------- the proprietary firms.
---------------------- c. The tax structure applicable to the partnership firms is reasonable.
----------------------
At present, the profits of partnership firm is taxed at the rate of 30%
which is further increased by the surcharge of 10% and the education
---------------------- cess of 2% is payable on the income tax as well as surcharge. The
effective rate of tax works out to be 33.66%. While calculating the
----------------------
profit of the partnership firm, following amounts can be claimed by
---------------------- the firm as the allowable expenditure.
---------------------- i. The firm can pay interest on capital to the partners on the amount
of capital introduced by them in the business but the rate of
---------------------- interest cannot exceed 12% per annum. This interest on capital
---------------------- can be paid by the firm to all the partners.
ii. The firm can remunerate the partners in the form of salary, bonus,
----------------------
commission etc. provided the partners are ‘working partners’. A
---------------------- working partner is a partner who is capable of participating in the
day-to-day affairs of the firm by virtue of experience or qualifications.
---------------------- However, the firm cannot remunerate the partners to any extent it
---------------------- wants. The maximum amount of remuneration that the firm can pay
to all the working partners taken together is prescribed in Income Tax
---------------------- Act, 1961. Section 44AA of the said Act provides that the maximum
amount of remuneration which the firm can pay to its working partners
---------------------- gets decided on the basis of its ‘book profits’ which means the amount
---------------------- of profits as per its profitability statement after calculating the interest
on capital paid to the partners. After deciding the amount of book
---------------------- profit, the remuneration is decided as below:
---------------------- If the firm is carrying on a profession:
• On the first Rs. 1,00,000 of the book profit or in case of a loss, Rs.
----------------------
50,000 or 90% of the book profit whichever is more.
---------------------- • On the next Rs. 1,00,000 of the book profit, at the rate of 60%.
---------------------- • On the balance amount of book profit, at the rate of 40%. In case of
any other firm:
---------------------- • On the first Rs. 75,000 of the book profit or in case of a loss, Rs.
---------------------- 50,000 or 90% of the book profit whichever is more.
• On the next Rs. 75,000 of the book profit, at the rate of 60%.
----------------------
• On the balance amount of book profit, at the rate of 40%.
However, it should be remembered that the amount of interest on capital Notes
paid by the firm and the remuneration paid to the partners is taxable in the
hands of individual partners. ----------------------
After charging the above amounts, the balance amount of profits are ----------------------
transferred to the capital account of the partners, which is referred to as
‘share of profit’, and this share of profit is not taxable in the hands of ----------------------
individual partners.
----------------------
d. Not many of the government regulations are applicable to the partnership
firms. ----------------------
Disadvantages: ----------------------
a. This form of organisation also does not have any legal status. The ----------------------
partnership firms exist due to the existence of the partners. If the
partners cease to be in existence, the firm ceases to be in existence. ----------------------
The retirement or death of a partner leads to the dissolution of the
partnership firm. ----------------------
b. The capacity of the business to raise the funds and to cope up with ----------------------
the complex business operations is comparatively limited though it is
more than that of the proprietary firms. ----------------------
c. Partnership firm is also an unlimited liability organisation. In the ----------------------

sense, if the assets of the firm are insufficient to meet its liabilities,
personal property of the partners is always at stake. ----------------------
d. It is not possible to transfer the ownership of the business to somebody ----------------------

else without affecting the basic constitution of the business.
----------------------
2.4 JOINT STOCK COMPANIES ----------------------
Joint stock companies have become a major form of organisation in the ----------------------
recent past. This form of organisation can raise large amount of funds as the
resources of larger number of people can be pooled together. In this case, the ----------------------
total requirement of funds of the organisation is split into smaller units, each ----------------------
of such units being called as a ‘share’. Each such share carries a denomination
value, which is called as ‘face value’ or ‘nominal value’. An individual can ----------------------
participate in the capital requirement of an organisation by purchasing the
shares of the company and he becomes the part owner of the company to the ----------------------
extent of his shareholding in the overall amount of capital of the company. Such ----------------------
shareholder can exercise his ownership rights through the voting rights offered
to him. ----------------------
The joint stock companies have the following characteristic features: ----------------------
a. All the joint stock companies have a legal entity separate from their owner
----------------------
viz. shareholders. They gain the legal status by being registered under
Companies Act, 1956, which governs and regulates the operations of all ----------------------
joint stock companies in India. As legal entities, the joint stock companies
can own assets, incur liabilities, enter into contracts, sue and be sued. The ----------------------

Notes shareholders of the company cannot be held liable for the actions of the
company.
----------------------
b. Generally, all joint stock companies are limited liability organisations and
---------------------- the liability of the shareholders is limited to the extent of amount of shares
they undertake to purchase. For example, if Mr. A undertakes to purchase
---------------------- 100 shares of a company of Rs. 100 each, his liability ceases once he pays
Rs. 10,000 to the company. His personal property is never in danger despite
----------------------
the losses and liabilities incurred by the company.
---------------------- c. Segregation of ownership and management is a typical feature of joint
stock companies. In case of the companies, shareholders are the owners.
----------------------
However, due to large number of shareholders and their wide geographical
---------------------- spread, it may not be possible for the shareholders to exercise their
ownership rights by participating in the day-to-day affairs of the company.
---------------------- As such, the shareholders appoint their representatives (viz. directors)
to manage the day-to-day affairs of the company. In case of joint stock
----------------------
companies, shareholders are the owners while directors/board of directors
---------------------- are the managers.
d. Transferability of shares is a feature of a joint stock company. A shareholder
----------------------
can transfer his ownership rights in the company by transferring his shares
---------------------- to some other person. In case of public limited companies, shares are freely
transferable and such transfer can be greatly facilitated if the shares are
---------------------- listed on the stock exchange. In case of private limited companies, there
may be some restrictions on the transfer of shares.
----------------------
e. Being an artificial legal person, the company enjoys a perpetual existence.
---------------------- The company can die only a legal death, after complying with the prescribed
---------------------- legal formalities. There is a very famous case under the Companies Act,
where during the war, all the members of a private company, while in
---------------------- meeting, were killed by a bomb, but the company survived.
---------------------- f. A company is an artificial legal person that does not have a body like a
natural person and hence it cannot sign any documents. However, being
---------------------- a legal personality, it is bound only by those documents, which bear its
signature. Hence, as a substitute to the signature, the law provides for the
---------------------- use of common seal. Any document having the common seal and witnessed
---------------------- by at least two directors is binding on the company legally.
Advantages:
----------------------
a. The capacity of the corporate organisations to raise the funds is comparatively
---------------------- high. As the number of persons contributing to the requirement of funds is
large, it is possible to raise large amount of funds.
----------------------
b. As the company has a separate legal entity, apart from its owners, viz.
---------------------- shareholders, the personal property of the shareholders is generally not in
danger.
----------------------
c. Transferability of shares is a facility available to the shareholders. If the
---------------------- shareholders want to release their investment in shares, they can transfer
their shares to any other person. However, it should be remembered that in Notes
case of private limited companies, the shares are not freely transferable.
----------------------
Disadvantages:
The company form of organisation is subjected to elaborate legal and procedural ----------------------
formalities to be complied with, not only for the purpose of formation but also
----------------------
for the regular operation. The basic applicable law in this connection is in the
form of Companies Act, 1956. However, it should be noted that in case of ----------------------
private limited companies, these formalities are less rigorous in nature.
----------------------
As the company form of organisation is the most frequently found form of
organisation, for the future discussion in the following units, we will refer the ----------------------
business organisation to be a ‘company’.
----------------------
In practical situations, we come across two types of limited liability companies:
a. Private Limited Company ----------------------
In non-technical language, operations of a private limited company affect ----------------------

the fate of a smaller number of people. As such, Companies Act, 1956 is very
liberal towards the private limited companies. Private Limited Company is ----------------------
entitled to many privileges/ exemptions from the various provisions of the ----------------------
Companies Act, 1956. A private limited company is characterised by the
following features: ----------------------
a. Minimum number of shareholders is 2 and the maximum number is ----------------------
50.
----------------------
b. A private limited company cannot approach public in general for
subscribing to the shares/debentures of the company. Similarly, a ----------------------
private limited company cannot invite or accept deposits from public
in general other than its shareholders, directors or their relatives. The ----------------------
funds required by the company are required to be collected through
----------------------
the private circulation only.
c. In case of a private limited company, right of the shareholders to ----------------------
transfer the shares is restricted. These restrictions are usually in two ----------------------
forms:
i. That the shares to be transferred should be offered to the existing ----------------------
members on priority basis and if the existing members do not ----------------------
want to take up those share, they can be transferred to anybody
else. ----------------------
ii. That the directors will have the power to refuse to register the ----------------------
transfer of shares provided that such power should be exercised
by the directors in good faith and in the interest of the company. ----------------------
d. A private limited company needs to have a minimum paid-up share ----------------------
capital of Rs. 1 Lakh or any higher amount as may be prescribed.
----------------------
----------------------

Notes b. Public Limited Company
In non-technical language, a public limited company affects the fate of a
----------------------
larger number of people. As such, operations of public limited companies
---------------------- are subjected to a close control in the form of compliance to the various
provisions of Companies Act, 1956.
----------------------
A public limited company is characterised by the following features:
---------------------- a. Minimum number of shareholders is 7 and there is no restriction on the
maximum number of shareholders.
----------------------
b.
Public limited company can freely approach public in general for
---------------------- subscribing to the shares and/or debentures of the company.
---------------------- c. The shareholders of a public limited company can freely transfer their
shares to any other person. As such, shares of only a public limited company
---------------------- can be listed on the stock exchange.
---------------------- d. A public limited company needs to have a minimum paid-up share capital
of Rs. 5 Lakh or any higher amount as may be prescribed.
----------------------
---------------------- Check your Progress 2

----------------------
Multiple Choice Multiple Response.
---------------------- 1. Minimum and maximum number of partners is __________.
---------------------- i. Minimum two and maximum 10 in case of banking
---------------------- ii. Minimum 10 and maximum 20 in case of banking and 10 in case
of other businesses
----------------------
iii. Minimum 3 and maximum 10 in case of banking and 20 in case of
---------------------- other businesses
iv. Minimum two and maximum 20 in case of other businesses
----------------------
2. Formation and operation of partnership is:
----------------------
i. Difficult
---------------------- ii. Easy
---------------------- iii. Expensive
---------------------- iv. Economic
3. Profits of a partnership firm are taxed in the following manner:
----------------------
i. @ 30 %
----------------------
ii. 32%
----------------------
iii. @ 10% surcharge and 2% educational cess
---------------------- iv. 2% surcharge and 10 % educational cess
----------------------
Notes
4. The liability of partners is
i. Limited ----------------------
ii. Unlimited
----------------------
iii. Joint and several
iv. Unique ----------------------
5. Partnership firm as such has ----------------------
i. Legal status
ii. No legal status ----------------------
iii. No perpetual succession ----------------------
iv. Perpetual succession
----------------------
1. Shareholders of a Joint Stock Company are its ----------------------
i. Creditors
----------------------
ii. Debtors
iii. Suppliers ----------------------
iv. Owners
----------------------
2. If the face value of a share is Rs.100 and the shareholder has already
paid Rs.75, then the liability of the shareholder is restricted to ----------------------
i. Rs.100
----------------------
ii. Rs.75
iii. Rs.25 ----------------------
3. Shareholders are
i. Shareholders but not the members ----------------------
ii. Managers but not the owners ----------------------
iii. Owners but not managers
----------------------
iv. Members but not the shareholders
4. A Joint Stock Company comes into existence when it is ----------------------
i. Promoted
----------------------
ii. Incorporated
iii. Functioning ----------------------
iv. None of the above
----------------------
5. Public companies are
i. Government companies ----------------------
ii. Non-government companies ----------------------
iii. Having minimum 7 members
----------------------
----------------------

Notes
---------------------- 1. Company is an artificial person and therefore it cannot sign.
---------------------- 2. Company can die a natural death.
---------------------- 3. Common seal is a signature of the company.

4. Company can sue but cannot be sued.
----------------------
5. A shareholder may me a member but a member may not be a shareholder.
----------------------
6. If the liabilities of a Joint Stock Company are unpaid, the creditor can
---------------------- sue the members.
7. During war period, even a bomb cannot kill a company.
----------------------
8. Shares of all Joint Stock Companies are freely transferable.
----------------------
9. Shares are transferable but the right to transfer shares is restricted.
---------------------- 10. In a Joint Stock Company, owners and managers and managers are
---------------------- owners.
11. A private company can collect capital by issuing shares to the public at
---------------------- large.
---------------------- 12. Private company’s shares are listed in stock exchange.
----------------------
---------------------- Activity 2
----------------------
1. Meet the accountants officer in a partnership firm and collect the
---------------------- following information:
---------------------- a. Read the partnership deed of the firm and find out the profit sharing
ratio among the various partners and the capital contributed by
---------------------- each partner.
---------------------- b. Find out the method followed for computation of salary and
interest on capital of the various partners.
---------------------- 2. Study the Memorandum and Articles of Association of the company
---------------------- and note down the main objects of the company. State the Authorised
Capital of the company.
----------------------
3. Prepare a list of provisions of Companies Act, which are not applicable
---------------------- to a Private Limited Company.
----------------------
----------------------
----------------------
----------------------
Summary Notes
• This unit specifies the various types of constitutions under which any ----------------------
business activity can be conducted.
----------------------
• A business can be carried out as a proprietary concern or as a partnership
firm or as a corporate entity. ----------------------
• A proprietary concern is easy to operate; however, it does not have a legal ----------------------
status. One of the major disadvantages of a proprietary concern is the
unlimited liability of proprietor. ----------------------
• A partnership firm is an entity when two or persons come together to run a ----------------------
business activity. A major advantage of partnership firm is the pooling of
resources and skill sets of various partners. However, a partnership firm ----------------------
also is an unlimited liability organisation. ----------------------
• A joint stock company is an entity, which enjoys a legal status and is
----------------------
incorporated under the Companies Act, 1956. The drawback of unlimited
liability is eliminated in case of a company. ----------------------
• A joint stock company can be either a Private Limited Company or a
----------------------
Public Limited Company. Since a Public Limited Company can approach
the general public for funds, it is closely regulated under the Companies ----------------------
Act as compared to a Private Limited Company.
----------------------
Keywords ----------------------
• Joint stock companies: This form of organisation can raise large amount ----------------------
of funds as the resources of larger number of people can be pooled together.
----------------------
• Artificial legal person: The company enjoys a perpetual existence.
----------------------
Self-Assessment Questions ----------------------
1. Critically evaluate the following forms of business organisations: ----------------------
(a) Proprietary Firms ----------------------
(b) Partnership Firms
----------------------
(c) Joint Stock Companies
----------------------
2. Make a list of the advantage of Partnership Firms.
3. Define the features of Joint Stock Companies with its advantages. ----------------------
4. Differentiate between the following: ----------------------
a. Proprietary Firms and Partnership Firms ----------------------
b. Joint Stock Companies and Partnership Firms
----------------------
----------------------

Notes 5. Write short notes on the following:
a. Taxation of Partnership Firms
----------------------
b. Types of Companies
----------------------
---------------------- Answers to Check your Progress

----------------------
1. True
----------------------
2. False
---------------------- 3. True
---------------------- 4. True
---------------------- 5. False
6. True
----------------------
7. False
----------------------
8. True
---------------------- Multiple Choice Multiple Response.
---------------------- 1. Minimum and maximum number of partners is __________.
i. Minimum two and maximum 10 in case of banking
----------------------
iv. Minimum two and maximum 20 in case of other businesses
----------------------
2. Formation and operation of partnership is:
---------------------- ii. Easy
---------------------- iv. Economic
---------------------- 3. Profits of a partnership firm are taxed in the following manner:
---------------------- i. @ 30 %
iii. @ 10% surcharge and 2% educational cess
----------------------
4. The liability of partners is
----------------------
ii. Unlimited
---------------------- iii. Joint and several
---------------------- 5. Partnership firm as such has
---------------------- ii. No legal status

iii. No perpetual succession
----------------------
----------------------
Multiple Choice Single Response Notes
1. Shareholders of a Joint Stock Company are its
----------------------
iv. Owners
----------------------
2. If the face value of a share is Rs.100 and the shareholder has already paid
Rs.75, then the liability of the shareholder is restricted to ----------------------
iii. Rs.25 ----------------------
3. Shareholders are
----------------------
iii. Owners but not managers
----------------------
4. A Joint Stock Company comes into existence when it is
ii. Incorporated ----------------------
5. Public companies are ----------------------
iii. Having minimum 7 members ----------------------
----------------------
1. False
----------------------
2. False
----------------------
3. False
----------------------
4. False
----------------------
5. True
6. False ----------------------
7. True ----------------------
8. True ----------------------
9. True
----------------------
10. False
----------------------
11. False
12. False ----------------------
----------------------
Suggested Reading
----------------------
1. Krishnamurti & Viswanath. Advanced Corporate Finance.
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Notes
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Capitalisation
UNIT
3
Structure:
3.1 Introduction
3.2 Theories of Capitalisation
3.3 Overcapitalisation
3.4 Undercapitalisation
3.5 Overcapitalisation vs. Undercapitalisation
3.6 Watered Stock/Watered Capital
3.7 Watered Capital vs. Overcapitalisation
Summary
Keywords
Suggested Reading
Capitalisation 33
Notes
Objectives
----------------------
----------------------
• Determine the amount of funds an entity should deploy for its
---------------------- business operations
---------------------- • Explain the theories of capitalisation
• Analyse the concepts of overcapitalisation and undercapitalisation
----------------------
• Define the meaning of altered stock
----------------------
• Differentiate between overcapitalisation and undercapitalisation
----------------------
3.1 INTRODUCTION
----------------------
---------------------- The assessment of the funds needed by the company should be done in
such a way that the total amount of funds available should be neither too large
---------------------- nor too less. As such, one of the most important financial decisions becomes
the determination of the amount, which the company should have at its disposal
---------------------- (which may consist of funds required for fixed assets as well as the portion of
---------------------- current assets to be financed by the company out of long-term sources.) This is
capitalisation.
---------------------- Thus, the term capitalisation means total amount of long-term funds
---------------------- available to the company. In the words of Dewing, “Capitalisation includes
capital stock and debt”. Therefore, capitalisation includes shares and debentures
---------------------- issued by the company and also the long-term loans taken from the financial
institutions. The question arises regarding the inclusion of non-distributed profit
---------------------- in the capitalisation.
---------------------- As far as earned profits remained to be distributed (i.e. Reserves and
Surplus) are concerned, it is necessary to classify them as either capital surplus
---------------------- or revenue surplus. Capital Surplus will always be a part of total capitalisation,
---------------------- though it is available for cash dividend under certain circumstances. Revenue
Surplus will be a part of capitalisation, if the management wants to retain it in
---------------------- the business.
---------------------- The importance of the determination of amount of capitalisation need not
be overemphasised. The amount of capitalisation should be only that much
---------------------- which could be justified by its profits and by the normal rate of return for the
industry concerned. If the company earns less than the other companies in the
----------------------
same industry, value of the shares of company will reduce and the company will
---------------------- suffer.
For example, if the company earns an after tax profit of Rs. 20 lakh and
----------------------
the other companies in the same industry earn after tax return of 10% on their
---------------------- capitalisation, the expectation of investors will be the same from the company.
As such, the ideal capitalisation for the company will be Rs. 200 lakh. If the
---------------------- actual capitalisation is Rs. 250 lakh, the after tax return for the company becomes
8%, which is less than the industry standards. As a result, price of the shares of Notes
the company will be less than that of other companies in the same industry.
----------------------
3.2 THEORIES OF CAPITALISATION ----------------------
There are two important theories that act as guidelines for determining the ----------------------
amount of capitalisation.
1. Cost Theory: ----------------------
Cost theory of capitalisation considers the amount of capitalisation on ----------------------

the basis of cost of various assets required to set up the organisation. It
----------------------
gives more stress on current outlays than on the requirements, which are
necessary to accommodate the investment on a going concern basis. The ----------------------
company may need the funds to invest in fixed and current assets and also
to meet promotional and organisational expenses. The total sum required ----------------------
for all these purposes gives the amount of capitalisation. The cost theory of
----------------------
capitalisation seems to be ideal as it considers the actual funds to acquire
various assets, but it does not consider the earnings capacity of these assets. ----------------------
If the amount of capitalisation arrived at on this basis includes the cost of
assets acquired at inflated costs or the cost of idle and obsolete assets, the ----------------------
earnings are bound to be low which will not be able to pay favourable return
----------------------
on the cost of assets and this will result into over-capitalisation. Similarly,
cost theory of capitalisation may not be useful in case of a company with ----------------------
irregular earnings.
----------------------
2. Earnings Theory:
Earnings theory of capitalisation considers the amount of capitalisation on ----------------------
the basis of expected future earnings of the company, by capitalising the
----------------------
future earnings at the appropriate capitalisation rate. Thus, for determining
the amount of capitalisation, it is necessary to take the following steps: ----------------------
(a) To decide future earnings: ----------------------
Estimations of future earnings may be comparatively an easy task in
case of established concerns as there can be some basis of past data. In ----------------------
case of new concerns, estimating the future earnings is a difficult task. ----------------------
While estimating future earnings, the following factors should be kept
in mind. ----------------------
i. The smaller the period, the more accurate will be the estimations ----------------------
of future earnings. While estimating future earnings on the basis
of past earnings, weighted average of past earnings may be ----------------------
considered giving maximum weightage to recent earnings.
----------------------
ii. While considering future earnings on the basis of past earning,
care should be taken to adjust the earnings on account of non- ----------------------
recurring factors. Moreover, adjustments should be made for
----------------------
known factors in future.
----------------------
Capitalisation 35
Notes iii. In case of new concerns, the estimations of future earnings depend
upon correct estimation of future sales (which in turn should be
---------------------- based upon proper sale forecast) and future costs. Allowance
should be made for contingencies.
----------------------
(b) To determine Capitalisation rate:
----------------------
This is the most tricky and delicate issue and is entirely a subjective
---------------------- concept. The concepts of capitalisation rate may take any of the
following forms:
----------------------
i. The rate of return is required to attract investors to the particular
---------------------- organisation.
---------------------- ii. It is the cost of capital.

iii. It is the rate of earnings of similar organisations in the same
---------------------- industry.
---------------------- (c) To capitalise the future earnings at the decided rate of Capitalisation:
---------------------- Following example will illustrate the working of earnings theory of capitalisation.
Illustration:
----------------------
Expected future earnings of A Ltd. are Rs. 3,00,000. Find out the amount of
---------------------- capitalisation, if rate of return earned by similar types of companies is 15%.
---------------------- 100
Amount of capitalisation = Rs. 3,00,000 X
15
---------------------- = Rs. 20,00,000
---------------------- The earnings theory of capitalisation is ideal in the sense that it considers
earnings capacity of the organisation. But it has limitations in the sense that it
----------------------
involves the estimation of two variables i.e. future earnings and capitalisation
---------------------- rate, which are too difficult to ascertain.
As such, in case of established concerns, earnings theory may be useful, whereas
----------------------
new concerns may prefer cost theory to decide the amount of capitalisation.
----------------------
----------------------
---------------------- Fill in the Blanks.

---------------------- 1. Capitalisation includes ______and _______.
2. The term capitalisation means the total amount of ______funds
----------------------
available to the company.
---------------------- 3. Earned profits include ________and ___________.
---------------------- 4. _____ surplus will always be a part of total capitalisation.
---------------------- 5. ______ surplus will be a part of capitalisation if the management wants

to retain it in business.
----------------------
State True or False. Notes
1. The smaller the period, the more accurate will be the estimations of ----------------------
future earnings.
----------------------
2. Estimation of future earnings is easy for a newly formed company and
is difficult for an existing company. ----------------------
3. Capitalisation does not include shares and debentures. ----------------------
----------------------
Activity 1
----------------------
Meet the finance manager of any firm having more than one manufacturing ----------------------
units. Discuss with him the basis on which capital deployed in the business
----------------------
is decided.
----------------------
3.3 OVERCAPITALISATION ----------------------
In simple terms, overcapitalisation means existence of excess capital as ----------------------
compared to the level of activity and requirements. For example, if a company
is earning a profit of Rs. 50,000 and the normal rate of return applicable for the ----------------------
same industry is 10%, it means that the amount of shares and debentures should ----------------------
be Rs. 5,00,000. If the amount of shares and debentures issued by the company
is more than Rs. 5,00,000, then the company will be said to be overcapitalised. ----------------------
The term overcapitalisation should not be taken to mean excess funds. ----------------------
There can be a situation of overcapitalisation; still the company may not be
having sufficient funds. Similarly, the company maybe having more funds and ----------------------
still maybe having a low earning capacity thus resulting into overcapitalisation.
----------------------
Causes of overcapitalisation:
----------------------
The situation of overcapitalisation may arise due to various reasons as stated
below: ----------------------
1. The assets might have been purchased during the inflationary situations.
----------------------
As such, the real value of the assets is less than the book value of the assets.
2. Adequate provision might not have been made for depreciation on the ----------------------
assets. As such, the real value of the assets is less than the book value of
----------------------
the assets.
3. The company might have spent huge amounts during its formation stage or ----------------------
might have spent huge amounts for the purchase of intangible assets like ----------------------
goodwill, patents, trademarks, copyrights and designs etc. As a result, the
earning capacity of the company may be adversely affected. ----------------------
4. The requirement of funds might not have been properly planned by the ----------------------
company. As a result, the company may have shortage of capital and to
overcome the situation of shortage of capital, the company may borrow the ----------------------
Capitalisation 37
Notes funds at unremunerative rates of interest, which in its turn will reduce the
earnings of the company.
----------------------
5. The company might have followed the lenient dividend policy without
---------------------- bothering much about building up the reserves. As a result, the retained
profits of the company may be adversely affected.
----------------------
6. If there is a very high rate of taxation for companies, the company may
---------------------- not be having sufficient funds left with it for modernisation or renovation
programmes. As such, the real value and the earning capacity of the assets
---------------------- will be lower.
---------------------- 7. There may be many instances, where the management of the company may
raise large amounts by issuing securities, irrespective of the fact whether
---------------------- they are really required or not, in order to take benefit of favourable capital
market conditions. As a result, only the liability of the company increases
----------------------
but not the earning capacity.
---------------------- 8. According to the earnings theory of capitalisation, the capitalisation is the
---------------------- amount of earnings capitalised at a representative rate of return. As such, if
the capitalisation rate is wrong, the amount of capitalisation will be wrong,
---------------------- in such a way that lower the rate of capitalisation, higher will be amount of
capitalisation.
----------------------
Effects of Overcapitalisation:
---------------------- 1. On Company:
---------------------- The real value of the business and its earning capacity reduces with the
adverse affect on market value of shares. Credit standing of the company
----------------------
in the market falls down and it is difficult to raise further capital. The
---------------------- temporary means like lower amount of depreciation and maintenance
charges are followed to improve the earnings, which aggravates the
---------------------- situation further.
---------------------- 2. On Shareholders:
---------------------- This is the worst affected class. The shares held by them are not having any
backing of tangible assets. Due to the reduced market values, the shares
---------------------- become nontransferable or are required to be transferred at extremely low
prices.
----------------------
3. On Consumers:
---------------------- To overcome the situation of overcapitalisation and to improve the
---------------------- earnings, the company may be tempted in increasing the selling price,
more particularly in monopoly conditions. Due to this, the quality of the
---------------------- products may also be affected.
---------------------- 4. On Society at Large:
The increasing selling prices and reducing quality cannot be continued for a
----------------------
very long time due to the competition existing in the market. This situation
---------------------- means losing the backing of the shareholders as well as the consumers. As
a result, the company is dragged towards the winding up which ultimately Notes
affects the society at large in an adverse way in terms of lost industrial
production, unemployment generated, unrest among the workers as a part ----------------------
of society etc.
----------------------
Remedies Available:
----------------------
In order to overcome the situation of overcapitalisation, the company may resort
to any of the following remedial measures: ----------------------
1. To reduce the debts by repaying them. But the debts should be repaid out
----------------------
of the own earnings of the company. There is no point in repaying the debts
out of the fresh issue of shares or debentures, as it does not reduce the ----------------------
amount of capitalisation.
----------------------
2. To redeem the preference shares if they carry too high rate of dividend.
3. The persons holding the debentures may be persuaded to accept new ----------------------
debentures, which carry lower rate of interest. ----------------------
4. The par value of the equity shares may be reduced but this also will have
to be done only after taking the shareholders into confidence. ----------------------
5. The number of equity shares may be reduced but this also will have to be ----------------------
done only after taking the shareholders into confidence.
----------------------
3.4 UNDERCAPITALISATION ----------------------
As against the indication of overcapitalisation, the situation of ----------------------

undercapitalisation indicates the excess of real worth of the assets over the
aggregate of shares and debentures outstanding. Thus, if a company succeeds ----------------------
in earning abnormally high income continuously for a very long period of time, ----------------------
it indicates symptoms of undercapitalisation. As such, undercapitalisation is an
indication of effective and proper utilisation of funds employed in the business. ----------------------
It also indicates sound financial position and good management of the company.
Hence, it is said, “undercapitalisation is not an economic problem but a problem ----------------------
in adjusting capital structure”. ----------------------
Causes of Undercapitalisation:
----------------------
The situation of undercapitalisation may arise due to various reasons as stated
below: ----------------------
1. Sometimes, it may so happen that while deciding the amount of shares ----------------------
and debentures to be issued, the future earnings may be underestimated.
As a result, if the actual earnings turn out to be higher, capitalisation of ----------------------
these earnings may result into undercapitalisation. Similarly, use of low ----------------------
rate of capitalisation for capitalising the future earnings may also result in
undercapitalisation. ----------------------
2. There may be cases where the earnings of the business come as a windfall. ----------------------
This may arise during transition from depression to boom. Thus, while
recovering from depression, the companies may find their earnings too ----------------------
high to result into the state of undercapitalisation.
Capitalisation 39
Notes 3. Sometimes, the company may follow a conservative policy for paying the
dividends keeping aside more and more profit for making further additions
---------------------- and investments. As a result, the company may find itself to be in too high
profits and thus undercapitalisation.
----------------------
4. The company may be in the position to improve its efficiency through
---------------------- constant modernisation programmes financed out of its own savings. As
such, the earnings capacity of the company may increase to such an extent
----------------------
that the real value of the assets is much more than the book value, which
---------------------- results into the state of undercapitalisation.
Effects of Undercapitalisation:
----------------------
1. On Company:
----------------------
Financial stability and solvency of the company is not affected due to
---------------------- undercapitalisation, but it still affects the company adversely.
---------------------- (a) As earnings per share ratio is very high, it increases the competition
unduly by creating a feeling that the line of business is very lucrative.
---------------------- (b) Increasing amounts of profits increases the tax liability of the company.
---------------------- (c) Marketability of the shares of the company gets restricted due to very
high market prices of shares.
----------------------
(d) Very high profitability of the company induces the employees to
---------------------- demand increase in wages, reduced working hours, more welfare
schemes and more social amenities.
----------------------
(e) Very high profitability of the company creates a feeling among the
---------------------- customers that the company is charging very high prices for its
---------------------- products. They try to bring pressure on the company for reducing the
prices of the product.
---------------------- (f) Increasing profitability coupled with unrest among the employees as
---------------------- well as consumers increases the possibility of Government control
and intervention over such companies. This proves to be quite
---------------------- embarrassing for the company.
---------------------- 2. On Shareholders:
Generally, the shareholders of undercapitalised concerns are benefited.
----------------------
Firstly, they get a very high dividend income regularly. Due to the
---------------------- increasing share prices, the investment of shareholders in the company
appreciates considerably which can be encashed at any time. Secondly,
---------------------- in times of need, the shareholders may get loans on the security of these
shares on easy terms due to high credit standing of the company in market.
----------------------
However, the shareholders of the undercapitalised concerns may suffer in
---------------------- the sense that the market for the shares is limited due to very high market
prices of the shares.
----------------------
----------------------
3. On Society: Notes
The effects of undercapitalisation on the society as a whole may not
----------------------
necessarily be adverse ones. It may encourage new entrepreneurs to start
new ventures or existing ones to expand. This may increase the industrial ----------------------
production and reduce the unemployment problems. The consumers may
get a variety of products at competitive prices. ----------------------
However, society may not be benefited if the state of undercapitalisation is ----------------------
not taken into right spirit. If the feeling is developed among the workers and
consumers that they are being exploited due to ever-increasing profitability ----------------------
of the undercapitalised company, it may disturb not only the company itself
----------------------
but also the society as a whole. Possibility of Government intervention and
introduction of various control measures (say in the form of price control, ----------------------
dividend ceiling and dividend freeze) increases.
----------------------
Remedies Available:
The main indication of existence of a situation of undercapitalisation is the ever- ----------------------
increasing amount of earnings per share. If the situation of undercapitalisation ----------------------
is to be resolved, the company can take any of the following two measures in
order to reduce the amount of earnings per share. ----------------------
1. Issue of Bonus Shares: ----------------------
If the company has sufficient amount of reserves and surplus in hand,
----------------------
whole or a part of reserves and surplus may be capitalised by way of bonus
shares. As a result, number of shares as well as amount of share capital will ----------------------
increase and amount of reserves and surplus will be reduced. It should be
noted that it will affect neither the amount of capitalisation nor the total ----------------------
income of the shareholders. But it will reduce the amount of earnings per
----------------------
share.
For example, Suppose that the present capitalisation of the company ----------------------
comprise of Equity Share Capital of Rs. 1,00,000 (divided into 1000
----------------------
Equity Shares of Rs. 100/- each) and reserves of Rs. 75,000. If the present
earnings are Rs. 50,000, the present earnings per share will Rs. 50 i.e. ----------------------
Rs. 50,000/1000 equity shares. The company decides to issue 500 equity
shares of Rs. 100/- each as bonus shares. As such, the equity share capital ----------------------
will increase to Rs. 150,000 and reserves will reduce to Rs. 25,000. The
----------------------
earnings of the company will be considered against total of 1500 equity
shares and as such, earnings per share will reduce to Rs. 33.33 i.e. Rs. ----------------------
50,000/ 1500 Equity Shares.
----------------------
2. Splitting the Shares:
To overcome the situation of undercapitalisation, the company may decide ----------------------
to split the shares in order to spread the earnings over a greater number of ----------------------
shares so that the earnings per share may be reduced.
For example, suppose that the present capitalisation of the company ----------------------
consists of equity share capital of Rs. 1,00,000 (divided into 1000 equity ----------------------
Capitalisation 41
Notes shares of Rs. 100/- each) and its present earnings are Rs. 50,000. As such,
present earning per share will be Rs. 50, i.e. 50,000/1000 equity shares.
---------------------- The company decided to reduce per value of shares by 50% and increase
the number of shares in the same proportion. As such, now the number of
---------------------- equity shares will become 2,000 and the earnings of Rs. 50,000 will be
---------------------- distributed over 2,000 equity shares of Rs. 50/- each and earnings per share
will reduce to Rs. 25/- i.e. Rs. 50,000/2,000 equity shares.
----------------------
----------------------
---------------------- State True or False.

---------------------- 1. Over capitalisation means existence of deficit capital as compared to
the level activity and requirements.
----------------------
2. Profits Rs.50,000. Rate of return applicable for the same industry is
---------------------- 10% and the total amount of shares and debentures is Rs.5,25,000. So
this company is overcapitalised.
----------------------
3. Capitalisation means existence of excess funds.
----------------------
4. When the real value of the assets is less than the book value of the
---------------------- assets, there is over capitalisation.
5. Due to overcapitalisation, the credit standing of the company increases.
----------------------
----------------------
i. Remedy for overcapitalisation a. High earnings, low capital
---------------------- ii. Overcapitalisation b. Issue shares and debentures
iii. Undercapitalisation c. Reduce face value of shares
---------------------- iv. Remedy for undercapitalisation d. Very low earnings, high capital
----------------------
---------------------- 3.5 OVERCAPITALISATION VS. UNDERCAPITALISATION

---------------------- If effects of both of these situations of overcapitalisation and
undercapitalisation are studied and observed carefully, one will find that both
---------------------- the situations are having bad effects. But the effects of overcapitalisation are
---------------------- more serious which affect the company, shareholders, consumers and society at
large in an adverse way and the ultimatum involved with this situation is only
---------------------- the liquidation and winding up of the company, which is a very high cost for
the company to pay. Situation of undercapitalisation increases the competition
---------------------- for the company, there is discontentment on the part of the employees and the
---------------------- consumers get the feeling that they are being exploited. But the fact remains
that the shareholders and the society at large are benefited due to the increased
---------------------- prosperity of the company. Naturally, if the choice is to be made between these
two situations, undercapitalisation will be a preferable situation. As such a
---------------------- statement is usually made – “Both overcapitalisation and undercapitalisation
---------------------- are undesirable. Of the two, however, overcapitalisation is more fatal and
dangerous”.
However, ideally the company should try to avoid both the extremes of Notes
overcapitalisation as well as undercapitalisation. It should ideally aim at fair
capitalisation or balanced capitalisation. ----------------------
----------------------
----------------------
Fill in the Blanks.
----------------------
1. When share capital is not represented by the assets of equal value, the
situation may mean introduction of _____ in the capital. ----------------------
2. When the service of promoters is valued highly, they are generally ----------------------
paid in the form of shares. As such, ______is increased but it is not
supported by an increase in _________. ----------------------
3. When the purchase price of an asset is more than the worth of the asset, ----------------------
________ situation is created.
----------------------
4. The concept of watered capital is confined to the time of _____ of the
company. ----------------------
5. If the asset is purchased at high price and it is proved to be worthless, ----------------------
the _____ situation may arise.
----------------------
Activity 2 ----------------------
----------------------
Obtain the financial statements of any two or more companies belonging
to the same industrial sector having similar levels of activity in terms of ----------------------
sales. Study the capital structure of both the companies. Do you feel that the ----------------------
capital deployed by each of the companies is commensurate with the level
of its operations? Is one of the companies overcapitalised as compared to ----------------------
the other? Give your analysis.
----------------------
3.6 WATERED STOCK/WATERED CAPITAL ----------------------
When share capital is not represented by the assets of equal value, the situation ----------------------
may mean introduction of water in the capital or watered capital. ----------------------
This situation may arise due to following reasons:
----------------------
1. The services of the promoters are valued highly and they are paid usually
in the form of shares of the company. As such, share capital is increased ----------------------
but no assets are created.
----------------------
2. Sometimes, the company pays higher price to the vendors of the assets
transferred i.e., the price which is more than the worth of the assets. ----------------------
As such, possibility of the existence of the watered stock or watered capital can
----------------------
be traced to the intention of the promoters who sell the shares. If the promoters
deliberately acquire the assets at inflated prices, the situation of watered capital ----------------------
may exist.
Capitalisation 43
Notes 3.7 WATERED CAPITAL VS. OVERCAPITALISATION
---------------------- Sometimes, the terms watered capital and overcapitalisation are confused
with each other, but it is not true. The concept of watered capital is confined
---------------------- to the time of promotion of the company. Thus, at the time of promotion, the
company is expected to acquire the assets at a price, which justifies its real
---------------------- worth. If the assets prove to be worthless or are bought at an inflated price, the
situation of watered capital may exist.
----------------------
On the other hand, if the company has worked for several years and during
---------------------- these years has failed to earn sufficient earnings to justify the amount of its
capital, the company will be in the state of overcapitalisation.
----------------------
Thus, the existence of watered capital may be one of the causes of
---------------------- overcapitalisation, but it is not inevitably the cause of overcapitalisation as the
subsequent earnings may justify the amount of capitalisation though the capital
---------------------- may remain watered.
---------------------- The following illustration may make the relationship between watered
capital and overcapitalisation clearer:
----------------------
Suppose, that a company issues and subscribes for 1000 equity share of Rs.
---------------------- 100 each (i.e., total equity share capital is Rs. 1,00,000). This amount has been
used to purchase the fixed assets of the company, the real value of which is only
---------------------- Rs. 75,000. It means that the company is watered to the tune of Rs. 25,000.
---------------------- The company operates for six years during which it has earned the average
profits of Rs. 16,000. If the earnings are capitalised at the rate of 5%, the
---------------------- capitalised value of earnings will be Rs. 3,20,000. It means that the company
will be having watered capital but it will not be overcapitalised.
----------------------
Now suppose, that the original amount of Rs. 1,00,000 is used by
---------------------- the company to purchase fixed assets, the real worth of which is really Rs.
1,00,000. It means that there is no watered capital. However, after operating for
---------------------- six years the company is able to earn the average profits of only Rs. 3,000. If the
earnings are capitalised at the rate of 5%, the capitalised value of the earnings
---------------------- will be Rs. 60,000. It means that the company has no water in capital but it is
overcapitalised.
----------------------
---------------------- Summary
---------------------- • Capitalisation refers to the total amount of funds, which a company should
possess for conducting its business activities.
----------------------
• The Capital available with the company should be justified by its profits as
---------------------- well as the normal rate of return for the industry concerned.
• Cost theory of capitalisation considers the amount of capitalisation based
----------------------
on cost of various assets required to set up and run the business activity.
---------------------- • Earnings theory of capitalisation considers the amount of capitalisation on
the basis of expected future earnings of the company, by capitalising the
---------------------- future earnings at the appropriate capitalisation rate.
---------------------- • Overcapitalisation means existence of excess capital as compared to the
level of activity and requirements.
• Undercapitalisation indicates the excess of real worth of the assets over the Notes
aggregate of shares and debentures outstanding.
• Both overcapitalisation and undercapitalisation are undesirable. Of the ----------------------
two, however, overcapitalisation is more fatal and dangerous. ----------------------
• When share capital is not represented by the assets of equal value, the
situation may mean introduction of water in the capital or watered capital. ----------------------
----------------------
Keywords
----------------------
• Cost Theory: Cost theory of capitalisation considers the amount of
capitalisation on the basis of cost of various assets required to set up the ----------------------
organisation.
----------------------
• Earnings Theory: Earnings theory of capitalisation considers the amount
of capitalisation on the basis of expected future earnings of the company, ----------------------
by capitalising the future earnings at the appropriate capitalisation rate.
----------------------
Self-Assessment Questions ----------------------
1. “As between under and apitalizedntio, the former is the lesser evil of ----------------------
the two but still both should be discouraged and the ideal should be fair
apitalizedn.” Comment. ----------------------
2. What are the causes of apitalizedntio? State the dangers of apitalizedntio to ----------------------
the society. How will you secure balanced apitalizedn?
3. Discuss the symptoms, causes and remedies of apitalizedntio. ----------------------
4. What are the causes of apitalizedntion? State the dangers and disadvantages ----------------------
of apitalizedntion.
----------------------
5. Write short notes on:
a. Balanced Capitalisation ----------------------
b. Undercapitalisation
----------------------
c. Watered Capital
d. Earnings Theory of Capitalisation ----------------------
e. Theories of Capitalisation ----------------------
f. Overcapitalisation
----------------------
----------------------
----------------------
Fill in the Blanks.
----------------------
1. Capitalisation includes capital stock and debts.
2. The term capitalisation means the total amount of long-term funds available ----------------------
to the company. ----------------------
3. Earned profits include reserves and surplus.
----------------------
4. Capital surplus will always be a part of total apitalizedn.
Capitalisation 45
Notes 5. Revenue surplus will be a part of apitalizedn if the management wants to
retain it in business.
---------------------- 1. True
2. True
----------------------
3. False
----------------------
---------------------- 1. False
2. True
----------------------
3. False
---------------------- 4. True
---------------------- 5. False
----------------------
i. c
---------------------- ii. a
---------------------- iii. d
iv. b
----------------------
----------------------
Fill in the Blanks.
---------------------- 1. When share capital is not represented by the assets of equal value, the
situation may mean introduction of water in the capital.
----------------------
2. When the service of promoters is valued highly, they are generally paid in
---------------------- the form of shares. As such, share capital is increased but it is not supported
by an increase in assets.
----------------------
3. When the purchase price of an asset is more than the worth of the asset,
---------------------- watered stock/watered capital situation is created.
4. The concept of watered capital is confined to the time of promotion of the
----------------------
company.
---------------------- 5. If the asset is purchased at high price and it is proved to be worthless, the
watered capital/watered stock situation may arise.
----------------------
---------------------- 1. Eugene Brigham, Michael Ehrhardt. Financial Management: Theory &

Practice
---------------------- 2. I.M. Pandey. Financial Management
----------------------
----------------------
Sources of Long-Term and Medium-Term Finance
UNIT
4
Structure:
4.1 Introduction
4.2 Shares
4.3 Debentures
4.4 Term Loans
4.5 Public Deposits
4.6 Lease Financing
4.7 Hire Purchasing
4.8 Retained Earnings
Summary
Keywords
Suggested Reading
Sources of Long-Term and Medium-Term Finance 47

Notes
Objectives
----------------------
----------------------
• State the concept of share capital and its types
----------------------
• Define the concept of debentures
---------------------- • Explain the different sources of long-term and medium-term finance
---------------------- • Compare the nature of lease finance and hire purchase transactions
----------------------
4.1 INTRODUCTION
----------------------
While discussing about apitalizedn, we have seen that the amount of
---------------------- long-term capital should not be less than requirement nor it should be more
than requirement. There should be a situation of what can be called as fair
---------------------- apitalizedn. The next question that arises is what should be the various sources
from which the long-term capital may be raised?
----------------------
The various sources from which a company may meet its long-term and
---------------------- medium term requirement of funds are discussed under the following headings:
----------------------
4.2 SHARES
----------------------
A share indicates a smaller unit into which the overall requirement of
---------------------- capital of a company is subdivided. For example, if the capital required by a
company is Rs. 10 Crore, it can be subdivided into 1 crore smaller units called
----------------------
as ‘Shares’, each one of the units having the value of Rs.10 each, which in
---------------------- technical words is referred to as ‘Face Value’ or ‘Nominal Value’. In the Indian
circumstances, the Face Value or Nominal Value can be decided by the company
---------------------- on its own. Generally, found face value or nominal value is Rs. 10 or Rs. 100
each share.
----------------------
In the Indian circumstances, a company can raise the long-term funds by issuing
---------------------- two types of shares.
---------------------- a. Equity Shares
---------------------- These are the cornerstones of the financial structure of the company. On
the strength of these shares, the company procures other sources of capital.
---------------------- Equity Shares as a source of long-term funds for the company has the following
characteristic features:
----------------------
1 Investors in the equity shares are the real owners of the company. As
---------------------- such, the investors in equity shares are entitled to the profits earned by the
company or the losses incurred by the company.
----------------------
2 Funds raised by the company by way of equity shares are available on
---------------------- permanent basis. In other words, funds raised by the company by way
of equity shares are not required to be repaid by the company during the
----------------------
lifetime of the company. They are required to be repaid only at the time of Notes
closing down of the company i.e. winding up of the company.
----------------------
3 Funds raised by the company by way of equity shares are available to the
company on unsecured basis i.e. the company does not offer any of its ----------------------
assets by way of security to the investors in equity shares.
----------------------
4 Return that the company pays on equity shares is in the form of dividend.
The rate of dividend is not fixed. It generally depends upon the profits ----------------------
earned by the company. However, a profit making company is under no
obligation to pay dividend on equity shares. ----------------------
5 Equity shares, as a source of raising the long-term funds, is a risk free ----------------------
source for the company, as the company does not commit anything on
equity shares. ----------------------
6 Equity shares, as an investment, is very risky for the investors. As such, ----------------------
the investors are granted the voting rights. By exercising the voting rights,
the investors can participate in the affairs regarding the business of the ----------------------
company. These voting rights are generally proportionate voting rights,
----------------------
in the sense the voting rights of the investors are in proportion to their
investment on the overall capital of the company. However, it should be ----------------------
noted that due to some recent amendments to the Companies Act, 1956,
it may be possible for the companies to issue the equity shares with ----------------------
disproportionate voting rights.
----------------------
7 Equity shareholders may not be able to compel the company to pay the
dividend, but they enjoy the right to maintain the proportionate interest in ----------------------
profits, assets and control of the company. As such, if the company wants
to issue additional equity shares, it is under legal obligation to offer these ----------------------
equity shares to the existing shareholders first, before going to the open ----------------------
market as a general offer. This right of equity shareholders is called ‘Pre-
emptive Right’. ----------------------
8 In financial terms, equity shares, as a source of raising the funds, is a costly ----------------------
source available to the company. The reasons for this will be discussed in
the following paragraphs. ----------------------
Advantages of Equity Shares ----------------------
To the Company
----------------------
While issuing the equity shares, the company does not accept any obligation of
any type. The company neither offers any security to the investors in the form ----------------------
of assets of the company nor commits the repayment of these shares during
----------------------
the lifetime of the company nor commits the payment of any dividend to the
shareholders. This is a total risk free source of capital for the company. ----------------------
To the Investors ----------------------
a. As per the law, the liability of the equity shareholders is restricted only
to the extent of face value of the shares purchased by the investors. The ----------------------
personal properties of the investors are not at stake even if the company ----------------------
fails to fulfil its contractual obligations.

Notes b. Possibility of getting higher returns is always there in case of equity shares.
The investors can gain from equity shares in two forms. Firstly, the regular
---------------------- dividend paid by the company in the form of cash or by way of bonus
shares. Secondly, the capital appreciation received by the investors by
---------------------- selling the equity shares in the secondary market, i.e. stock exchanges.
---------------------- As such, equity shares are a good investment attracting the risk taking
investors.
----------------------
Disadvantages of Equity Shares
---------------------- a. As the investors in equity shares enjoy the voting powers to control
the affairs of the company, the management of the company is always
----------------------
under constant danger of being interfered and disturbed in the regular
---------------------- administration.
b. The cost associated with the equity shares is on the higher side as compared
----------------------
to the borrowed capital. By issuing more and more equity shares, the
---------------------- company loses the cost advantage.
---------------------- c. Many categories of investors, i.e. institutional investors may not be able to
invest in the equity shares due to various statutory restrictions.
---------------------- d. The excessive issue of equity shares may result in over capitalisation to be
---------------------- realised in future.
b. Preference Shares
----------------------
These are the shares, which enjoy preferential treatment as compared to the
---------------------- equity shares in respect of the following factors:
---------------------- a. Unlike in case of equity shares, the preference shares carry the dividend
at a fixed rate which is payable even before any dividend is paid on equity
---------------------- shares.
---------------------- b. In the case of winding up of the company, preference shareholders are paid
back their investment even before the investment of equity shareholders is
---------------------- paid off.
---------------------- Preference Shares as a source of funds for the company involves the following
characteristic features:
----------------------
1. Investors in preference shares are not the absolute owners of the company.
----------------------
2. Funds raised by the company by way of preference shares are required to
---------------------- be repaid during the existence of the company. As per the provisions of
Section 80 of the Companies Act, the company can issue the preference
---------------------- shares maximum for the duration of 20 years. As such, unlike equity shares,
preference share is not a permanent capital available for the company.
----------------------
3. Like in case of equity shares, funds raised by the company by way of
---------------------- preference shares are available to the company on unsecured basis i.e. the
company does not offer any of its assets by way of security to the investors
----------------------
in preference shares.
----------------------
4. Return which the company pays on preference shares is also in the form Notes
of dividend which is payable by the company out of the profits earned.
However, unlike in case of equity shares, the rate of dividend is prefixed ----------------------
and pre-communicated to the investors.
----------------------
5. As compared to equity shares, risk on the part of company is more in case
of preference shares. ----------------------
6. Preference shares, as an investment, is comparatively less risky for the ----------------------
investors. As such, generally, preference shares do not carry any voting
rights and hence they do not have any say in controlling the affairs of the ----------------------
company. However, Companies Act, 1956 provides for voting rights to
----------------------
preference shareholders in the following circumstances.
a. If any resolution directly affecting the rights of the preference ----------------------
shareholders is discussed by the equity shareholders (For example,
----------------------
winding up of the company or reduction of share capital etc.), the
preference shareholders can vote on such resolutions. ----------------------
b. If the dividend has not been paid on the preference shares, in case of ----------------------
cumulative preference shares for an aggregate period of two years and
in case of noncumulative preference shares, either for a period of two ----------------------
consecutive years or for an aggregate period of three years out of the
six preceding years, then the preference shareholders can vote on all ----------------------
the matters placed before the company in the meeting of the equity ----------------------
shareholders.
Types of Preference Shares ----------------------
If the company wants to issue the preference shares, they can be of different varieties. ----------------------
1. Convertible Vs. Non-convertible ----------------------
Convertible Preference Shares are those which can be converted in
----------------------
the equity shares at a later date, the terms of conversion (i.e. when the
conversion will take place, at what rate it will take place etc.) being known ----------------------
to the investors in the beginning only.
----------------------
Non-convertible Preference Shares are those which cannot be converted
in the form of equity shares. They are issued as preference shares and they ----------------------
remain the preference shares.
----------------------
2. Cumulative Vs. Non-cumulative
Preference Shares are to be paid dividend at a fixed rate. However, dividend ----------------------
is payable only if there are profits. The question arises as to what happens ----------------------
if the company is unable to pay dividend, as there are no profits earned by
the company. It depends upon the types of preference shares. ----------------------
If the preference shares are cumulative preference shares and the company ----------------------
is unable to pay the dividend in a certain year due to non-availability of profits,
the arrears of dividend go on accumulating till the company earns the profits ----------------------
and once the company earns the profits, the arrears of preference dividend are
----------------------
required to be paid first, then only the dividend can be paid on equity shares.

Notes If the preference shares are non-cumulative preference shares and the
company is unable to pay the dividend in a certain year due to non-availability
---------------------- of profits, the arrears of preference dividend do not accumulate. The dividend
lapses in the year of loss.
----------------------

----------------------
Fill in the Blanks.
---------------------- 1. A share means a ____ in the capital of the company.
---------------------- 2. The value printed on the share certificate is called _____ or _____ value.
3. The value at which the share is sold by the company for the first time
---------------------- in the life of the share is called ______ price.
---------------------- 4. The value at which the share is traded in the market is called _____ value.
5. Equity shareholders are _____ of the company.
----------------------
6. Funds raised by the company by way of equity shares are available on
---------------------- ______ basis and on _____ basis.
7. Returns on equity are called _______.
----------------------
8. The rate of equity dividend is _________.
---------------------- 9. Payment of dividend on equity shares is not _____ but is ______.
---------------------- 10. Right to receive newly issued shares before they are offered to outsiders
is called the right of _______.
---------------------- 11. Preference shares have a preferential treatment for receiving ____ and
---------------------- ______.
12. The rate of dividend on preference shares is ________.
---------------------- 13. Investors in preference shares are not ______ owners of the company.
---------------------- 14. Funds raised through preference shares are required to be _____ during
the life of the company.
----------------------
---------------------- 1. Equity shares is a costly source of financing.
---------------------- 2. Liability of the investor in equity shares is restricted to the market
value of equity shares that he holds.
---------------------- 3. Voting rights enjoyed by the equity shareholders makes the equity
---------------------- share source of capital risky.
4. Preference shareholders have a right to dividend.
----------------------
5. Preference shareholders have a right to receive dividend first.
----------------------
----------------------
----------------------
----------------------
Notes
Activity 1
----------------------
Meet the company secretary of a public limited company. Obtain details of ----------------------
the capital structure of the company. Write a report on the amount of equity
capital and preference share capital raised by the company. ----------------------
----------------------
4.3 DEBENTURES ----------------------
In simple words, Debenture means a document containing an acknowledgement ----------------------
of indebtedness issued by a company and giving an undertaking to repay the
debt at a specified date or at the option of the company and in the meantime to ----------------------
pay the interest at a fixed rate and at the intervals stated in the debenture.
----------------------
The above description of debentures indicates the following characteristic
features of debentures. ----------------------
1 Investors who invest in the debentures of the company are not the owners ----------------------
of the company. They are the creditors of the company or in other words,
the company borrows the money from them. ----------------------
2 Funds raised by the company by way of debentures are required to be repaid ----------------------
during the lifetime of the company at the time stipulated by the company.
As such, debentures are not a source of permanent capital. Debentures can ----------------------
be considered to be a long-term source.
----------------------
3 In practical circumstances, debentures are generally secured i.e. the
company offers some of the assets as security to the investors in debentures. ----------------------
4 Return paid by the company is in the form of interest. Rate of interest is ----------------------
predetermined, but the same can be freely decided by the company. The
interest on debenture is payable even if the company does not earn the ----------------------
profits. ----------------------
5 Debentures as a source of raising long-term funds are very risky from the
company’s point of view. The risk accepted by the company in case of ----------------------
debentures is twofold. First, to pay the interest at the predefined rate and ----------------------
at predefined time intervals irrespective of non-availability of profits and
second, to repay the principal amount of debentures during the lifetime of ----------------------
the company.
----------------------
6 Risk on the part of investors is very less in case of debentures. The
investors in debentures being the creditors of the company, they cannot ----------------------
control the affairs of the company. As such, the debentures do not carry any
----------------------
voting rights. However, in the event of non-payment of interest or principal
amount, they can interfere in the operations of the company by taking legal ----------------------
action.
----------------------
7 In financial terms, debentures prove to be a cheap source of funds from
the company’s point of view. The reasons for this will be discussed in the ----------------------
following paragraphs.
Notes Types of Debentures
A Company can issue debentures of different varieties as described below:
----------------------
a. Registered Vs. Bearer
----------------------
Registered Debentures are those the holders of which are registered in
---------------------- the company as debenture holders and those can be transferred to another
person only through the company. Holders of bearer debentures are not
---------------------- registered with the company and can be transferred to anybody by mere
delivery.
----------------------
b. Convertible Vs. Non-Convertible
----------------------
Convertible Debentures are the debentures, which have the right to
---------------------- be converted into the equity shares of the company. Non-Convertible
Debentures do not enjoy such right.
----------------------
Based upon the conversion criteria, debentures can be classified as below –
----------------------
i. Fully Convertible Debentures (FCD)
---------------------- ii. Partly Convertible Debentures (PCD)
---------------------- iii. Non-Convertible Debentures (NCD)
---------------------- iv. Optionally Convertible Debentures

FCDs are the debentures, which are entirely convertible in the form of equity
---------------------- shares of the company. For example, the terms of issue may provide that the
---------------------- face value of the debenture is Rs. 100. At the end of 5 years, the investors will
get one equity share of the company. This is the case of FCD.
----------------------
PCDs are the debentures, which are partly convertible in the form of equity
---------------------- shares of the company. For example, the terms of issue may provide that the
face value of the debenture is Rs. 200. At the end of 5 years, the investors will
---------------------- get one equity share of Rs. 100 each while the remaining amount of Rs. 100 will
be repaid at the end of 7 years. This is the case of PCD.
----------------------
NCDs are the debentures, which are not convertible in the equity shares of the
---------------------- company. They are issued as debentures and they are repaid as debentures.
---------------------- In case of optionally convertible debentures, the investors are given the option
to convert their investment in the form of equity shares of the company.
----------------------
Advantages of Debentures
----------------------
To the company
---------------------- a. By issuing the debentures, the controlling position of the existing equity
shareholders does not get affected as the debentures do not carry any voting
----------------------
rights.
---------------------- b. Cost associated with debentures is comparatively less than the cost
associated with the equity shares. As such, it is economical for the company
----------------------
to issue debentures.
----------------------
c. During the period of depression, when the investors are not prepared to Notes
take much of risk, the company may be compelled to issue debentures as a
source of raising long-term capital. ----------------------
d. The company might have borrowed various small amounts of debts of short ----------------------
duration, which may prove to be costly and burdensome for the company.
All these small debts may be converted into a single issue of debentures, ----------------------
which may prove to be less costly for the company.
----------------------
To the investors
----------------------
Debentures prove to be a good investment option for the conservative investors
as well as the institutional investors, mainly due to the following two reasons: ----------------------
a. Fixed rate of interest payable by the company irrespective of non- ----------------------
availability of profits.
b. Security available for the investment. ----------------------
Disadvantages of Debentures ----------------------

a. By issuing the debentures, the company accepts the risk of two types- ----------------------
one, to pay the interest at a fixed rate, irrespective of the non-availability
of profits and second, repayment of principal amount at the predecided ----------------------
time. If earnings of the company are not stable or if the demand for the
----------------------
products of the company is highly elastic, debentures prove to be a very
risky proposition for the company. Any adverse change in the earnings or ----------------------
demand may prove to be fatal for the company.
----------------------
b. Debentures are usually a secured source for raising the long-term
requirements of funds and usually the security offered to the investors is ----------------------
the fixed assets of the company. A company that requires less investment
in fixed assets, viz. A trading company may find debentures as a wrong ----------------------
source for raising the long-term requirement of funds, as it does not have
----------------------
sufficient fixed assets to offer as security.
----------------------
4.4 TERM LOANS
----------------------
Term Loans indicate liabilities accepted by the company, which are for
----------------------
the purpose of purchasing the fixed assets, and are repayable over a period
of 3 to 10 years. The term loans may be granted by the Banks (nationalised, ----------------------
cooperative, rural etc.) or the Financial Institutions like Industrial Development
Bank of India (IDBI), Industrial Credit and Investment Corporation of India ----------------------
(ICICI), Industrial Finance Corporation of India (IFCI) etc.
----------------------
Features of Term Loans
----------------------
1. Banks or Financial Institutions granting the term loans are not at all the
owners of the company. They are creditors of the company. They lend the ----------------------
funds to the company.
----------------------
2. Term Loans are required to be repaid during the lifetime of the company
at the predecided intervals say monthly, quarterly, yearly etc. The initial ----------------------

Notes gap after which the repayment of term loan starts (technically referred to
as the moratorium period) also depends upon the agreement between the
---------------------- borrowing company and the lending bank or financial institution.
---------------------- 3. The term loans may be secured or unsecured, though normally all the
term loans are secured. The security offered for the term loans is the
---------------------- hypothecation or mortgage of the fixed assets purchased with the help of
term loans.
----------------------
4. Return payable by the company on term loans is in the form of interest,
---------------------- which may be calculated on monthly or quarterly or half-yearly basis at a
predecided rate on the outstanding balance of the term loan. The interest on
----------------------
term loan is payable despite the non-availability of profits.
---------------------- 5. Term Loans as a source of raising long-term funds is very risky from the
company’s point of view. The risk accepted by the company in case of
----------------------
term loans is twofold- one, to pay the interest at the predecided rate and
---------------------- at predecided time intervals irrespective of non-availability of profits and
Second, to repay the principal amount of term loans.
----------------------
6. Risk on the part of lending bank or financial institution is very less in
---------------------- case of term loans. The banks or financial institutions being the creditors
of the company, they cannot control the affairs of the company. As such,
---------------------- they do not have any voting rights. However, in the event of non-payment
---------------------- of interest or principal amount, they can interfere in the operations of the
company by taking legal action.
---------------------- 7. In financial terms, as in case of debentures, term loans also prove to be a
---------------------- cheap source of funds from the company’s point of view. The reasons for
this will be discussed in the following paragraphs.
---------------------- Operational Formalities
---------------------- Term Loans is a contract between the borrowing company and lending bank or
financial institution. This contract is a written contract referred to as ‘term loan
----------------------
agreement’. The term loan agreement stipulates the various terms and conditions
---------------------- on which the relationship between the borrowing company and lending bank or
financial institution is regulated. Term Loan agreement has various clauses.
----------------------
1. Amount of loan and the period of repayment
---------------------- 2. Rate of interest payable and the method of payment of interest
---------------------- 3. Nature of security offered
---------------------- In addition to the general security offered for the term loan, the agreement
may provide for certain additional covenants in order to protect the interests of
---------------------- the lender. These covenants may take various forms, some of which are stated
below:
----------------------
1. That the borrowing company will submit the copy of Annual Accounts to
---------------------- the lender, soon after they are finalised.
----------------------
2. That the assets purchased with the help of term loans will be properly Notes
maintained and insured by the borrowing company.
----------------------
3. That the lender may have a representative on the Board of Directors of the
company ( viz. Nominee Director) if the loan amount is sizeable. ----------------------
4. The lender will like to ensure that the borrowing company has the liquid
----------------------
resources in its hands whenever the interest or the installments of the
term loans are due. As such, the lender will like to confirm that the liquid ----------------------
resources of the company are not blocked for unnecessary purposes. Hence,
the agreement may stipulate that, ----------------------
a. The company will not pay dividend without the consent of the lender. ----------------------
b. The company will not make long-term loans to directors/officers. ----------------------
c. The company will not invest in outside corporate securities.
----------------------
d. The company will not redeem the debt before maturity.
----------------------
Fill in the Blanks. ----------------------

1. Debenture means a document containing an ______ of _______ issued ----------------------
by a company.
----------------------
2. Debenture is an undertaking issued by the company to ____ the debt
at a specified _____ or at the ____ of the company. ----------------------
3. Debentures carry ______ at a _____ rate. ----------------------
4. Interest is _______ on profits.
----------------------
5. Debentureholder is not an ________ but a ______of the company.
----------------------
6. Generally, debentures are ______ so investors are assured of getting
their money back. ----------------------
State True or False. ----------------------
1. Generally, debentures are unsecured.
----------------------
2. Interest is predetermined but the same can be freely decided by the
company. ----------------------
3. Debenture, as a source of financing, is very safe. ----------------------
4. Risk on the part of investors is less in case of debentures.
----------------------
5. Bearer debentures are freely transferable.
----------------------
6. Bearer debentures are unlike bearer cheques.
----------------------
----------------------
----------------------

Notes
Activity 2
----------------------
---------------------- 1. Meet the company secretary of a company that has issued debentures.
Obtain details of debenture issue. What are the terms and conditions of
---------------------- the debenture issue?
---------------------- 2. Meet the branch manager of a bank. Obtain details of various loan
facilities offered by the bank. Write a report on eligibility requirements
---------------------- for obtaining such loans and the terms and conditions subject to which
these loans are sanctioned.
----------------------
----------------------
4.5 PUBLIC DEPOSITS
----------------------
In the recent past, Public Deposits has become one of the most important
---------------------- sources available to the companies for meeting the medium term requirement
of funds. The companies find public deposits as an attractive source mainly due
---------------------- to the following reasons:
---------------------- a. Raising the funds in the form of public deposits is more convenient than
borrowing the funds from banks and financial institutions. Borrowing
---------------------- the funds from banks or financial institutions is a tedious job involving
---------------------- the compliance with many procedural requirements like margin money
stipulations, security requirements, submission of periodical statements
---------------------- etc. None of these procedural requirements is to be complied with in case
of public deposits.
----------------------
b. The rate of interest, which the company is required to pay on public
---------------------- deposits is comparatively less than the rate of interest payable on the funds
borrowed from banks or financial institutions.
----------------------
c. Public Deposits are unsecured borrowings for the company.
----------------------
d. The company can raise the funds in the form of public deposits which can
---------------------- be used for any purpose. The end use of the funds raised in the form of
public deposits is not committed by the company.
----------------------
e. In the situations of credit squeeze introduced by the banks, public deposits
---------------------- plays a ery important role.
----------------------
4.6 LEASE FINANCING
----------------------
In the recent years, the lease financing has emerged as one of the most
---------------------- important sources of long-term financing. Under the leasing agreements, the
company acquires the right to use the asset without holding the title to it. Thus,
---------------------- it is the written agreement between the owner of the assets, called ‘the lessor’,
and the user of the assets, called ‘the lessee’ whereby the lessor permits the
----------------------
lessee to economically use the asset for a specific period of time but the title of
---------------------- the asset is retained by the lessor. This economical use of the asset is permitted
by the lessor on the payment of periodical amount, which is in the form of Notes
‘lease rent’.
----------------------
Lease Agreement or Lease Deed:
Lease agreement/deed is the most important document in any leasing activity as ----------------------
it starts the legal relationship between the lessor and lessee.
----------------------
The usual contents of the lease agreement/deed are as stated below :
----------------------
1) Description and cost of equipment to be acquired.
2) Commencement date for lease contract. ----------------------
3) Amount of lease rentals and mode of payments. ----------------------
4) Fixed period of lease, renewal options and the terms during secondary
----------------------
period as to the amount of lease rentals or purchase option.
Note: After the fixed period of lease, the lessee is usually given the option ----------------------
either to renew the lease from time to time at a nominal lease rental or to
----------------------
purchase the asset at a price, which is reasonably lower than the fair value
of the asset. ----------------------
5) Guarantee for payment of lease rental by lessee.
----------------------
6) Variation of lease rentals.
7) Termination of the lease agreement in the event of certain occurrences. ----------------------
8) In order to protect the interests of the lessor and lessee, certain covenants ----------------------
as stated below may also be incorporated as a part of the lease deed.
----------------------
i) That lessee will maintain the asset in good working condition and pay
all taxes, insurance etc. ----------------------
ii) That lessee will not sell or mortgage or charge the land or building on
----------------------
which equipment is installed without notifying the lessor.
iii) That lessee will not claim any grant or relief available to the lessor. ----------------------
iv) That lessee will not alter or modify equipment without the lessor’s ----------------------
knowledge.
----------------------
v) That lessee will accept the lessor’s right to inspect the equipment.
Advantages of Leasing for the Lessee: ----------------------
1. Risks of ownership: Leasing facilitates lessee to avoid the risks attached ----------------------
with the ownership of the equipments, say risk of obsolescence in the area
of ever-changing technologies. ----------------------
2. Saving of capital outlay: Leasing enables lessee to make full use of the ----------------------
asset without making immediate payments of the purchase price which
otherwise would be payable by him. Some lessors may also finance to the ----------------------
extent of 100% of the cost of the equipment where lessee is not required to ----------------------
make any provision for asset acquisition.
3. Tax advantages: Under the leasing propositions, the payment of lease ----------------------
rents is the tax-deductible expenditure. On the other hand, if the company ----------------------

Notes decides to own the same asset by resorting to the borrowing, the expenses,
which are available for deduction for tax purposes, are in the form of
---------------------- depreciation and interest on borrowing.
---------------------- 4. Structuring of lease rents: Lessor may structure the payments of lease
rents in such a way that it matches the revenue expectations of the lessee
---------------------- from the equipments, which may not be possible if the lessee resorts to
borrowing for owning the asset.
----------------------
5. No effect on borrowing power: As the obligations accepted by the lessee
---------------------- under the lease deed appear nowhere on the balance sheet as debt, the
borrowing power of the lessee still remains unaffected. The lessee may still
----------------------
resort to debt capital provided equity base of the company permits further
---------------------- borrowing.
6. Convenience: Leasing is the quickest method of financing the requirements
----------------------
of long-term capital and lessee is relieved from the rigid and time
---------------------- consuming procedures and terms and conditions involved in other forms
of term borrowings say term loans.
----------------------
Types of Leases:
---------------------- a) Financial Lease:
---------------------- In this type of lease, the lessor acts as a financier. Lessee selects the asset
and bears the cost of repairs, maintenance and insurance of the asset.
---------------------- Lessor reserves the right to confiscate the asset in the event of any default
---------------------- on the part of lessee. The lessor recovers a major part of the cost of asset
by way of lease rent during the lease period; the lessor agrees to transfer
---------------------- the ownership of the asset to the lessee by paying a nominal price, which
is referred to as ‘repurchase price’. This type of lease is also referred to as
---------------------- ‘capital lease’.
---------------------- b) Operating Lease:
---------------------- In this type of lease, the lessee gets a limited right to use the asset. Lessor
selects and purchases the asset and leases the same to the lessee. Lessor
---------------------- bears the cost of repairs, maintenance and insurance of the asset. Operating
lease is for a smaller duration of time and imposes no long-term obligation
----------------------
either on the lessor or on the lessee. The lease rent paid by the lessee does
---------------------- not contain any part towards the cost of the asset. After the lease period is
over, the possession of the asset reverts back to the lessor who can lease
---------------------- out the asset to another party. The lease deed is cancellable at the option of
the lessor or the lessee after giving specific notice.
----------------------
c) Sale and Lease Back:
----------------------
In this type of lease, the lessee purchases the asset of his own choice and then
---------------------- sells the same to the lessor. On the sale of asset to the lessor, the ownership
of the asset is transferred to the lessor. Lessor then leases out the same asset
---------------------- to the lessee. After this stage, it becomes a routine lease transaction both
---------------------- for the lessor as well as for the lessee. In practical circumstances, this type
of lease is very regularly found in case of some old asset, which is used Notes
by an organisation for a certain duration of time. To explain the concept of
sale and lease back, let us take an example. ----------------------
Company A has purchased an equipment 10 years back for an amount of ----------------------
Rs. 5,00,000 and has been using the same since then. After providing for
depreciation for the last 10 years, written down value of the equipment in ----------------------
the books of the company is only Rs. 15,000. This equipment is sold by
the company to a leasing company for an amount of Rs. 5,00,000. Leasing ----------------------
company pays the purchase consideration of Rs. 5,00,000 to the company ----------------------
and leases back the same equipment to the company. In this arrangement,
the company as well as the lessor is benefited. The company is benefited ----------------------
as the company receives an amount of Rs. 5,00,000 for an equipment,
which is 10 years old without parting with the equipment. For lessor, it is ----------------------
a business proposition. Being a lease transaction, the lessor can claim the ----------------------
depreciation on the asset leased out by him. Under ideal circumstances,
lessor should be able to claim the depreciation on Rs. 5,00,000 being the ----------------------
consideration paid by the lessor to the company. However, in the light of
recent amendments made to the Income Tax Act, 1961, the lessor can claim ----------------------
the depreciation on Rs. 15,000 only, which is the written down value of the
----------------------
asset in the books of the company at the time of transfer of the asset to the
lessor. ----------------------
----------------------
Fill in the Blanks.
----------------------
1. Lease financing is a source of financing ______ financing.
2. Under the leasing agreement, the company acquires a _____ to use the ----------------------
asset without holding the title to it. ----------------------
3. In lease financing, the owner of the asset is called _____, the user of
the asset is called ____ and the amount paid by the user to the owner is ----------------------
called ____.
----------------------
4. ________ is an important document in lease agreements.
----------------------
5. Payment of ______ is a tax-deductible item of expenditure.
6. In case of _______ type of lease, the lesser acts as a financer. ----------------------
7. In ______ type of lease, the lesser gets to use the asset. ----------------------
----------------------
Activity 3
----------------------
Meet the accounts officer of a company that has issued public deposits. ----------------------
Obtain details of the procedure followed by the company while accepting
public deposits. Study the format of application form, deposit receipt and ----------------------
deposit register.
----------------------

Notes 4.7 HIRE PURCHASING
---------------------- Now-a-days, in addition to Lease Financing, Hire Purchasing is also
emerging as a popular source of long-term financing whereby the company can
---------------------- acquire long-term infrastructural facilities, say fixed assets. It will be pertinent
to note here the relationship between lease financing and hire purchasing.
----------------------
Hire purchase indicates an agreement between the owner of goods, called
---------------------- as ‘the hiree’ and the user of the goods, called as ‘the hirer’ whereby the hiree
---------------------- deliver the goods to the hirer but the ownership of the goods remains with
the hiree. In return, the hirer makes the periodical payments of hire charges,
---------------------- which are partly against the capital repayment and partly against the interest
payable. For accounting and tax purposes, only the interest is treated as revenue
---------------------- expenditure and is considered to be a tax-deductible expenditure. The hirer
---------------------- capitalises the asset purchased under the hire purchase agreement though
he is not the owner of the assets. Depreciation is considered by the hirer as
---------------------- expenditure, debiting the same to profit and loss account and hence becomes
the tax-deductible expenditure. The further hire purchase installments towards
---------------------- capital, which are not yet due, are shown as liability on the Balance Sheet.
---------------------- After the hire charges are paid by the hirer in full, he gets an option of
purchasing the asset entirely in which case the installments paid earlier are
---------------------- converted into the purchase price and the ownership of the asset is transferred
---------------------- to the hirer. If the hirer fails to pay any installment, hiree can take the possession
of the asset without refunding any installment paid earlier. It is the duty of the
---------------------- hirer to keep the asset in good condition. As such, the hiree may stipulate that
the assets should be properly insured, the premium being paid by the hirer.
---------------------- Further, it may also be stipulated that the hirer will not sell or exchange the asset
---------------------- till he becomes the owner of the asset. The hirer has a right to put an end to the
agreement before the last installment is paid, but the installments paid by him
---------------------- previously are not refunded to him.
---------------------- Accounting for Leasing and Hire Purchase:
It can be seen from the above discussion that leasing and hire purchase are
----------------------
similar to each other in certain respects. In both the cases, right to use the asset
---------------------- is available to the lessee or hirer but ownership of the asset remains with the
lessor or hiree.
----------------------
Accounting of lease transactions from Lessee’s point of view:
---------------------- Accounting implications of lease transactions need to be considered from
---------------------- financial accounting point of view as well as from income tax point of view.
For financial accounting, the provisions of Accounting Standard 19 (AS19)
---------------------- are relevant.
---------------------- From financial accounting point of view, the lease rent paid by the lessee
in respect of the operating lease is treated as revenue expenditure and is debited
---------------------- to Profit and Loss Account. For income tax purposes, also the same is treated as
---------------------- revenue expenditure, which reduces the taxable profits of the lessee.
From financial accounting point of view, the lease rent paid by the lessee in Notes
respect of the financial lease is split into two parts – finance charges and principal
amount. The finance charges are treated as revenue expenditure and debited to ----------------------
Profit and Loss Account and principal amount is used to reduce the liability,
which is created at the time of inception of lease. At the time of inception, the ----------------------
asset is capitalised in the books of the lessee at the present value of committed ----------------------
lease rent and the said is matched by a corresponding liability on the balance
sheet. Depreciation is calculated by the lessee as per his depreciation policy. ----------------------
For income tax purposes, the lease rent paid by the lessee is treated as revenue
expenditure, which reduces the taxable profits of the lessee. ----------------------
Accounting of hire purchase transactions: ----------------------

a) Entire amount of hire charges paid by the hirer to the hiree are not ----------------------
considered to be revenue expenditure in the books of hirer. The hire charges
paid by the hirer are split as the payment against capital repayment and the ----------------------
payment against the interest. The component of interest payment only is
----------------------
debited to Profit and Loss account, whereas the payment against the capital
repayment reduces liability for the hirer. ----------------------
b) Asset taken by the hirer on hire is capitalised in the books of the hirer,
----------------------
though the ownership does not transfer to the hirer till the last installment
of hire charges is paid by him. Only the payment against interest payment ----------------------
is a tax-deductible expenditure for the hirer. Similarly, liability for the
future hire charges is also disclosed as the liability on the balance sheet of ----------------------
the hirer. Hirer claims the depreciation on the asset taken by him on hire
----------------------
purchase and the same is treated as a tax-deductible expenditure for the
hirer. Thus, unlike in case of leasing transactions, hire purchase is not a ‘off ----------------------
the balance sheet mode of financing’ for the hirer.
----------------------
4.8 RETAINED EARNINGS ----------------------
Retained earnings or ploughed back profits is one of the best sources of ----------------------
raising long-term funds for the company. It indicates that whatever profits are
earned by the company are not distributed by it by way of dividend but are kept ----------------------
aside for being used in future for expansion or other purposes. If the company
----------------------
follows a regular policy of ploughing back of profits, i.e. keeping aside profits
without distributing them, the shareholders may resent this policy. As such, ----------------------
while deciding the amount of profits to be retained, the company has to be very
careful, about its consequences on the expectations of shareholders and also on ----------------------
the prices of the shares.
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------

1. In case of higher purchasing, ______ is transferred to the buyer but not
----------------------
the _______.
---------------------- 2. In hire purchase, the owner of the asset is called _____ and the user is
called ____.
----------------------
3. For lease accounting, the provisions of Accounting Standard ____ are
---------------------- applicable.
---------------------- 4. The entire amount of hire charges paid by the hirer to the hiree is not
considered to be ______expenditure in the books of hirer.
----------------------
5. Retained earnings is also called ______back of profits.
----------------------
---------------------- Activity 4
----------------------
Meet the manager of a finance company and obtain the information regarding
---------------------- the lease financing products of the company. Also, obtain a sample copy of
lease agreement and hire purchase agreements.
----------------------
----------------------
Summary
----------------------
• Long-term finance refers to the permanent source of finance or finance
---------------------- available for a long period such as more than 10 years.
---------------------- • The financial sources are broadly classified into share capital (both equity
and preference) and debt (including debentures, long-term borrowings or
---------------------- other debt instrument).
---------------------- • Equity shareholders are the owners of the company and Company pays
dividend to equity shareholders as consideration for the risk.
----------------------
• Preference shareholders are not the absolute owner of the company but they
---------------------- have the preferential right of receiving dividend over equity shareholders.
Preference shares are to be paid dividend at a fixed rate. These shareholders
---------------------- have no voting rights.
---------------------- • Debenture refers to a document containing an acknowledgement of
indebtedness issued by the company and a fixed rate of interest. Generally,
---------------------- debentures are secured against the asset of the company.
---------------------- • A public limited company can only accepts deposits from public. Public
deposits are unsecured borrowing for the company.
----------------------
----------------------
• In lease financing, the company acquires the right to use the asset without Notes
holding the title to it and lease agreement or lease deed is the document in
leasing activity. ----------------------
• In hire purchase agreement, the ownership is not transferred but goods are ----------------------
transferred for use to the other party against a periodical payment of hire
charges. ----------------------
• Retained earnings indicates that whatever profits are earned by the company ----------------------
are not distributed by it by way of dividend but are kept aside for being
used in future for expansion or other purposes. ----------------------
----------------------
Keywords
----------------------
• Equity Shares: These are the cornerstones of the financial structure of
the company. On the strength of these shares, the company procures other ----------------------
sources of capital. ----------------------
• Preference Shares: These are the shares, which enjoy preferential
treatment in payments of dividends. ----------------------
----------------------
----------------------
1. Examine critically ‘Debentures’ as a source of corporation finance. ----------------------
2. Examine the comparative merits and demerits of the following methods of
raising additional finance required by a joint stock company. ----------------------
a. Redeemable Preference Shares ----------------------
b. Debentures ----------------------
c. Public Deposits
----------------------
3. Critically appraise the preference shares as a source of finance in the Indian
corporate sector. ----------------------
4. Does leasing increase a firm’s borrowing capacity? Does it release the firm ----------------------
from bad investment and freeing of funds for more profitable uses?
5. Account for the growing amount of public deposits with corporate ----------------------
organisations. ----------------------
6. Explain the control and regulations of public deposits.
----------------------
7. What is meant by lease financing? State and explain the different types of
lease. ----------------------
8. Write short notes: ----------------------
a. Public deposits
----------------------
b. Regulation of public deposits
c. Convertible Debentures ----------------------
d. Lease financing ----------------------

Notes Answers to Check your Progress

1. A share means a share in the capital of the company.
----------------------
2. The value printed on the share certificate is called face or nominal value.
----------------------
3. The value at which the share is sold by the company for the first time in the
---------------------- life of the share is called issue price.
4. The value at which the share is traded in the market is called market value.
----------------------
5. Equity shareholders are owners of the company.
----------------------
6. Funds raised by the company by way of equity shares are available on
---------------------- permanent basis and on unsecured basis.
---------------------- 7. Returns on equity are called dividend.
8. The rate of equity dividend is fluctuating.
----------------------
9. Payment of dividend on equity shares is not compulsory but is optional.
----------------------
10. Right to receive newly issued shares before they are offered to outsiders is
---------------------- called the right of pre-emption.
---------------------- 11. Preference shares have a preferential treatment for receiving dividend and
repayment of capital.
---------------------- 12. The rate of dividend on preference shares is fixed.
---------------------- 13. Investors in preference shares are not absolute owners of the company.
---------------------- 14. Funds raised through preference shares are required to be repaid during the
life of the company.
----------------------
---------------------- 1. False
---------------------- 2. False
---------------------- 3. True
4. False
----------------------
5. True
----------------------
---------------------- 1. Debenture means a document containing an acknowledgement of
indebtedness issued by a company.
----------------------
2. Debenture is an undertaking issued by the company to repay the debt at a
---------------------- specified time or at the option of the company.
---------------------- 3. Debentures carry interest at a fixed rate.
4. Interest is charge on profits. Notes
5. Debentureholder is not an owner but a creditor of the company.
----------------------
6. Generally, debentures are secured so investors are assured of getting their
money back. ----------------------
1. False ----------------------
2. False
----------------------
3. False
----------------------
4. True
5. True ----------------------
6. True ----------------------
Fill in the Blanks.
----------------------
1. Lease financing is a source of financing long-term financing.
----------------------
2. Under the leasing agreement, the company acquires a right to use the asset
without holding the title to it. ----------------------
3. In lease financing, the owner of the asset is called the lessor, the user of the
----------------------
asset is called the lessee and the amount paid by the user to the owner is
called Lease rent. ----------------------
4. Lease Agreement or Lease deed is an important document in lease ----------------------
agreements.
5. Payment of lease rent is a tax-deductible item of expenditure. ----------------------
6. In case of financial type of lease, the lesser acts as a financer. ----------------------

7. In operating lease type of lease, the lesser gets to use the asset. ----------------------
----------------------
Fill in the Blanks.
----------------------
1. In case of higher purchasing, possession is transferred to the buyer but not
the ownership. ----------------------
2. In hire purchase, the owner of the asset is called hiree and the user is called ----------------------
hirer.
----------------------
3. For lease accounting, the provisions of Accounting Standard AS 19 are
applicable. ----------------------
4. The entire amount of hire charges paid by the hirer to the hiree is not
----------------------
considered to be revenue expenditure in the books of hirer.
5. Retained earnings is also called ploughing back of profits. ----------------------
----------------------

Notes
Suggested Reading
----------------------
1. Eugene Brigham, Michael Ehrhardt. Financial Management: Theory &
---------------------- Practice
2. I.M. Pandey. Financial Management
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Capital Structure
UNIT
5
Structure:
5.1 Introduction
5.2 Goals/Principles of Capital Structure Management
5.3 Factors affecting Capital Structure
5.4 Cost of Capital
5.5 Composite Cost of Capital
Summary
Keywords
Problems
Suggested Reading
Capital Structure 69
Notes
Objectives
----------------------
----------------------
• State the principles of capital structure management
----------------------
• Explain the factors affecting capital structure
---------------------- • Define the concept of cost of capital
---------------------- • Identify different ways of measuring the cost of capital
---------------------- • Compute the composite cost of capital
---------------------- 5.1 INTRODUCTION

---------------------- After considering the various sources in which the long-term requirements
of the funds can be met, the next question, which arises, is that what should be
---------------------- the proportion in which the various sources of long-term finance should be used
---------------------- in order to raise the required amount of capital. Here comes into the picture
the decision regarding capital structure. Capital structure refers to the mix of
---------------------- sources from which the long-term funds required by a business are raised, i.e.,
what should be the proportion of equity share capital, preference share capital,
---------------------- internal sources, debentures and other sources of funds in the total amount of
---------------------- capital which an undertaking may raise for establishing its business.
---------------------- 5.2 GOALS/PRINCIPLES OF CAPITAL STRUCTURE

---------------------- MANAGEMENT
For considering the suitable pattern of capital structure, it is necessary to
---------------------- consider certain basic principles, which are related to each other. It is necessary
---------------------- to find a golden mean by giving proper weightage to each of them.
1. Cost Principle: According to this principle, ideal capital structure should
----------------------
minimise cost of financing and maximise earnings per share. Debt capital
---------------------- is a cheaper form of capital due to two reasons. First, the expectations of
returns of debt capital holders are less than those of equity shareholders.
---------------------- Secondly, interest is a deductible expenditure for tax purposes whereas
dividend is an appropriation of profits.
----------------------
2. Risk Principle: According to this principle, ideal capital structure should
---------------------- not accept unduly high risk. Debt capital is a risky form of capital, as it
involves contractual obligations as to the payment of interest and repayment
----------------------
of principal sum, irrespective of profits or losses of the business. If the
---------------------- organisation issues large amount of preference shares, out of the earnings
of the organisation, less amount will be left for equity shareholders as
---------------------- dividend on preference shares are required to be paid before any dividend
is paid to equity shareholders. Raising the capital through equity shares
----------------------
involves least risk, as there is no obligation as to the payment of dividend.
----------------------
3. Control Principle: According to this principle, ideal capital structure should Notes
keep controlling position of owners intact. As preference shareholders and
holders of debt capital carry limited or no voting rights, they hardly disturb ----------------------
the controlling position of residual owners. Issue of equity shares disturb
the controlling position directly as the control of the residual owners is ----------------------
likely to be diluted. ----------------------
4. Flexibility Principle: According to this principle, ideal capital structure
----------------------
should be able to cater to additional requirements of funds in future, if any.
E.g. If a company has already raised too heavy debt capital, by mortgaging ----------------------
all the assets, it will be difficult for it to get further loans in spite of good
market conditions for debt capital and it will have to depend on equity ----------------------
shares only for raising further capital. Moreover, organisation should avoid
----------------------
capital on such terms and conditions, which limit the company’s ability to
procure additional funds. E.g. If the company accepts debt capital on the ----------------------
condition that it will not accept further loan capital or dividend on equity
shares will not be paid beyond a certain limit, then it loses flexibility. ----------------------
5. Timing Principle: According to this principle, ideal capital structure ----------------------
should be able to seize market opportunities, should minimise cost of
raising funds and obtain substantial savings. Accordingly, during the ----------------------
days of boom and prosperity, company can issue equity shares to get the
----------------------
benefit of investors’ desire to invest and take the risk. During the days of
depression, debt capital may be used to raise the capital, as the investors ----------------------
are afraid to take any risk.
----------------------
1. Capitalisation refers to sources of procurement of _____term finance ----------------------

and capital structure refers to the ______, in which the various sources
_____term finance should be used. ----------------------
2. Capital structure means deciding ____of sources from which the funds ----------------------
required by a business are raised.
----------------------
3. Funds can be procured from _____sources and ______sources.
----------------------
4. Debt capital involves ______ obligation as to the payment of interest
and repayment of capital sum. ----------------------
5. Interest must be paid irrespective of ______. ----------------------
----------------------
----------------------
----------------------
----------------------
Notes
---------------------- 1.
Capitalisation and capital structure are diagrammatically opposite
concepts.
----------------------
2. When there is a loss, interest payment can be skipped.
----------------------
3. Dividend payment is not statutorily obligatory.
---------------------- 4. Dividend is an apportionment of profit.
---------------------- 5. Interest is an apportionment of profit and dividend is a charge on
profits.
----------------------
----------------------
i. Debt capital is risky capital a. Cost principle
---------------------- ii. Cater to the additional requirements of funds b. Risk principle
iii. Size market opportunities c. Control principle
---------------------- iv. Maximum EPS minimum investments d. Flexibility principle
v. Keep controlling position of owners intact e. Timing principle
----------------------
----------------------
Activity 1
----------------------
---------------------- Refer to any reference book and find out the advantages and limitations of
issuing of preference shares and debentures.
----------------------
----------------------
5.3 FACTORS AFFECTING CAPITAL STRUCTURE
----------------------
Before deciding the mix of various long-term sources of funds, it is necessary
---------------------- for the company to take into consideration various factors, which can be broadly
classified as below:
----------------------
Internal Factors
----------------------
1. Cost Factor
---------------------- Cost Factor as the factor affecting the capital structure decisions refers
to the cost associated with the process of raising the various long-term
----------------------
sources of funds, which is referred to as Cost of Capital. While deciding
---------------------- the capital structure, it should be ensured that the use of capital is capable
of earning enough revenue to justify the cost of capital associated with it.
---------------------- It should be noted that the borrowed capital is a cheaper form of capital for
the company and this is due to the following reasons:
----------------------
a. The expectations of the lenders of borrowed funds (viz. debentures,
---------------------- term loans etc.) are less than the expectations of the investors who
invest in the own capital of the company (viz. shares). This is because
----------------------
the risk on the part of lenders of borrowed funds is comparatively less
---------------------- than the risk on the part of investors in own funds.
b. The return, which the company pays on borrowed funds (i.e. interest), Notes
is an income tax deductible expenditure for the company whereas
the return paid on own capital (i.e. dividend) is not an income tax ----------------------
deductible expenditure for the company. As such, when the company
pays the interest on borrowed capital, its tax liability is reduced, ----------------------
whereas payment of dividend does not affect the tax liability of the ----------------------
company as the same is paid out of profit after taxes.
----------------------
2. Risk Factor
In financial terms, risk and return always go hand in hand. Whichever ----------------------
capital is cheap for the company is risky for the company. Cost associated
----------------------
with the borrowed funds may be less, but the borrowed capital is more
risky for the company. This is due to the following reasons. ----------------------
a. Payment of interest at the predetermined rate of interest at the
----------------------
predetermined time intervals irrespective of non-availability of profits
is a contractual obligation for the company. ----------------------
b. The company is required to repay the principal amount of borrowed ----------------------
capital at the predetermined maturity date.
c. Borrowed capital is usually secured capital. If the company fails to ----------------------
meet its contractual obligations, the lenders of borrowed funds may ----------------------
enforce the sale of assets offered to them as security.
Cost associated with own funds may be more for the company, but the risk ----------------------
associated with them is less. This is due to the following reasons: ----------------------
a. As the return paid on own capital i.e. dividend is the appropriation of
----------------------
profits, the company is not bound to pay any dividend unless there are
profits. There are many companies who have not paid any dividend on ----------------------
equity shares for years together due to non-availability of profits.
----------------------
b. The company is not expected to repay the own capital during the
lifetime of the company. ----------------------
c. Own capital is an unsecured capital. As such, none of the assets of the ----------------------
company are offered as a security to the investors in own funds.
3. Control Factor ----------------------
While planning the capital structure and more particularly while raising ----------------------
additional funds required by the company, the control factor essentially
becomes an important factor to be considered, specifically for the closely ----------------------
held private limited companies. Control factor refers to the capacity of ----------------------
the existing owners of the company to retain control over operations of
the company. If the company decides to meet the additional requirements ----------------------
of funds by issuing the equity shares or preference shares, the controlling
interest of the existing owners is likely to be diluted as the investors in equity ----------------------
shares enjoy the absolute voting rights while investors in preference shares ----------------------
enjoy limited voting rights. If the company decides to meet the additional
requirement of funds by way of borrowed capital, the controlling interest ----------------------
Notes of the existing owners remains intact, as the lenders of borrowed funds do
not enjoy any voting rights. However, it should be remembered here that
---------------------- if the existing owners contribute to the rights shares which indicate the
additional shares offered to the existing owners in the existing proportion,
---------------------- their controlling interest may not get affected. Similarly, while raising the
---------------------- additional requirements of funds by way of borrowed capital, the existing
owners of the company need to remember that their controlling interests
---------------------- may be indirectly affected if the lending Bank or Financial Institutions
appoint their representatives as Nominee Directors on the Board of
---------------------- Directors of the borrowing company.
---------------------- 4. Objects of the Capital Structure Planning
---------------------- While planning the capital structure, following objects of the capital
structure planning come into play.
----------------------
a. To maximise the profits available to the owners of the company. This
---------------------- can be ensured by issuing the securities carrying less cost of capital.
---------------------- b. To issue the securities which are easily transferable. This can be
ensured by listing the securities on the stock exchange.
---------------------- c. To issue further securities in such a way that the value of shareholding
---------------------- of present owners is not adversely affected.
d. To issue the securities which are understandable by the investors.
----------------------
e. To issue the securities which are acceptable to the lenders or investors.
----------------------
External Factors
---------------------- 1. General Economic Conditions
---------------------- While planning the capital structure, the company needs to consider the
general conditions existing in the economy. If the economy is in boom
---------------------- and the interest rates are likely to decline, the company will like to raise
---------------------- equity capital immediately, leaving the borrowed capital to be considered
in future. It may also be possible to raise more equity capital in a boom,
---------------------- as the investors may be ready to take risk and to invest. If the economy is
in depression, the company will like to go for equity capital as it involves
---------------------- less amount of risk. However, it may not be possible to raise the capital by
---------------------- way of equity during the period of depression, as the investors may not be
willing to take the risk. Under such circumstances, the company may be
---------------------- required to go for borrowed capital.
---------------------- 2. Behaviour of Interest Rates

While planning the capital structure, the company may be required to take
----------------------
into consideration the likely behaviour of interest rates in the economy.
---------------------- If the interest rates in the economy are likely to decline, depending more
upon the long-term sources carrying fixed rate of return (viz. debentures,
---------------------- preference shares) will prove to be dangerous for the company. If the
interest rates in the economy are likely to increase, the company will be
----------------------
benefited by issuing the long-term securities carrying fixed rate of return.
3. Policy of the Lending Institutions Notes
If the policy of the lending banks or financial institutions is too harsh
----------------------
or rigid, it will be advisable not to go for borrowed funds. Instead, the
company will like to go for more convenient sources such as leasing or hire ----------------------
purchase, though they are more costly propositions.
----------------------
4. Taxation Policy
Taxation policy as a factor affecting the capital structure decisions needs to ----------------------
be viewed from the angle of the company as well as the investor.
----------------------
As far as interest is concerned, from company’s point of view, the return
paid on the borrowed capital i.e. interest is a tax-deductible expenditure. ----------------------
From investor’s point of view, return received by him on the funds lent to ----------------------
the company is a taxable income. Further, if the interest on debentures/
bonds exceeds Rs. 2,500, the paying company is required to deduct the tax ----------------------
at source and pay the same to the Central Government.
----------------------
As such, income received by the investors in their hands is reduced to the
extent of tax deducted at source. ----------------------
As far as dividend is concerned, as per the provisions of Section 10(36) ----------------------
of the Income Tax Act, 1961, dividend received by the shareholders,
whether interim or final, is not taxable in their hands. However, as per the ----------------------
provisions of Section 115-O of the Income Tax Act, 1961, the company
paying the dividend is required to pay additional tax (over and above the ----------------------
normal income tax payable on the taxable profits of the company). This ----------------------
tax is in the form of ‘tax on distributable profits’ and the same is popularly
referred to as ‘dividend tax’. Rate at which dividend tax is payable by the ----------------------
company is 12.5% of the amount of dividend paid. This basic rate is further
increased by the surcharge of 10% and the education cess of 2%. As such, ----------------------
the effective rate of dividend tax works out as 14.025%. Dividend Tax is ----------------------
payable by the company within 14 days from the date of declaration or
payment of dividend, whichever is earlier. ----------------------
5. Statutory Restrictions ----------------------
The statutory restrictions prescribed by the Government and various other
----------------------
statutes are required to be taken into consideration before the capital
structure is planned by the company. The company has to decide the capital ----------------------
structure within the overall framework prescribed by the Government or
various other statutes. ----------------------
General Factors ----------------------
1. Constitution of the Company ----------------------
While deciding the capital structures, constitution of the company plays a
very important role. If the company is a private limited company or a closely ----------------------
held company, control factor may play a dominant role. If the company is ----------------------
a public limited company or a widely held company, cost factor may play
a dominant role. ----------------------
Notes 2. Characteristics of the Company
Characteristics of the company in terms of its size, age and credit standing
----------------------
play a very important role in the capital structure decisions. Very small
---------------------- companies and the companies in their early stage of life have to depend
more upon the equity capital, as they have limited bargaining capacity and
---------------------- they do not enjoy the confidence of the investors. As such, it is better for
these companies to go for equity capital in the early years of life, increase
----------------------
the capital base, increase the bargaining capacity and then go for borrowed
---------------------- capital in the later years of their life. Similarly, the companies having good
credit standing in the market may be in the position to tap the source of
---------------------- their own choice, whereas the choice may not be available to the companies
having poor credit standing in the market.
----------------------
3. Stability of Earnings
----------------------
If sales and earnings of the company are stable and predictable in future,
---------------------- the company does not mind taking the risk and it can borrow the funds,
as cost factor and control factor will play more important role. However,
---------------------- if the sales and earnings are not likely to be stable and predictable over a
period of time and are likely to be subject to wide fluctuations, the risk
----------------------
factor plays an important role and the company will not like to have more
---------------------- borrowed capital in its capital structure.
---------------------- 4. Attitude of the Management

If the management attitude is conservative, the control factor and risk
---------------------- factor may play an important role in the capital structure decisions. If the
---------------------- management attitude is aggressive, cost factor may play an important role.
---------------------- 5.4 COST OF CAPITAL

---------------------- In the previous chapter, we discussed about the various sources from which
---------------------- the long-term requirement of the capital can be met. Each of these sources
involves some cost. The cost of capital can be defined as “the rate at which an
---------------------- organisation must pay to the suppliers of capital for the use of their funds”.
---------------------- In economic terms, the cost of capital is viewed from two different angles.
1. The cost of raising funds to finance a project. This cost may be in the form
---------------------- of the interest, which the company may be required to pay to the suppliers
---------------------- of funds. This may be the explicit cost attached with the various sources of
capital.
----------------------
2. The cost of capital may be in the form of opportunity cost of the funds
---------------------- of company, i.e. rate of return, which the company would have earned
if the funds are not invested. For example, suppose that a company has
---------------------- an amount of Rs. 1,00,000, which either may be utilised for purchasing
a machine or may be invested with a bank as fixed deposit carrying the
----------------------
interest 10% p.a. If the company decides to use the amount for purchasing
---------------------- the machine, obviously it will have to forgo the interest, which it would
have earned by investing the same in fixed deposit with the bank. Thus, the Notes
cost of capital of this capital of Rs. 1,00,000 is 10%.
----------------------
Concepts of Cost of Capital
Besides the general concept of cost of capital, the following concepts are also ----------------------
used frequently.
----------------------
(a) Component Cost and Composite Cost
----------------------
Component cost refers to the cost of individual components of capital viz.
equity shares, preference shares, debentures and so on. Composite cost of ----------------------
capital refers to the combined or weighted average cost of capital of the
various individual components. For capital budgeting decisions, it is the ----------------------
composite cost of capital, which is considered. ----------------------
(b) Average Cost and Marginal Cost
----------------------
The average cost refers to the weighted average cost of capital. Marginal
cost refers to the incremental cost attached with new funds raised by the ----------------------
company.
----------------------
(c) Explicit Cost and Implicit Cost
----------------------
Explicit cost is the one, which is attached with the source of capital explicitly
or apparently. Implicit cost is the hidden cost that is not incurred directly. ----------------------
E.g. In case of the debt capital, the interest that the company is required
to pay on the same is explicit cost of capital. However, if the company ----------------------
introduces more and more doses of debt capital in the overall capital
----------------------
structure, it makes the investment in the company a risky proposition.
As such, the expectations of the investors in terms of return on their ----------------------
investment may increase and share prices of the company may decrease.
These increased expectations of the investors or the decreased share prices ----------------------
may be considered the implicit cost of debt capital.
----------------------
----------------------
----------------------
1. The company must be earning enough revenue to justify the cost of
capital associate. ----------------------
2. Payment of interest at contractual rate and time is not a contractual
----------------------
obligation.
3. Owned capital need not be repaid during the lifetime. ----------------------
4. Interest on borrowed capital is flexible. ----------------------
5. Equity shares are non-redeemable and preference shares are redeemable. ----------------------
----------------------
----------------------
Notes 5.5 COMPOSITE COST OF CAPITAL
---------------------- After ascertaining the cost of each source of the capital constituting the
capital structure, the next step is to compute the composite cost of capital, which
---------------------- is defined as the weighted average of the cost of each specific type of capital.
The reason behind considering weighted average and not the simple average is
----------------------
to give consideration to the proportion of various sources of funds in the capital
---------------------- structure of the company. Thus, the process of computing the composite cost of
capital is carried on by following the steps stated below.
----------------------
The above process can be explained with the help of the following illustrations.
---------------------- Illustration I:
---------------------- The capital structure of a company and the cost of specific sources of funds are
as below:
----------------------
Sources of funds Book value Specific Weighted cost
---------------------- (weights) Rs. Cost Rs.
1 2 3 (1 x 2)
----------------------
Debentures 1,50,000 5% 7,500
---------------------- Preference shares 50,000 9% 4,500
Equity shares 2,00,000 15% 30,000
---------------------- Retained earnings 1,00,000 8% 8,000
5,00,000 50,000
----------------------
Total weighted costs x 100
Composite cost of capital = x 100
---------------------- Total weights
50,000
---------------------- = x 100
5,00,000
----------------------
= 10%
----------------------
Illustration II:
----------------------
From the information given below, calculate the weighted cost of capital (before
---------------------- tax) for Z Ltd.
Rs. in Lakhs
----------------------
1. Shareholders’ funds
---------------------- Share Capital – Equity 500
– Preference 100
----------------------
Retained Earnings 300
---------------------- 2. Loan Funds
Secured Loans 800
---------------------- Unsecured Loans (Incl. intercorporate deposit) 700
2,400
----------------------
(a) Normal yield on Equity shareholders’ fund anticipated at 15%.
----------------------
(b) Dividend rate on preference shares - 12%.
---------------------- (c) Tax rate for Z Ltd. - 60%
(d) Interest on secured loans - 16.25% Notes
(e) Interest on unsecured loans - 20%
----------------------
Solution:
----------------------
Computation of after tax cost of capital:
Source Book value Tax Adjusted Weighted Cost ----------------------
(weights) Cost ----------------------
1 2 3 4 i.e. 2 x 3
Equity shares 500 15% 75 ----------------------
Preference shares 100 12% 12
Retained Earnings 300 15% 45 ----------------------
Secured Loans 800 6.50% i.e. 52
----------------------
40% of 16.25%
Unsecured loans 700 8% i.e. 56 ----------------------
40% of 20%
2400 240 ----------------------
Weighted costs ----------------------
Weighted Average Cost = x 100
Total weights
----------------------
240
= x 100
2,400 ----------------------
= 10% ----------------------
----------------------
----------------------
1. While assigning weights to various sources of funds, weights may be
in the form of _____ of funds or ____ of funds. ----------------------
2. For calculation of composite cost of capital, _____ of funds and ----------------------
_______ are required to be multiplied.
----------------------
3. The composite cost is calculated by dividing total _____ cost by the
total _______. ----------------------
4. If total of weighted cost is Rs.50,000 and total of weights is Rs.5,00,000,
----------------------
then the composite cost is ________%.
1. Capital structure refers to the mix of sources of long-term funds ----------------------
required in a business.
2. Cost principle aims at maximising the cost of capital. ----------------------
3. Risk principle aims not accepting unduly risky capital. ----------------------
4. Control principle aims at diluting the control of the existing equity
----------------------
shareholders.
5. Flexibility principle aims to cater additional requirement of funds in future. ----------------------
Notes 5.6 ILLUSTRATIVE PROBLEMS
---------------------- 1. In considering the most desirable capital for a company, the following
estimates of the cost of debt and equity capital (after tax) have been made
---------------------- at various levels of debt-equity mix.
---------------------- Debt as % of total Cost of debt Cost of equity
capital employed % %
---------------------- 0 7.0 15.0
---------------------- 10 7.0 15.0
20 7.0 15.5
---------------------- 30 7.5 16.0
40 8.0 17.0
---------------------- 50 8.5 19.0
60 9.5 20.0
----------------------
You are required to determine the optimal debt equity mix for the company by
---------------------- calculating composite cost of capital.
---------------------- Solution:
---------------------- Calculation of composite cost of capital

Debt as % of total Cost of Cost of Composite cost of capital
----------------------
capital employed debt equity %
---------------------- 0 7.0 15.0 7.0 x 0.0 + 15.0 x 1.0 = 15.00
10 7.0 15.0 7.0 x 0.1 + 15.0 x 0.9 = 14.20
---------------------- 20 7.0 15.5 7.0 x 0.2 + 15.5 x 0.8 = 13.80
30 7.5 16.0 7.5 x 0.3 + 16.0 x 0.7 = 13.45
---------------------- 40 8.0 17.0 8.0 x 0.4 + 17.0 x 0.6 = 13.40
---------------------- 50 8.5 19.0 8.5 x 0.5 + 19.0 x 0.5 = 13.75
60 9.5 20.0 9.5 x 0.6 + 20.0 x 0.4 = 13.70
---------------------- It can be seen from the above that composite cost of capital is minimum i.e.
13.40% when capital structure is as below:
----------------------
40% debt
----------------------
60% equity
---------------------- 100%
---------------------- Hence, that is the optimal debt-equity mix.
---------------------- 2. Following items have been extracted from the liabilities side of XYZ
company, as at 31st March, 2008:
---------------------- Paid-up Capital Rs.
---------------------- 4,00,000 Equity shares of Rs. 10 each 40,00,000
Reserves and Surplus 60,00,000
----------------------
Loans
----------------------
15% Non-convertible Debentures 20,00,000
---------------------- 14% Institutional Loans 60,00,000
Other information about the company as relevant is given below: Notes
Year ended Dividend per Earnings per share Average market
----------------------
31st March share price per share
Rs. Rs. Rs. ----------------------
2008 4.00 7.50 50.00
2007 3.00 6.00 40.00 ----------------------
2006 4.00 4.50 30.00
----------------------
You are required to calculate the weighted average cost of capital, using book
values as the weights and Earnings/Price (E/P) ratio as the basis of cost of ----------------------
equity.
----------------------
Assume Income Tax Rate at 50%.
----------------------
Solution:
Calculation of Cost of Capital ----------------------
Sources of Funds Book Value Tax Adjusted Weighted ----------------------

(Weights) Cost Cost
Equity Shares 40,00,000 15% 6,00,000 ----------------------
Reserves and Surplus 60,00,000 15% 9,00,000 ----------------------
Non-convertible Debentures 20,00,000 7.5% 1,50,000
Institutional Loans 60,00,000 7% 4,20,000 ----------------------
1,80,00,000 20,70,000
----------------------
Weighted average cost of capital
20,70,000 ----------------------
= x 100
1,80,00,000 ----------------------
= 11.5%
----------------------
Working Notes:
----------------------
(a) It is assumed that the company is subjected to tax rate of 50%.
(b) Cost of equity shares is calculated on E/P basis as under: Average EPS ----------------------
Average EPS ----------------------
x 100
Average Market Price
----------------------
Rs. 6.00
i.e. x 100 ----------------------
Rs. 40.00
= 15% ----------------------
3. A company needs Rs. 5,00,000 for the construction of a new plant. ----------------------
Following alternative capital structures are under consideration:
----------------------
a. The company may issue 50,000 Equity Shares of Rs. 10 per share at
par. ----------------------
b. The company may issue 2,500 debentures of Rs. 100 per debenture
----------------------
carrying the rate of interest of 12% p.a. and balance by way of Equity
Shares of Rs. 10 per share issued at par. ----------------------
Notes c. The company may issue 2,500 Preference Shares of Rs. 100 per share
at par carrying the rate of dividend of 10% and balance by way of
---------------------- Equity Shares of Rs. 10 per share issued at par.
---------------------- If the company’s Profit Before Interest and Tax is Rs. 60,000 or Rs. 80,000 or
Rs. 1,00,000 what will be the Earning Per Share under each of the above capital
---------------------- structures? If the objective of the company is to maximise the EPS, which of the
capital structures will be recommended? Assume 50% as the corporate tax rate.
----------------------
Solution:
----------------------
It is assumed that the following three plans are possible for the company:
---------------------- Plan 1 - Only Equity Shares
---------------------- Plan 2 - Equity Shares and Debentures
---------------------- Plan 3 - Equity Shares and Preference Shares
a. When Profit Before Interest and Tax is Rs. 60,000
----------------------
Plan 1 Plan 2 Plan 3
---------------------- Profit Before Interest and Tax 60,000 60,000 60,000
Interest – 30,000 –
----------------------
Profit Before Tax 60,000 30,000 60,000
---------------------- Tax 30,000 15,000 30,000
Profit After Tax 30,000 15,000 30,000
---------------------- Preference Dividend – – 25,000
Distributable Profit 30,000 15,000 5,000
---------------------- No. of Equity Shares 50,000 25,000 25,000
---------------------- Earnings Per Share Re. 0.60 Re. 0.60 Rs. 0.20
b. When Profit Before Interest and Tax is Rs. 80,000
----------------------
---------------------- Profit Before Interest and Tax 80,000 80,000 80,000
Interest – 30,000 –
---------------------- Profit Before Tax 80,000 50,000 80,000
---------------------- Tax 40,000 25,000 40,000
Profit After Tax 40,000 25,000 40,000
---------------------- Preference Dividend – – 25,000
Distributable Profit 40,000 25,000 15,000
---------------------- No. of Equity Shares 50,000 25,000 25,000
Earning Per Share Re. 0.80 Rs. 1.00 Re. 0.60
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
c. When Profit Before Interest and Tax is Rs. 1,00,000 Notes
----------------------
Profit Before Interest and Tax 100,000 100,000 100,000
Interest – 30,000 – ----------------------
Profit Before Tax 100,000 70,000 100,000
Tax 50,000 35,000 50,000 ----------------------
Profit After Tax 50,000 35,000 50,000
Preference Dividend – – 25,000 ----------------------
Distributable Profit 50,000 35,000 25,000 ----------------------
No. of Equity Shares 50,000 25,000 25,000
Earning Per Share Re. 1.00 Rs. 1.40 Re. 1.00 ----------------------
4. A company needs Rs. 12 lakh for the installation of a new factory, which
----------------------
would yield an annual EBIT of Rs. 2,00,000. The company has the objective
of maximising the EPS. It is considering the possibility of issuing equity ----------------------
shares plus raising a debt of Rs. 2,00,000, Rs. 6,00,000 or Rs. 10,00,000.
The current market price per share is Rs. 40, which is expected to drop to ----------------------
Rs. 25 per share if the market borrowings were to exceed Rs. 7,50,000.
----------------------
Costs of borrowings are indicated as under.
Up to Rs. 2,50,000 – 10% p.a. ----------------------
Between Rs. 2,50,001 and Rs. 6,25,000 – 14% p.a. ----------------------

Between Rs. 6,25,001 and Rs. 10,00,000 – 16% p.a. ----------------------
Assuming a tax rate of 50%, work out the EPS and the scheme, which
----------------------
would meet the objective of the management. Issue price of share Rs. 10/-
per share at par. ----------------------
Solution:
----------------------
On the basis of the information available, following are the alternative capital
structures possible: ----------------------
Plan 1 Plan 2 Plan 3 ----------------------

Debt 2,00,000 6,00,000 10,00,000
Equity 10,00,000 6,00,000 2,00,000 ----------------------
12,00,000 12,00,000 12,00,000 ----------------------
Following is the calculation of EPS under each of the above capital structures.
----------------------
Calculation of EPS
----------------------
Earnings Before Interest and Tax 2,00,000 2,00,000 2,00,000
Interest 20,000 84,000 1,60,000 ----------------------
Earnings Before Tax 1,80,000 1,16,000 40,000
Tax 90,000 58,000 20,000 ----------------------
Earnings After Tax 90,000 58,000 20,000
No. of Equity Shares* 1,00,000 60,000 20,000 ----------------------
Earnings Per Share 0.90 0.97 1.00 ----------------------
----------------------
Notes As Earnings Per Share is maximum in Plan 3, the company will go for the said
plan.
----------------------
5. The following figures of Krish Ltd. are presented to you.
---------------------- Rs.
EBIT 23,00,000
----------------------
Less : Debenture interest @ 8% 80,000
---------------------- Long Term Loan interest @ 11% 2,20,000 3,00,000
20,00,000
---------------------- Less : Income Tax 10,00,000
Earnings After Tax 10,00,000
---------------------- No. of Equity Shares of Rs. 10 each 5,00,000
---------------------- EPS Rs. 2
Market Price of Shares Rs. 20
---------------------- P/E Ratio 10
---------------------- The company has undistributed reserves and surplus of Rs. 20 lakh. It is in
need of Rs. 30 lakh to pay the debentures and modernise its plant. It seeks your
---------------------- advice on the following alternative models of raising finance.
---------------------- Alternative I: Raising entire amount as term loan from banks @12%.
Alternative II: Raising part of the funds by issue of 2,00,000 shares of Rs. 10
---------------------- each at par and the rest by term loan @ 12%.
---------------------- The company expects to improve its rate of return on capital employed by 2%
as a result of modernisation, but P/E ratio is likely to go down to 8 if the entire
----------------------
amount is raised as term loan.
---------------------- (a) Advise the company on the financial plan to be selected.
---------------------- (b) If it is assumed that there will be no change in the P/E ratio, if either of the
two alternatives is adopted, would your advice still hold good?
----------------------
Solution :
---------------------- Present Capital Employed Rs.
---------------------- Equity share capital 50,00,000
Reserves and Surplus 20,00,000
---------------------- 8% Debentures 10,00,000
11% Term Loan 20,00,000
---------------------- ... Capital Employed 100,00,000
EBIT 23,00,000
----------------------
Rate of EBIT on Capital Employed 23%
---------------------- Alternative I : Term Loan Only Rs.
EBIT 120,00,000 x 25 = 30,00,000
----------------------
100
----------------------
Less : Interest
---------------------- 11% Term Loan 20,00,000 x 11 2,20,000
100
----------------------

EBT
12% Term Loan
100 [ 30,00,000 x 13
24,20,000
] 3,60,000 5,80,000 Notes
----------------------
Taxes @ 50% 12,10,000
Profit After Taxes 12,10,000 ----------------------
E.P.S.
P/E Ratio [
5,00,000 ]
12,10,000 2.42
8
----------------------
----------------------
Market Price of the share 19.36
Alternative II : Term Loan and Equity Shares ----------------------
EBIT 30,00,000
----------------------
Less : Interest
11% Term Loan 2,20,000 ----------------------
12% Term Loan 1,20,000 3,40,000 ----------------------
EBT 26,60,000
----------------------
Taxes @ 50% 13,30,000
Profit After Taxes 13,30,000 ----------------------
E.P.S. 13,30,000 1.90 ----------------------
7,00,000
P/E Ratio 10 ----------------------
Market Price of the share 19 ----------------------
Conclusion: ----------------------
(a) As the market price of the share in the first alternative is going to be more, ----------------------
the company will select that financial plan.
(b) Yes, Since Market Price is more. ----------------------
6. The existing capital structure of XYZ Ltd. is as under: ----------------------

Equity shares of Rs. 100 each Rs. 40,00,000 ----------------------
Retained Earnings Rs. 10,00,000 ----------------------
9% Preference Shares Rs. 25,00,000
----------------------
7% Debentures Rs. 25,00,000
----------------------
The existing rate of return on the company’s capital employed is 12% and the
income tax rate is 50%. The company requires a sum of Rs. 25,00,000 to finance ----------------------
its expansion programme for which it is considering the following alternatives:
----------------------
i. Issue of 20,000 equity shares at a premium of Rs. 25 per shares.
ii. Issue of 10% preference shares. ----------------------
iii. Issue of 8% debentures. ----------------------
If it is estimated that the P/E ratios in the case of equity, preference and debenture ----------------------
financing would be 20, 17 and 16 respectively, which of the above alternatives
would you consider the best if the objective of the company is to maximise ----------------------
market price of the shares?
Notes Solution:
Calculation of EPS and Market Price of the shares under various alternate
----------------------
financial plans
---------------------- Alternative Alternative II Alternative III
I (Equity (Preference (Debentures)
----------------------
shares) shares)
---------------------- Rs. Rs. Rs.
----------------------
----------------------
EBIT
[ 1,25,00,000 x 12
100 ] 15,00,000 15,00,000 15,00,000
Less : Interest
---------------------- 7% Debentures 1,75,000 1,75,000 1,75,000
8% Debentures – – 2,00,000
---------------------- EBT 13,25,000 13,25,000 11,25,000
Less : Income Tax @ 50% 6,62,500 6,62,500 5,62,500
---------------------- Profit After Tax 6,62,500 6,62,500 5,62,500
---------------------- Less : Preference Dividend
9% Preference shares 2,25,000 2,25,000 2,25,000
---------------------- 10% Preference shares – 2,50,000 –
Distributable Profits 4,37,500 1,87,500 3,37,500
---------------------- No. of Equity shares 60,000 40,000 40,000
EPS (Rs.) 7,.29 4.69 8.44
---------------------- P/E Ratio 20 17 16
---------------------- Market Price (Rs.) 145.80 79.73 135.04
As the market price will be maximum under the Alternative I, the company
---------------------- will select that financial plan, i.e. to raise the additional fund by way of issue of
---------------------- equity shares.
7. The Evergreen Company has to decide between debt fund and equity
----------------------
expansion programme. Its current position is as follows:
---------------------- Rs.
Debt @5% 40,000
----------------------
Equity capital (Rs. 10 per share) 1,00,000
---------------------- Reserves and Surplus 60,000
Total Capitalisation 2,00,0000
---------------------- Sales 6,00,000
Total Costs 5,38,000
---------------------- PBIT 62,000
---------------------- Less : Interest 2,000
PBT 60,000
---------------------- Less : Income Tax @50% 30,000
PAT 30,000
----------------------
The expansion programme is estimated to cost Rs. 1,00,000. If this is financed
---------------------- through the debt, the rate of new debt will be 7% and the P/E Ratio will be 6
----------------------
times. If the expansion programme is financed through the equity shares, the new Notes
shares can be sold netting Rs. 25 per share and the P/E Ratio will be 7 times. The
expansion will generate additional sales of Rs. 3,00,000 with a return of 10% on ----------------------
the additional sales before interest and taxes.
a. If the company is to follow the policy of maximising the market value of ----------------------
its shares, which form of financing should it choose? ----------------------
b. At what level of PBIT will EPS remain the same, whether the financing is
----------------------
by way of equity or debt?
Solution ----------------------
Part a ----------------------
Debt Equity ----------------------
Financing Financing
Profit Before Interest and Tax (62,000 + 30,000) 92,000 92,000 ----------------------
Less : Interest – Existing 2,000 2,000
– New 7,000 – ----------------------
Profit Before Tax 83,000 90,000
----------------------
Less : Tax 41,500 45,000
Profit After Tax 41,500 45,000 ----------------------
No. of Equity Shares 10,000 14,000
Earning Per Share 4.15 3.21 ----------------------
Price Earning Ratio 6 times 7 times
Hence, Market Price 24.90 22.47 ----------------------
As objective is to maximise the market value of the shares, the company will ----------------------
opt for the debt financing.
----------------------
Part b –
----------------------
We know that PBIT - Interest = PBT and PBT - Tax = PAT
and PAT / No. of Equity Shares = EPS ----------------------
As tax rate is 50%, 1/2 of PBT is PAT ----------------------
Hence we can say that - ----------------------
1/2 (PBIT - Interest)
= EPS ----------------------
No. of Equity Shares
----------------------
We wish to know the level of PBIT where EPS will be the same whether the
financing is through debt or equity. This leads us the following equation - ----------------------
1/2 (PBIT - 7,000) 1/2 (PBIT - 2,000) ----------------------
=
10,000 14,000 ----------------------
Solving for PBIT, we get the value of PBIT to be Rs. 26,500. It means that if PBIT is
----------------------
Rs. 26,500, EPS will be the same whether the financing is through debt or equity.
----------------------
----------------------
Notes Summary
---------------------- • Capital Structure refers to the mix of sources from where the long-term
funds required in a business may be raised.
----------------------
• The principles of capital structure management should consider i) Cost
---------------------- principle i.e. it should minimise the cost of capital ii) Risk principle i.e.
it should not accept unduly high risk. iii) Control principle, i.e. it should
----------------------
keep controlling position of owners intact. iv) Flexibility principle, i.e.
---------------------- it should be able to cater to additional requirements of funds in future.
v) Timing principle, i.e. it should be able to seize market opportunities,
---------------------- should minimise cost of raising funds and obtain substantial savings.
---------------------- • The cost of capital may be defined as, “the rate at which an organisation
must pay to the suppliers of capital for the use of their funds”.
---------------------- • There are various methods for measuring the cost of capital: a) Cost of debt:
---------------------- the cost of capital in the form debt is the interest, which the company has
to pay. But this is not the real cost attached with debt capital. To ascertain
---------------------- the real cost of debt, adjustments are required to be made for it tax impact.
b) Cost of preference shares: The fixed dividend rate is the cost of capital
---------------------- in case of preference share. c) Cost of equity shares: The cost of equity
shares basically depends upon the expectations of equity shareholders. d)
----------------------
Cost of retained earnings: The cost of retained earnings is in the form of
---------------------- the opportunity cost in terms of dividend foregone by or withheld from the
equity shareholders.
----------------------
Keywords
----------------------
• Cost Principle: According to this principle, ideal capital structure should
----------------------
minimise cost of financing and maximise earnings per share.
---------------------- • The Cost of capital: The rate at which an organisation must pay to the
suppliers of capital for the use of their funds.
----------------------
• E/P Approach: According to this approach, the cost of equity shares is
---------------------- based upon the stream of unchanged earnings earned by a company.
---------------------- Self-Assessment Questions
----------------------
1. Define the term ‘Capital Structure’ and give principles of capital structure
---------------------- management.
2. Explain the factors that influence the capital structure of a company.
----------------------
3. What do you mean by ‘Cost of Capital’ and what is the importance of cost
---------------------- of capital for a company?
---------------------- 4. Write short notes on:
a. D/P approach for computation of cost of equity shares
----------------------
b. E/P approach for computation of cost of equity shares
---------------------- c. Realised yield approach for computation of cost of equity shares.
5. How do you compute the composite cost of capital? Notes
6. How is the cost of capital calculated?
----------------------
a. Equity Shares
----------------------
b. Preference Shares
c. Debentures ----------------------
d. Retained Earnings ----------------------
----------------------
PROBLEMS
----------------------
1. Calculate the cost of various forms of capital of A Ltd. from the following
information. ----------------------
(a) 15% Debentures redeemable after 10 years. Face value is Rs. 100, net ----------------------
amount realised is Rs. 95 per debenture. Tax rate is 50%.
(b) 10% Preference shares. Face value Rs. 100, net amount realised Rs. ----------------------
105 per share. ----------------------
(c) Market price of equity shares Rs. 150, dividend expected Rs. 12 per
----------------------
share. The dividend per share is expected to grow at 5% per year.
2. A Ltd. has the following capital structure: ----------------------
12% Debt Rs. 30 Lakhs ----------------------
Equity Capital (Rs. 100 per share) Rs. 20 Lakhs ----------------------
Retained earnings Rs. 40 Lakhs
----------------------
Market value of equity Rs. 50 Lakhs
----------------------
Earnings per share and dividend per share have grown steadily at the rate
of 5% per year. Future dividend per share expected is Rs. 15. Market price ----------------------
per share is Rs. 250. Tax rate for the company is 60%.
----------------------
Calculate the average cost of capital for the company.
----------------------
3. A Ltd. has the following capital structure:
----------------------
Equity Capital
(1 Lakh shares of Rs. 10) Rs. 10 Lakhs ----------------------
10% Preference Capital
----------------------
(1,000 shares of Rs. 100) Rs. 1 Lakhs
13% Debentures ----------------------
(5000 Debentures of Rs. 100) Rs. 5 Lakhs ----------------------
14% Term Loans Rs. 8 Lakhs
Retained Earnings Rs. 12 Lakhs ----------------------
Rs. 36 Lakhs ----------------------
----------------------
Notes Expected dividend per share is Rs. 1.50 with the expected growth rate of
7%. Market price per share is Rs. 20. Preference shares and debentures are
---------------------- selling at Rs. 75 and Rs. 80 respectively. The tax rate for the company is
50%.
----------------------
Calculate the average cost of capital using:
---------------------- (a) Book value weights
---------------------- (b) Market value weights
---------------------- 4. A company is considering raising of funds at about Rs. 100 lakh by one
of the two alternative methods, viz. 14% institutional term loan and 13%
---------------------- non-convertible debentures. The term loan option would attract no major
incidental cost. The debentures would have to be issued at a discount of
----------------------
2.5% and would involve issue cost of Rs. 1 lakh.
---------------------- Advice the company as to the better option based on the effective cost of
capital in each case. Assume a tax rate of 50%.
----------------------
5. The following is an extract from the financial statements of KPN Ltd.
----------------------
(Rs. in Lakhs)
----------------------
Operating Profit 105
---------------------- Less : Interest on Debentures 33
PBT 72
----------------------
Less : Income Tax 36
---------------------- PAT 36
---------------------- Equity share capital (share of Rs. 10 each) 200
Reserves and Surplus 100
---------------------- 15% Non-convertible Debentures (of Rs. 100 each) 220
---------------------- 520
---------------------- The market price per equity share is Rs. 12 and per debenture is Rs. 93.75
i. What is the earnings per share?
----------------------
ii. What is the percentage cost of capital to the company for the debenture
---------------------- funds and the equity?
---------------------- 6. X Company Limited is considering three different plans to finance its total
project cost of Rs. 100 lakh. These are:
----------------------
(Rs. in lakh)
---------------------- Plan A Plan B Plan C
---------------------- Rs. Rs. Rs.
Equity (Rs. 100 per share) 50 34 25
---------------------- 8% Debentures 50 66 75
100 100 100
----------------------
Sales for the first three years of operations are estimated at Rs. 100 lakh,
---------------------- Rs.125 lakh and Ra. 150 lakh and a 10% profit before interest and taxes is
forecast to be achieved. Corporate taxation to be taken at 50%. Compute Notes
Earnings Per share in each of the alternative plans of financing for the three
years. ----------------------
7. AB Limited provides you with the following figures. ----------------------
Rs.
PBIT 3,00,000 ----------------------
Less : Interest on debentures @ 12% 60,000 ----------------------
PBIT 2,40,000
Less : Income Tax @ 50% 1,20,000 ----------------------
PAT 1,20,000
----------------------
No. of Equity shares (Rs. 10 each) 40,000
EPS 3 ----------------------
Ruling prices in market 30
P/E Ratio 10 ----------------------
The company has undistributed reserves of Rs. 6,00,000. The company ----------------------
needs Rs. 2,00,000 for expansion. This amount will earn at the same rate as
funds already employed. You are informed that a debt-equity ratio (Debt/ ----------------------
Debt + Equity) higher than 35%, will push the P/E Ratio down to 8 and ----------------------
raise the interest rate on additional amount borrowed to 14%. You are
required to ascertain the probable price of the share: ----------------------
(a) If the additional funds are raised as debt ----------------------
(b) If the amount is raised by issuing equity shares
----------------------
Answers to Check your Progress ----------------------

1. Capitalisation refers to sources of procurement of long-term finance and
----------------------
capital structure refers to the mix, in which the various sources long-term
finance should be used. ----------------------
2. Capital structure means deciding mix of sources from which the funds
----------------------
required by a business are raised.
3. Funds can be procured from external sources and internal sources. ----------------------
4. Debt capital involves contractual obligation as to the payment of interest ----------------------

and repayment of capital sum.
----------------------
5. Interest must be paid irrespective of profits.
----------------------
1. False ----------------------
2. False ----------------------
3. True ----------------------
Notes 4. True
5. False
----------------------
----------------------
i. b
---------------------- ii. d
---------------------- iii. e
iv. a
----------------------
v. c
---------------------- 1. True
2. False
----------------------
3. True
---------------------- 4. False
---------------------- 5. False
----------------------
Fill in the Blanks.
----------------------
1. While assigning weights to various sources of funds, weights may be in the
---------------------- form of book value of funds or market value of funds.
2. For calculation of composite cost of capital, cost of funds and weights are
---------------------- required to be multiplied.
---------------------- 3. The composite cost is calculated by dividing total weighted cost by the
total weights.
----------------------
4. If total of weighted cost is Rs.50,000 and total of weights is Rs.5,00,000,
---------------------- then the composite cost is 10%.
----------------------
1. True
----------------------
2. False
---------------------- 3. True
---------------------- 4. False
5. True
----------------------

---------------------- 1. Prasanna Chandra, Prasanna. Financial Management
---------------------- 2. Eugene Brigham, Joel Houston. Fundamentals of Financial Management,
Concise Edition
----------------------
Leverages and Theories of Capital Structure
UNIT
6
Structure:
6.1 Introduction
6.2 Concept of Leverages
6.3 Leverages
6.4 Theories of Capital Structure
Summary
Keywords
Problems
Suggested Reading
Leverages and Theories of Capital Structure 93

Notes
Objectives
----------------------
----------------------
• Explain the concept of leverages and theories of capital structure
----------------------
• Recognize the different types of leverages
---------------------- • Elaborate on the significance of operating, financial and combined
leverage
----------------------
• Analyse various theories of capital structure
----------------------
---------------------- 6.1 INTRODUCTION

---------------------- A finance manager has to estimate the requirement of funds for meeting the
laid down objectives of the concern. He procures the estimated funds. Before
---------------------- procuring these funds, he determines the best mix of such funds or decides about
---------------------- the capital structure of the concern. The desired structure of funds influences
the shareholder’s return and risk. Leverages analysis is the technique used by
---------------------- business firms to quantify risk-return relationship of different alternative capital
structures.
----------------------
---------------------- 6.2 CONCEPT OF LEVERAGES

---------------------- Before we go ahead with discussing the concept of Leverages, consider the
following example–Let us assume that there are two companies A and B, which
---------------------- are exactly similar to each other in terms of nature of business, size, extent of
---------------------- turnover etc. As such, the amount of capitalisation is also the same for both the
companies, which is assumed to be Rs. 10,000. However, strategies for raising
---------------------- the capital are different from each other. Assuming that the required capital can
be raised by way of equity or debt, following particulars are available:
----------------------
Company A Company B
---------------------- Equity Share capital
(Each Share of Rs. 10 each) 1,000 9,000
---------------------- 10% Debentures 9,000 1,000
---------------------- 10,000 10,000
Profitability statements of both the companies when the sales are Rs. 20,000
---------------------- and Rs. 18,000 are as below:
---------------------- Company A Company B
a) Sales 20,000 18,000 20,000 18,000
---------------------- b) Less : Variable Cost 10,000 9,000 10,000 9,000
c) Contribution (c = a-b) 10,000 9,000 10,000 9,000
----------------------
d) Less : Fixed Cost 5,000 5,000 5,000 5,000
---------------------- e) PBIT : (e = c-d) 5,000 4,000 5,000 4,000
f) Less : Interest 900 900 100 100
---------------------- g) PBT (g = e-f) 4,100 3,100 4,900 3,900
Company A Company B Notes
h) Less : Income Tax @50% 2,050 1,550 2,450 1,950
i) PAT (i = g-h) 2,050 1,550 2,450 1,950 ----------------------
j) Number of Equity Shares 100 100 900 900
----------------------
k) Earnings per share (k = j ) 20.50 15.50 2.72 2.16
It can be noted from the above example that A Ltd. is able to earn more ----------------------
amount per equity share because in its capital structure, the amount of debentures
----------------------
is more and also because the interest paid on debentures is tax-deductible
expenditure and amount of tax is less in case of A Ltd. ----------------------
It can also be noted from the above example that a 10% reduction in sales
----------------------
in case of A Ltd. reduces the earnings per share by around 24% while the same
percentage of reduction in sales in case of B Ltd. reduces the earnings per share ----------------------
by around 20%. It happens so because the risk of reduction in sales and earnings
gets distributed among less number of equity shares in case of company A Ltd., ----------------------
while the said risk gets distributed among more number of equity shares in case
----------------------
of company B Ltd.
Explanations: ----------------------
Operating costs incurred by a company can be classified into three categories: ----------------------
a. Variable Cost ----------------------
b. Fixed Cost
----------------------
c. Semi-variable Cost
----------------------
Fixed Cost is the cost, which remains constant irrespective of changes in
the sales revenue, at least over a shorter span of time. ----------------------
Variable Cost is the cost, which varies, in direct proportion to the sales ----------------------
revenue.
Semi-variable Cost lies in between the two extremes of fixed cost and ----------------------
variable cost. Such costs remain constant up to a certain sales revenue and ----------------------
increase if the sales revenue increases beyond a certain point. There may be some
statistical or mathematical techniques available whereby the semi-variable cost ----------------------
can be segregated into the fixed cost component and variable cost component.
Hence, let us assume that the costs can be either fixed costs or variable costs. ----------------------
Difference between the sales revenue and variable cost is referred to as ----------------------
contribution or marginal contribution. Significance of the term contribution is
that it is equated with the term profits over a shorter period, as the fixed cost ----------------------
remains the same at all levels of activities. As such, sales revenue generated by ----------------------
the company after deducting the variable cost incurred for the same contributes
towards the profit, which is technically referred to as contribution. The operating ----------------------
profit earned by the company is in the form of contribution duly reduced by the
fixed operating cost. ----------------------
As such, using the above-referred terms, the operating statement of a ----------------------

company can be presented as below
----------------------

Notes Sales Revenue
Less : Variable Operating Cost
----------------------
Contribution
----------------------
Less : Fixed Operating Cost
----------------------
Operating Profit
----------------------
Breakeven point is that level of sales revenue at which there is no profit or
---------------------- no loss. Till the sales revenue reaches the breakeven point, the company incurs
the losses. It is only after crossing the breakeven point that the profit generating
---------------------- capacity of the company starts. As such, it is the intention of every company to
reach the breakeven point as early as possible.
----------------------
The essential implication of high fixed cost in the cost structure is that
---------------------- the breakeven point is high which indicates that the amount of sales revenue a
---------------------- company is required to generate to be in a no profit no loss situation is very high
which makes the company a very risky proposition.
---------------------- The operating profit earned by a company is also referred to as Profit
---------------------- Before Interest and Taxes (PBIT) in financial terms. After the level of operating
profit, the company is contractually required to pay the interest on the long-term
---------------------- borrowed capital like debentures, term loans etc. The amount of profit earned
after recovering the interest on long-term sources of capital is referred to as
---------------------- Profit Before Taxes (PBT). The company is required to pay the taxes as per
---------------------- the provision of Income Tax Act, 1961 after the amount of profit before taxes
is arrived at. Profit remaining after the payment of income tax is referred to as
---------------------- Profit After Taxes (PAT). This profit can be distributed among the owners of the
company by way of dividend.
----------------------
We have already seen that before the company can pay the dividend on
---------------------- Equity Shares, it is bound to pay the dividend on Preference Shares. After
paying the dividend on preference shares, remaining profits can be distributed
----------------------
among the equity shareholders by way of dividend and hence are referred to as
---------------------- distributable profits.
In financial terms, Profit Before Interest and Taxes (PBIT) can be referred
----------------------
as Earnings Before Interest and Taxes (EBIT) and Profit After Tax (PAT) can be
---------------------- referred to as Earnings After Tax (EAT).
Using the above terms, the profitability statement of a company takes the
----------------------
following form:
---------------------- Profit before Interest and Taxes (PBIT)
---------------------- Less : Interest on long term borrowings
Profit before Taxes (PBT)
----------------------
Less : Taxes
---------------------- Profit after Taxes (PAT)
Less : Preference Dividend
----------------------
Distributable Profits for Equity
If both the calculations are merged, the following relationship emerges. Notes
Sales Revenue
----------------------
Less : Variable Operating Cost
Contribution ----------------------
Less : Fixed Operating Cost
----------------------
Profit before Interest and Taxes (PBIT)
Less : Interest on Long term borrowings ----------------------
Profit before Taxes (PBT) ----------------------
Less : Taxes
----------------------
Profit after Taxes (PAT)
Less : Preference Dividend ----------------------
Distributable Profits for Equity ----------------------
In continuation of these calculations, the following two calculations are made ----------------------
very frequently in practical situations
----------------------
Earnings Per Share (EPS)
Earnings Per Share is a very widely used ratio to measure the profits available ----------------------
to the equity shareholders on a per share basis. ----------------------
EPS is calculated as:
----------------------
Profit after Tax - Preference Dividend
----------------------
----------------------
EPS is calculated on the basis of current profits and not on the basis of retained
profits. EPS does not indicate the amount of profits distributed among the owners ----------------------
by way of dividend and also the amount of profits retained in the business.
----------------------
This calculation is very significant for an investor in equity shares as higher
EPS indicates higher amount of profits available to him. ----------------------
Price Earning Ratio (P/E Ratio) ----------------------
Price Earning Ratio indicates the price currently being paid in the stock market
----------------------
for every one rupee of EPS.
P/E Ratio is calculated as: ----------------------
Market Price Per Share ----------------------
Earnings Per Share ----------------------
P/E Ratio is of great significance to an operator on the stock exchange ----------------------
buying and selling the shares. An ideal investor makes a comparison between
the current market price and future EPS as the market value of shares depends ----------------------
upon the future EPS also.
----------------------
----------------------

Notes
----------------------

1. The operating profit earned by a company is also referred to as _______
----------------------
in financial terms.
---------------------- 2. The Price Earning Ratio indicates the price _______ being paid in the
stock market for every one rupee of EPOS.
----------------------
----------------------
Activity 1
----------------------
---------------------- Study the contents of profitability statement of a company and draw a

standard statement.
----------------------
---------------------- 6.3 LEVERAGES
---------------------- In very simple words, the term leverage measures relationship between two
---------------------- variables. In financial analysis, the term leverage represents the influence of
one financial variable over some other financial variable. In financial analysis,
---------------------- generally three types of leverages may be computed:
---------------------- 1. Operating Leverage

It measures the effect of change in sales quantity on Earnings Before
----------------------
Interest and Taxes (EBIT). It is computed as:
---------------------- Sales - Variable Cost (i.e. Contribution)
---------------------- Earnings before interest and tax
---------------------- Contribution
Operating Leverage =
EBIT
----------------------
Indications:
----------------------
A high degree of operating leverage means that the component of fixed
---------------------- cost is too high in the overall cost structure. A low degree of operating average
means that the component of fixed cost is less in the overall cost structure. In
----------------------
other words, operating leverage measures the impact of percentage increase or
---------------------- decrease in sales on earnings before interest and taxes.
---------------------- E.g. In the example cited above, when sales are Rs. 20,000 contribution
is Rs. 10,000 and earnings before interest and taxes are Rs. 5,000. As such
---------------------- operating leverage can be calculated as:
----------------------
----------------------
Operating Leverage = Contribution Notes
EBIT
= Rs. 10,000 ----------------------
Rs. 5,000 ----------------------
= 2
----------------------
It means that every 1% increase in contribution will increase the EBIT
by 2% and vice versa. As such, when contribution is Rs. 9,000 instead of Rs. ----------------------
10,000 i.e. the contribution is reduced by 10%, the EBIT is reduced by 20% i.e. ----------------------
the EBIT has become Rs. 4,000 instead of Rs. 5,000.
2. Financial Leverage: ----------------------
It indicates the firm’s ability to use fixed financial charges to magnify the ----------------------
effects of changes in EBIT on the firm’s EPS. It indicates the extent to
----------------------
which the Earnings Per Share (EPS) will be affected with the change in
Earnings Before Interest and Tax (EBIT). It is computed as: ----------------------
EBIT EBIT
= ----------------------
EBIT - Interest EBT
Indications: ----------------------
A high degree of financial leverage indicates high use of fixed income
bearings securities in the capital structure of the company. A low degree of ----------------------
financial leverage indicates less use of fixed income bearing securities in the ----------------------
capital structure of the company.
----------------------
E.g. In the example cited above, in case of A Ltd., the EBIT is Rs. 5,000
and interest on debentures is Rs. 900, when sales are Rs. 20,000 whereas in case ----------------------
of B Ltd., the EBIT is Rs. 5,000 and interest on debentures is Rs. 100 when
sales are Rs. 20,000. As such, the degree of financial leverage can be computed ----------------------
as:
----------------------
EBIT
EBIT- Interest ----------------------
A Ltd. B Ltd. ----------------------

Rs. 5,000 Rs. 5,000 ----------------------
Financial leverage = =
Rs. 5,000 - Rs. 900 Rs. 5,000 - Rs. 100
----------------------
Rs. 5,000 Rs. 5,000
= = ----------------------
Rs. 4,100 Rs. 4,900
= 1.22 = 1.02 ----------------------
----------------------
High degree of financial leverage is supported by the knowledge of the
fact that in the capital structure of A Ltd, 90% is the debt capital component, ----------------------
whereas in case of B Ltd., 10% is the debt capital component.
----------------------
It means that in case of A Ltd. every 1% increase in EBIT will increase
EPS by 1.22% and vice versa. ----------------------

Notes As such, when EBIT is reduced from Rs. 5,000 to Rs. 4,000 (i.e. 20%
reduction), EPS of A Ltd. is reduced from Rs. 20.50 to Rs. 15.50 (i.e. 24.40%
---------------------- reduction) and EPS of B Ltd. is reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.40%
reduction).
----------------------
Uses of Financial Leverage:
----------------------
The degree of financial leverage gives an indication regarding the extent
---------------------- to which EPS may be affected due to every change in EBIT.As the use of debt
capital in the capital structure increases the EPS, the company may like to
---------------------- use more and more debt capital in its capital structure by using the financial
leverage.
----------------------
As explained in the example cited above, EPS in case of A Ltd. is Rs. 20.50
---------------------- when sales are Rs. 20,000, as 90% of its capital is debt capital. But in case of
B Ltd. EPS is only Rs. 2.72 when sales are Rs. 20,000, as only 10% of its total
----------------------
capital is debt capital. As such, the phrase is often used that financial leverage
---------------------- magnifies both profits and losses’.
---------------------- However, though financial leverage magnifies the profits as well as EPS, the
use of debt capital beyond a certain limit will not necessarily give a favourable
---------------------- impact. Use of financial leverage is useful as long as debt capital costs less than
what it earns. It reduces profits or EPS if it costs more than what it earns. As
---------------------- such, financial leverage also acts as a guideline in setting maximum limit up to
---------------------- which the company should use the debt capital.
However, the technique of financial leverage suffers from some limitations.
----------------------
Limitations:
----------------------
i. It ignores implicit cost of debt. It assumes that the use of debt capital may
---------------------- be useful so long as the company is able to earn more than the cost of debt,
i.e. interest. But it is not always correct. Increasing use of debt capital
---------------------- makes the investment in the company a risky proposition, as such the
market price of the shares may decline, which may not be maximising the
----------------------
shareholders’ wealth. Before considering the capital structure, the implicit
---------------------- cost of debt should be considered.
ii. It assumes that cost of debt remains constant regardless of degree of
----------------------
leverage, which is not true. With every increase in debt capital, the interest
---------------------- rate goes on increasing due to the increased risk involved with the same.
---------------------- 3. Combined Leverage:

The combined effect of operating leverage and financial leverage measures
---------------------- the impact of charge in contribution on EPS.
---------------------- It is computed as:
---------------------- Operating Leverage X Financial Leverage
---------------------- Sales - Variable Cost EBIT

= X
EBIT EBIT - Interest
----------------------

Sales - Variable Cost Notes
=
EBIT - Interest
----------------------
Combined Leverage = Contribution ----------------------
EBT
----------------------
In the example cited above, in case of both A Ltd. and B Ltd., when sales are
----------------------
Rs. 20,000, contribution is Rs. 10,000 but earnings after interest and before tax
are Rs. 4,100 and Rs. 4,900 respectively. As such, combined leverage can be ----------------------
computed as:
Sales - Variable Cost (i.e. contribution) ----------------------
EBIT - Interest ----------------------

A Ltd. B Ltd. ----------------------
Rs. 10,000 Rs. 10,000
= = ----------------------
Rs. 4,100 Rs. 4,900
----------------------
= 2.44 = 2.04
It means that in case of A Ltd. every 1% increase in contribution will ----------------------
increase EPS by 2.44% and vice versa, while in case of B Ltd. every 1% increase ----------------------
in contribution, will increase EPS by 2.04%. As such when contribution gets
reduced from Rs. 10,000 to Rs. 9,000 i.e. 10% reduction, EPS of A Ltd. gets ----------------------
reduced from Rs. 20.50 to Rs. 15.50 (i.e. 24.4% reduction) and EPS of B Ltd.
gets reduced from Rs. 2.72 to Rs. 2.16 (i.e. 20.4 reduction). ----------------------
Indications: ----------------------
The indications given by the combined effect of operating and financial ----------------------
leverages may be studied under the following possible situations:
----------------------
1. High Operating Leverage, High Financial Leverage:
It indicates a very risky situation as a slight decrease in sales and/or ----------------------
contribution may affect the EPS to a very great extent. As far as possible, ----------------------
this situation should be avoided.
2. High Operating Leverage, Low Financial Leverage: ----------------------
It indicates that a slight decrease in sales and/or contribution may affect ----------------------
EBIT largely due to existence of high fixed cost but this possibility is
already taken care of by low proportion of debt capital in the overall capital ----------------------
structure. ----------------------
3. Low Operating Leverage, High Financial Leverage:
----------------------
It indicates that the decrease in sales/contribution will not affect EBIT
greatly as the component of fixed cost is negligible in the overall cost ----------------------
structure. As such, the company has accepted the risk of borrowing more
----------------------
debt capital in order to increase EPS to the maximum possible extent. This
may be considered to be an ideal situation. ----------------------

Notes 4. Low Operating Leverage, Low Financial Leverage:
It indicates that the decrease in sales/contribution will not affect EBIT
----------------------
largely as the component of fixed cost is negligible in the overall cost
---------------------- structure. But still, the company has not accepted the risk of having a large
component of debt capital in its capital structure. It may indicate a very
---------------------- cautious policy followed (unnecessarily) by the management, as it will not
maximise the shareholders’ wealth. At the same time, it may also indicate
----------------------
that the company is not utilising its borrowing capacity properly and fully.
----------------------
----------------------
---------------------- 1. The term leverage measures relationship between two variables.

2. Operating leverage is calculated by dividing Fixed Costs by Earnings
---------------------- Before Interest and Tax.
---------------------- 3. Use of financial leverage is useful as long as equity capital costs less
than what it earns.
----------------------
----------------------
Activity 2
----------------------
Study the level of Financial Leverage from the Balance Sheet of a Company
----------------------
and note down the limitations of the same.
----------------------
---------------------- 6.4 THEORIES OF CAPITAL STRUCTURE

---------------------- In the previous pages, we have seen that the introduction of debt capital
in the capital structure increases the earning per share of equity shareholders.
----------------------
We have also seen that the introduction of debt capital increases the risk also
---------------------- which is the risk of insolvency due to non-availability of cash and variability
of earnings available to equity shareholders. As such, increasing the debt
---------------------- component beyond a certain limit will not increase the earnings per share. If
debt component crosses a particular limit, the expectations of the lenders of
----------------------
money also increase due to the risk factor involved. Similarly, the shareholders
---------------------- also will demand a higher rate of return on their investment to compensate for
the risk arising out of additional amount of debt capital in the capital structure.
---------------------- As such, introduction of a heavy amount of debt capital in the capital structure
will not only reduce the valuation of the firm but will also increase the cost of
----------------------
capital.
---------------------- However, this view is not universally accepted. It is not an accepted
principle that the valuation of a firm and its cost of capital may be affected
----------------------
by the change in financing mix. Different views have been expressed in this
---------------------- context. We will classify these views in the form of the following four theories

of capital structure. Notes
(a) Net Income Approach
----------------------
(b) Net Operating Income Approach
----------------------
(c) Traditional Approach
(d) Modigliani - Miller Approach ----------------------
For this purpose, following assumptions have been made: ----------------------

1. Firms use only long-term debt capital or equity share capital to raise funds. ----------------------
2. Corporate Income Tax does not exist.
----------------------
3. Firms follow policy of paying 100% of its earnings by way of dividend.
----------------------
4. Operating earnings are not expected to grow.
Following definitions and symbols are also used: ----------------------
Following definitions and symbols are also used. ----------------------

S = Market Value of equity shares ----------------------
B = Market Value of debt
----------------------
V = Total Market Value of firm
----------------------
NOI = Net Operating Income i.e. EBIT
I = Total Interest Payments ----------------------
NI = Net Income available to equity shareholders. ----------------------

i.e. EBIT - I = EBT ----------------------
EBIT ----------------------
Overall cost of capital =
V
----------------------
a) Net Income Approach:
According to this approach as proposed by Durand, there exists a direct ----------------------
relationship between the capital structure and valuation of the firm and
----------------------
cost of capital. By the introduction of additional debt capital in the capital
structure, the valuation of the firm can be increased and cost of capital can ----------------------
be reduced and vice versa.
----------------------
To explain the approach more precisely, we will consider the following example:
Present 50% 50% ----------------------
Position Increase in Decrease in ----------------------
Debt Capital Debt Capital
Rs. Rs. Rs. ----------------------
8% Debentures 6,00,000 9,00,000 3,00,000
NOI i.e. EBIT 1,50,000 1,50,000 1,50,000 ----------------------
Interest 48,000 72,000 24,000 ----------------------
NI i.e. EBT 1,02,000 78,000 1,26,000
Equity Capitalisation Rate 10% 10% 10% ----------------------

Notes Market value of Equity Shares (S) 10,20,000 7,80,000 12,60,000
Market value of Debentures (B) 6,00,000 9,00,000 3,00,000
---------------------- Total value of firm V = S + B 16,20,000 16,80,000 15,60,000
---------------------- Overall cost of capital 9.26% 8.93% 9.62%
It can be seen from above, that by the increase in debentures, the total value
---------------------- of the firm increases and cost of capital reduces and vice versa. However, this
---------------------- will hold good only if the cost of debentures i.e. rate of interest is less than the
equity capitalisation rate.
----------------------
b) Net Operating Income Approach:
---------------------- According to this approach, also proposed by Durand, the valuation of the
firm and its cost of capital are independent of its capital structure. Any change
----------------------
in the capital structure does not affect the value of the firm or cost of capital,
---------------------- though the further introduction of debt capital may increase equity capitalisation
rate and vice versa.
----------------------
To explain the approach, more precisely, we will consider the following example.
---------------------- Present 50% 50%
---------------------- Position Increase in Decrease in
Debt Capital Debt Capital
---------------------- Rs. Rs. Rs.
8% Debentures 6,00,000 9,00,000 3,00,000
---------------------- Overall Capitalisation Rate 10% 10% 10%
---------------------- EBIT 1,50,000 1,50,000 1,50,000
Total value of firm (V) 15,00,000 15,00,000 15,00,000
---------------------- Overall cost of capital 1,50,000 1,50,000 1,50,000
15,00,000 15,00,000 15,00,000
---------------------- EBIT/V 10% 10% 10%
Market value of Debentures (B) 6,00,000 9,00,000 3,00,000
---------------------- Market value of Equity shares (S)
---------------------- i.e.V-B 9,00,000 6,00,000 12,00,000
Interest 48,000 72,000 24,000
---------------------- Equity Capitalisation Rate
EBIT-I 1,02,000 78,000 1,26,000
----------------------
V-B 9,00,000 6,00,000 12,00,000
----------------------
11.3% 13% 10.5%
---------------------- It can be seen from the above that the market value of the firm remains
unaffected by change in the capital structure. However, the introduction of
----------------------
additional debentures increases the equity capitalisation rate and vice versa.
---------------------- c) Traditional Approach:
---------------------- This is the mean between two extreme approaches of net income approach
on one hand and net operating income on another. It believes the existence
---------------------- of what may be called ‘Optimal Capital Structure’. It believes that up to a
---------------------- certain point, additional introduction of debt capital, in spite of increase in

cost of debt capital and equity capitalisation rate individually, the overall Notes
cost of capital will reduce and total value of the firm will increase. Beyond
the point, the overall cost of capital will tend to rise and total value of the ----------------------
firm will tend to reduce. Thus, for the judicious mix of debt and equity
capital, it is possible for the firm to minimise overall cost of capital and ----------------------
maximise total value of the firm. Such a capital structure where overall ----------------------
cost of capital is minimum and total value of the firm is maximum is called
‘Optimal Capital Structure’. ----------------------
To explain this approach, more precisely, we will consider the following ----------------------
example:
----------------------
No Debt 5%n 8% Debentures
Debentures Rs. Rs. 6,00,000 ----------------------
3,00,000
EBIT 1,50,000 1,50,000 1,50,000 ----------------------
Less :
Interest on debentures – 15,000 48,000 ----------------------
NI i.e. EBT 1,50,000 1,35,000 1,02,000
Cost of Equity Capital 10% 11% 12% ----------------------
Market value of Equity Shares (S) 15,00,000 12,27,273 8,50,000
----------------------
Market value of Debentures (B) 0 3,00,000 6,00,000
Total value of firm i.e. V = S + B 15,00,000 15,27,273 14,50,000 ----------------------
EBIT 1,50,000 x 100 1,50,000 x 100 1,50,000 x 100
Overall capital cost = ----------------------
V 15,00,000 15,27,273 14,50,000
= 10% = 9.82% = 10.34% ----------------------
It can be seen from the above neither the no-debentures position nor the
----------------------
position where debentures are issued to the extent of Rs. 6,00,000 minimise
the overall cost of capital or maximise the total value of the firm. It is when ----------------------
debentures are issued to the extent of Rs. 3,00,000 that the overall cost of capital
is minimum and total value of the firm is maximum, hence that is the Optimal ----------------------
Capital Structure.
----------------------
d) Modigliani - Miller (MM) Approach:
----------------------
This approach closely resembles net operating income approach.
According to this approach, value of the firm and its cost of capital are ----------------------
independent of its capital structure. It argues, that overall cost of capital
is the weighted average of cost of debt capital and cost of equity capital. ----------------------
Cost of equity capital depends upon shareholders’ expectations. Now, if ----------------------
shareholders expect 10% from a certain company, they already take into
consideration debt capital in the capital structure. For every increase in debt ----------------------
capital the expectations of the shareholders also increase as in the eyes of
shareholders, risk in the company also increases. Thus, each change in the ----------------------
mix of debt capital and equity capital is automatically offset by change in ----------------------
the expectations of the shareholders, which in turn is attributable to change
in risk element. As such, they argue that, leverage i.e. mix in debt capital ----------------------
and equity capital, has nothing to do with overall cost of capital and overall
cost of capital is equal to the capitalisation rate of pure equity stream of a ----------------------

Notes risk class. Hence, leverage has no impact on share market prices or cost of
capital.
----------------------
----------------------
---------------------- Multiple Choice Single Response.

---------------------- 1. High Operating Leverage, High Financial Leverage indicates
---------------------- i. A very risky situation as slight decrease in sales/contribution may

affect EPS to a great extent
---------------------- ii. A very comfortable position of finance
---------------------- iii. A position of high returns and rewards
---------------------- iv. A position of very low returns and rewards
2. In the context of theories of capital structure, NOI means:
----------------------
i. Net Operating Income, i.e. EBIT
----------------------
ii. Non-Operating Income
----------------------
iii. New Obligatory Income
---------------------- iv. Non Objectionable Income
----------------------
---------------------- Activity 3
---------------------- Through a diagram, explain the components of Net Income Approach.

----------------------
---------------------- 6.5 ILLUSTRATIVE PROBLEMS

---------------------- 1. Assuming no taxes and given the earnings before interest and taxes (EBIT),
interest (I), at 10% and equity capitalisation rate (K), below, calculate the
---------------------- total market value of each firm:
---------------------- Firms EBIT I K
Rs. Rs.
----------------------
X 2,00,000 20,000 12.0%
----------------------
Y 3,00,000 60,000 16.0%
---------------------- Z 5,00,000 2,00,000 15.0%
---------------------- W 6,00,000 2,40,000 18.0%
---------------------- Also determine the weighted average cost of capital for each firm.
----------------------
----------------------

Firm X Firm Y Firm Z Firm W Notes
EBIT Rs. 2,00,000 3,00,000 5,00,000 6,00,000
Interest Rs. 20,000 60,000 2,00,000 2,40,000 ----------------------
NI (Net Income available to
----------------------
the shareholders) Rs. 1,80,000 2,40,000 3,00,000 3,60,000
Equity Capitalisation Rate 12% 16% 15% 18% ----------------------
Market value of Equity Shares* (S) Rs. 15,00,000 15,00,000 20,00,000 20,00,000
Market value of debt (B)* Rs. 2,00,000 6,00,000 20,00,000 24,00,000 ----------------------
Total value of the firm V = S + B Rs. 17,00,000 21,00,000 40,00,000 44,00,000
----------------------
Overall cost of capital
i.e. EBIT/V 10.59% 11.43% 7.50% 8.18% ----------------------
*Note : As the rate of interest i.e. 10% and the amount of interest is known, the
----------------------
amount of debt capital can be calculated as :
100 ----------------------
Amount of interest x
10 ----------------------
NI x 100
*Market value of Equity Shares =
Equity Capitalisation Rate ----------------------
2. Operating Leverage and Combined Leverage of a company is 2 and ----------------------
3 respectively at the present level of sales of 10,000 units. The selling
price per unit is Rs. 12 while its variable cost is Rs. 6. The company has ----------------------
no preference share capital. Applicable corporate income tax rate can be
----------------------
assumed to be 50%. The rate of interest on company’s debt is 16% p.a.
What is the amount of debt in the capital structure of the company? ----------------------
Solution: ----------------------
As Sales are Rs. 1,20,000 and Variable Cost is Rs. 60,000, Contribution is
known to be Rs. 60,000. ----------------------
As Operating Leverage is 2, Contribution / PBIT = 2 ----------------------

Hence, PBIT = Contribution / 2, i.e. Rs. 30,000 ----------------------
As Combined Leverage is 3, Contribution / PBT = 3
----------------------
Hence, PBT = Contribution / 3, i.e. Rs. 20,000.
As PBIT is Rs. 30,000 and PBT is Rs. 20,000, Interest will be Rs. 10,000. ----------------------
Rate of Interest is known to be 16%. Hence, the amount of debt capital in the ----------------------
capital structures will be
----------------------
10,000
x 100 = 62,500
16 ----------------------
3. The Capital Structure of a company is as below: ----------------------
Equity Share Capital
----------------------
(Each Share of Rs. 10) Rs. 60,000
10% Debentures Rs. 80,000 ----------------------
Retained Earnings Rs. 20,000 ----------------------

Notes Sales of the company are Rs. 6,00,000. Its variable operating cost is 40% of
sales and fixed operating cost is Rs. 1,00,000. Assuming the income tax rate of
---------------------- 50%,
---------------------- i. Calculate different types of leverages.
ii. Determine the likely level of PBIT if EPS is (a) Re.1 (b) Rs. 3 and (c) Re. 0.
----------------------
Profitability structure of the company will be as below:
----------------------
Sales Rs. 6,00,000
---------------------- – Variable Cost Rs. 2,40,000
---------------------- Contribution Rs. 3,60,000
---------------------- – Fixed Cost Rs. 1,00,000
EBIT Rs. 2,60,000
----------------------
– Interest Rs. 8,000
----------------------
EBT Rs. 2,52,000
---------------------- – Taxes Rs. 1,26,000
---------------------- Profit After Tax Rs. 1,26,000
---------------------- Calculation of leverage
(a) Operating Leverage:
----------------------
Contribution 3,60,000
---------------------- = = 1.38
EBIT 2,60,000
----------------------
(b) Financial Leverage:
---------------------- EBIT 2,60,000
= = 1.03
---------------------- EBT 2,52,000
(c) Combined Leverage:
----------------------
Contribution 3,60,000
---------------------- = = 1.43
EBT 2,52,000
---------------------- Calculation of EBIT
---------------------- We know that,
---------------------- 50% of (EBIT - Interest) = EPS

----------------------
We further know that
----------------------
Interest = Rs. 8,000
----------------------
No. of Equity shares = 6000
----------------------
----------------------

(a) 50% (EBIT - 8000) = 1 Notes
6000
----------------------
50% (EBIT - 8000) = 6000
1/2 EBIT - 4000 = 6000 ----------------------
1/2 EBIT = 10,000 ----------------------
EBIT = 20,000 ----------------------
(b) 50% (EBIT - 8000) = 3 ----------------------
6000
----------------------
... 50% (EBIT - 8000) = 18000
----------------------
... 1/2 EBIT - 4000 = 18000
... 1/2 EBIT = 22000 ----------------------
... EBIT = 44000 ----------------------
(c) 50% (EBIT - 8000) = 0 ----------------------

6000
----------------------
... 50% (EBIT - 8000) = 0
----------------------
... 1/2 EBIT - 4000 = 0
... 1/2 EBIT = 4000 ----------------------
... EBIT = 8000 ----------------------
----------------------
Summary
----------------------
• In financial analysis, leverage represents the influence of one financial
----------------------
variable over some other related financial variable. These financial
variables may be costs, output, sales revenue, Earning Before Interest and ----------------------
Tax (EBIT), Earning Per Share (EPS) etc.
----------------------
• There are three commonly used measures of leverage in financial analysis:
o Operating Leverage: Operating leverage is defined as the firm’s ability ----------------------
to use fixed operating costs to magnify effects of changes in sales on ----------------------
its earnings before interest and taxes.
o Financial leverage: Financial Leverage is defined as the ability of a ----------------------
firm to use fixed financial charges to magnify the effects of changes in ----------------------
EBIT /Operating profits, on the firm’s earning per share.
----------------------
o Combined Leverage: Combined leverage measures the effect of a %
change in Sales on % change in EPS. ----------------------
• Capital structure is the combination of different financial sources for the
----------------------
capital of the business in the most economical and efficient manner. There
are four theories, which are useful for determination of capital structure: ----------------------

Notes o Net Income approach: According to this approach, a firm can increase
its value or lower the overall cost of capital by increasing the proportion
---------------------- of debt in the capital structure.
---------------------- o Net Operating Income approach: According to this approach, the
market value of the firm is not affected by the capital structure changes.
----------------------
o Traditional approach: According to this approach, the firm should
---------------------- strive to reach the optimal capital structure and increase its total valuation
through a judicious use of the both equity and debt.
----------------------
o Modigliani -Miller approach: According to this approach, the total
---------------------- cost of capital of particular firm is independent of its methods and
level of financing.
----------------------
---------------------- Keywords
---------------------- • Leverage: Leverage represents the influence of one financial variable over
some other related financial variable.
----------------------
• Financial Leverage: The ability of a firm to use fixed financial charges to
---------------------- magnify the effect of changes in EBIT/Operating Profits.
---------------------- • Combined Leverage: Measures the effect of a percentage change in Sales
on percentage change in EPS.
----------------------
---------------------- Self-Assessment Questions

---------------------- 1. What do you mean by the term ‘Leverages’? Explain it with an example.
---------------------- 2. What are the different types of leverages? Explain the indication of each
type of leverages.
----------------------
3. Discuss the combined effect of the operating leverage and financial
---------------------- leverage.
4. What do you mean by the term ‘Optimal Capital Structure’? What is its
----------------------
link with cost of capital?
---------------------- 5. Explain Net income approach of capital structure.
---------------------- 6. Write short notes on the following:
---------------------- a. Operating and Financial Leverage
b. Traditional Approach
----------------------
c. Modigliani-Miller Approach
----------------------
----------------------
----------------------
----------------------

PROBLEMS Notes
1. An analytical statement of AB company is shown below. It is based on an ----------------------
output (sales) level of 80,000 units.
----------------------
Rs.
Sales 9,60,000 ----------------------
Variable Cost 5,60,000 ----------------------
Revenue before fixed costs 4,00,000
----------------------
Fixed costs 2,40,000
EBIT 1,60,000 ----------------------
Interest 60,000
----------------------
Earnings before tax 1,00,000
Tax 50,000 ----------------------
Net Income 50,000 ----------------------
Calculate the degree of ----------------------
(i) Operating leverage ----------------------
(ii) Financial Leverage
----------------------
(iii) Combined Leverage
----------------------
Calculate the degree of
----------------------
i. Operating leverage
ii. Financial Leverage ----------------------
iii. Combined Leverage ----------------------

2. Calculate operating leverage and financial leverage under situations A, ----------------------
B and C and financial plans I, II and III respectively from the following
information relating to the operation and capital structure of XYZ Co. Also ----------------------
find out the combinations of operating and financial leverages, which give
the highest value and the least value. How are these calculations useful to ----------------------
the financial manager in a company? ----------------------
Installed capacity 1200 units
----------------------
Actual production and sales 800 units
Selling per unit Rs. 15 ----------------------
Variable cost per unit Rs. 10 ----------------------
Fixed Cost – Situation A Rs. 1,000
----------------------
Situation B Rs. 2,000
Situation C Rs. 3,000 ----------------------
----------------------
----------------------

Notes
Capital Structure Financial Plan
---------------------- I II II
Equity Rs. 5,000 Rs. 7,500 Rs. 2,500
---------------------- Debt (12%) Rs. 5,000 Rs. 2,500 Rs. 7,500
---------------------- 3. The selected financial data for A, B and C companies for the year ended
31st March, 2008 are as follows:
----------------------
A B C
---------------------- Variable Expenses as % of sales 66 2/3 75 50
Interest Expenses Rs. 200 Rs.300 Rs. 1000
---------------------- Degree of Operating Leverage 5-1 6-1 2-1
---------------------- Degree of Financial Leverage 3-1 4-1 2-1
Income Tax rate 50% 50% 50%
---------------------- Prepare Income statements for A, B and C Companies.
---------------------- 4. Calculate the degree of operating leverage, degree of financial leverage
and the degree of combined leverage for the following firms and interpret
---------------------- the results.
---------------------- B Q R
Output (Units) 3,00,000 75,000 5,00,000
----------------------
Fixed costs (Rs.) 3,50,000 7,00,000 75,000
---------------------- Unit Variable Cost (Rs.) 1.00 7.50 0.10
Interest Expenses (Rs.) 25,000 40,000 Nil
---------------------- Unit Selling Price (Rs.) 3.00 25.00 0.50
---------------------- 5. The following figures relate to two companies.
---------------------- (Rs. in Lakh)
P. Ltd. Q. Ltd.
----------------------
Sales 500 1000
---------------------- Variable costs 200 300
Contribution 300 700
---------------------- Fixed costs 150 400
PBIT 150 300
---------------------- Interest 50 100
---------------------- PBT 100 200
You are required to:
---------------------- i. Calculate the operating, financial and combined leverages for two
---------------------- companies.
ii. Comment on relative risk position for them.
----------------------
----------------------
----------------------
----------------------

Answers to Check your Progress Notes
1. The operating profit earned by a company is also referred to as Profit
Before Interest and Taxes (PBIT) in financial terms. ----------------------
2. The Price Earning Ratio indicates the price currently being paid in the ----------------------
stock market for every one rupee of EPOS.
----------------------
----------------------
1. True ----------------------
2. False ----------------------
3. False ----------------------
----------------------
----------------------
1. High Operating Leverage, High Financial Leverage indicates
i. A very risky situation as slight decrease in sales/contribution may ----------------------
affect EPS to a great extent ----------------------
2. In the context of theories of capital structure, NOI means:
----------------------
i. Net Operating Income, i.e. EBIT
----------------------
Suggested Reading ----------------------
1. Prasanna Chandra, Prasanna. Financial Management ----------------------
2. Eugene Brigham, Joel Houston. Fundamentals of Financial Management, ----------------------
Concise Edition
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Capital Budgeting
UNIT
7
Structure:
7.1 Introduction
7.2 The Process of Capital Budgeting
7.3 How to Compute Cash Flows
7.4 Time Value of Money
7.5 Techniques for Evaluation of Capital Expenditure Proposals
7.6 Limitations of Capital Budgeting
7.7 Evaluation Criteria in Certain Typical Situations
7.8 Planning, Organisation and Control of Capital Expenditure
7.9 Capital Rationing
7.10 Capital Budgeting and Risk
Summary
Keywords
Problems
Suggested Reading
Capital Budgeting 115

Notes
Objectives
----------------------
----------------------
• Define the steps involved in the process
----------------------
• Explain the concept of time value of money
---------------------- • Evaluate various techniques of capital expenditure proposals
---------------------- • Describe the concept of capital rationing
----------------------
---------------------- 7.1 INTRODUCTION

---------------------- As discussed in the earlier units, the finance function has to deal with one of the
most important decisions regarding the amount to be invested in fixed assets
----------------------
and the decision is technically in the form of ‘Capital Budgeting’. Thus, the
---------------------- capital budgeting decisions are decisions as to whether or not money should
be invested in long-term projects. It includes analysis of various proposals
---------------------- regarding capital expenditure to evaluate their impact on the financial situation
of the company and to choose the best out of the various alternatives. The
----------------------
function of finance in this area is to enable the management to take a proper
---------------------- capital budgeting decision.
Capital budgeting decisions are the most crucial and critical decisions for a
----------------------
business to take. This is the fact due to the various reasons.
---------------------- 1. Capital budgeting decisions have long-term implications on the operations
---------------------- of the business. A wrong decision may affect the long-term survival of the
Company. The investment in fixed assets more than required, may increase
---------------------- the operating costs of the Company. The inadequate investment in fixed
assets may make it difficult for the Company to compete and may affect its
---------------------- market share.
---------------------- 2. Capital budgeting decisions involve large amount of the funds. As such, it
is necessary to take the decision very carefully and to make the arrangement
---------------------- of the funds for the procurement of these assets.
---------------------- 3. The capital budgeting decisions are irreversible due to the fact that it is
difficult to find the market for such capital goods. The only alternative is to
---------------------- scrap these assets, which involves huge losses.
---------------------- 4. Capital budgeting decisions are difficult to make because it involves the
assessment of future events that are difficult to ascertain. The investments
----------------------
are required to be made immediately but the returns are expected over a
---------------------- number of years.
----------------------
----------------------

7.2 THE PROCESS OF CAPITAL BUDGETING Notes
The process of capital budgeting involves generally the following steps: ----------------------
1. Project Generation: The generation of the proposals may fall under any ----------------------
of the following categories:
(a) Additions to the present product line. ----------------------
(b) Expansion of the capacity of the existing product line. ----------------------
(c) Proposals to reduce costs of the existing product line without affecting
----------------------
the scale of operations.
The generation of the projects may take place at the levels of top ----------------------
management or at the level of workers also, e.g. Proposal to replace on
old machine or to improve the production techniques may originate at the ----------------------
worker’s level also. ----------------------
2. Project Evaluation: As in case of any types of decision-making, the
capital budgeting decisions also have two faces. Firstly, estimation of the ----------------------
benefits and costs measured in terms of cash flows. Secondly, selection ----------------------
of an appropriate criterion to judge the desirability of the projects. It
is necessary that the evaluation of the projects is done by an impartial ----------------------
group and experts in the field. Care must be taken to choose the criteria to
judge the desirability of the projects and it should be consistent with the ----------------------
company’s basic objective to maximise the wealth. ----------------------
3. Project Selection: There is no fixed and laid down procedure to select
the final criteria among the various available alternatives. Generally, the ----------------------
selection of the final project is done by the top management though it ----------------------
may be scrutinised at various levels. In many cases, top management may
delegate the authority to approve certain projects to lower management ----------------------
also.
----------------------
4. Project Execution: After the final selection of the project is made, the
funds are appropriated and the execution of the project is carried on. ----------------------
However, there has to be a proper system to check that the execution of the
----------------------
project is being made as per the predecided plans and schedules.
Evaluation of the Projects ----------------------
As discussed earlier, the process of evaluation of the projects necessarily ----------------------
involves the cost benefit analysis. This cost benefit analysis will generally be
made in financial terms, though in some cases non-financial considerations ----------------------
may also come into play. E.g., sometimes a project may be undertaken to get ----------------------
established in the market or to satisfy certain legal requirements or for some
social welfare benefits or just for some emotional reasons. However, financial ----------------------
cost benefit analysis will be the basic evaluation criteria.
----------------------
There are many techniques and tools to evaluate the various investment
proposals. But before going into the details of these various techniques, one ----------------------
most important aspect of the evaluation has to be studied and that is ‘how to
compute the cash flows?’ ----------------------

Notes
----------------------

1. The process of capital budgeting involves proposal to reduce _________
----------------------
without affecting _____________.
---------------------- 2. The process of evaluation of the projects necessarily involves
__________________.
----------------------
----------------------
---------------------- Activity 1
---------------------- Study a project and note down the important areas in which it needs evaluation.
----------------------
---------------------- 7.3 HOW TO COMPUTE CASH FLOWS
---------------------- As the estimation of cash flows – both outflows as well as inflows – is the
crux for evaluating the projects, this estimation should be made as carefully as
----------------------
possible. The following stages should be considered for this purpose.
---------------------- 1. Following items constitute the cash outflow.
---------------------- i. Cost of new equipment.
---------------------- ii. Cost for demolition of old equipment (similarly, if there is some scrap
value receivable from the disposal of the old equipment, the outflow
---------------------- on account of the new equipment should be suitably adjusted.)
---------------------- iii. Cost of preparing site and installation charges incurred with respect to
the new equipment.
----------------------
Following factors should also be taken into consideration.
---------------------- i. If the cost of the new equipment is not to be incurred in one single
installment, but is to be paid over a period of years, it will involve the
----------------------
cash outflow not only in the first year but in the subsequent years also.
---------------------- Similarly, if the cost of the equipment/project is met by raising the
term borrowing, the cash outflow will come into consideration as and
---------------------- when the installment of term borrowings and interest on the same are
paid.
----------------------
ii. If the new equipment/project brings certain scrap value after the
---------------------- useful life is over, the amount realised as scrap value will constitute
---------------------- the cash inflow, but in relation to the year in which the amount is
actually received.
---------------------- iii. In some cases, implementation of the project may involve investment
---------------------- in the form of additional working capital due to increased inventory,

increased debtors etc. This additional investment in working capital Notes
constitutes cash outflow. Similarly, after the useful life of the project
is over, this investment in the working capital is released and hence ----------------------
should be considered as inflow but only with respect to the year in
which it is so released. Further, if the company resorts to some outside ----------------------
source of funds for financing working capital requirements, the cash ----------------------
outflow on account of investment in working capital will be the
amount invested by the company itself. The amount received from the ----------------------
outside source of working capital finance constitutes the cash inflow.
----------------------
iv. If a new asset is intended to be purchased in order to replace an
existing asset, the sale proceeds of the old asset should be considered ----------------------
as the cash inflow and the cash outflow required to purchase the new
----------------------
asset should be adjusted accordingly.
2. Following factors should be considered while computing cash inflows: ----------------------
i. Computation of cash inflows highly depends upon correct estimation ----------------------
of production and sales. On the basis of the additional production units
which can be sold and the price at which they can be sold, the gross ----------------------
revenue from the project can be worked out. However, while doing so,
----------------------
the possibility of reduction in selling price, introduction of a cheaper
product by competitors, etc. should also be considered. ----------------------
ii. Second stage in deciding the cash inflows is to estimate the costs ----------------------
attached to the project. These costs may be in the form of fixed costs
or variable costs or depreciation. ----------------------
iii. The difference between the gross revenue and the costs give the result ----------------------
of the net revenue, which should be adjusted for the taxation factor
for computation of cash inflows as it involves the actual payment of ----------------------
cash. However, the amount of depreciation, if it is already included
in the cost to consider the taxation factor should be added back while ----------------------
computing the cash inflow as depreciation does not involve the cash ----------------------
outflow. In simple words, the cash inflows should be computed in the
following stages. ----------------------
Sales Revenue Less: Costs (including depreciation) Net Revenue ----------------------
Less: Tax Liability Revenue after taxes Add: Depreciation Net cash
inflow ----------------------
iv. Care should be taken not to include the cost of interest and dividends ----------------------
while considering the costs attached to the project. This is due to the
fact that for evaluating the proposals if cost of capital is considered ----------------------
as the discounting factor (as discussed in details later), the amounts
----------------------
of interest and dividend are already given due consideration while
computing the cost of capital. ----------------------
v. Sometimes, the cash inflows may be considered in terms of net savings
----------------------
in costs rather than in terms of excess of sales over the additional cost.
Thus, for computing the cash inflows, these savings in costs will be ----------------------

Notes the starting point, which will have to be adjusted further for taxation
and depreciation factor. The cash inflows will be computed as below.
----------------------
Saving in costs
---------------------- (Other than Depreciation)
---------------------- Less: Depreciation
---------------------- Net Saving in costs

Less: Taxliability
----------------------
Saving after tax
----------------------
Add: Depreciation
---------------------- Net Cash inflows
----------------------
7.4 TIME VALUE OF MONEY
----------------------
It has already been discussed that the evaluation of capital expenditure
---------------------- proposals involves the comparison between cash outflows and cash inflows.
The peculiarity of evaluation of capital expenditure proposals is that it involves
----------------------
the decisions to be taken today whereas the flow of funds- either outflow or
---------------------- inflow- may be spread over a number of years. It goes without saying that for a
meaningful comparison between the cash outflows and cash inflows, both the
---------------------- variables should be on a comparable basis. As such, the question that arises is
that “is the value of flows arising in future the same in terms of today?” E.g. If
----------------------
a proposal involves the cash inflow of Rs. 10,000 after one year, is the value
---------------------- of this cash inflow really Rs. 10,000 as on today when the capital expenditure
proposal is to be evaluated? The ideal reply to this question is ‘no’. The value
---------------------- of Rs. 10,000 received after one year is less than Rs. 10,000 if received today.
The reasons for this can be stated as below:
----------------------
(1) There is always an element of uncertainty attached with the future cash
---------------------- flows.
---------------------- (2) The purchasing power of cash inflows received after the year may be less
than that of equivalent sum if received today.
----------------------
(3) There may be investment opportunities available if the amount is received
---------------------- today, which cannot be exploited if the equivalent sum is received after
one year.
----------------------
E.g., if Mr. X is given the option that he can receive an amount of Rs. 10,000
---------------------- either today or after one year, he will most obviously select the first option.
Why? Because, if he receives Rs. 10,000 today he can always invest the same,
---------------------- say in the fixed deposits with a bank carrying the interest of 10% p.a. As such, if
---------------------- the choice is given to him, he will like to receive Rs. 10,000 today or Rs. 11,000
(i.e. Rs. 10,000 plus interest @ 10% p.a. on Rs. 10,000) after one year. If he has
---------------------- to receive Rs. 10,000 only after one year, the real value of the same in terms of
today is not Rs. 10,000 but something less than that. This concept is called time
---------------------- value of money.

In the capital budgeting decisions, if there has to be a meaningful comparison Notes
between the cash outflows and cash inflows which may arise in future at different
points of time whereas the evaluation is required to be done as on today, both ----------------------
the future cash outflows and cash inflows are required to be expressed in terms
of today. ----------------------
There are two techniques available for this: ----------------------

(a) Compounding: ----------------------
In this technique, the interest is compounded and becomes a part of the initial
----------------------
principal at the end of the compounding period.
E.g. If Mr. X invests Rs. 10,000 in fixed deposit carrying interest @ 10% p.a. ----------------------
compounded annually, at the end of first year, Rs. 10,000 will be worth Rs. ----------------------
11,000 (i.e. Rs. 10,000 + interest on Rs. 10,000 @ 10% p.a.). If Rs. 11,000
are reinvested in the same fixed deposit, at the end of second year Rs. 11,000 ----------------------
will be worth Rs. 12,100 (i.e. Rs. 11,000 + interest on Rs. 11,000 @ 10% p.a.).
In other words, the value of today’s Rs. 10,000, if received after two years, ----------------------
becomes Rs. 12,100. ----------------------
The compounding of interest can be calculated with the help of following
equation: ----------------------
A = P(1+i)n where, ----------------------

A = Amount at the end of the period ----------------------
P = Amount of principal at the beginning of the priod
----------------------
i = Rate of interest
----------------------
n = Number of years
In the above example, after two years, the value of today’s Rs. 10,000 if invested ----------------------
in the investment carrying the interest of 10% p.a. can be computed as follows: ----------------------
A = 10,000 x (1 + 0.10) 2
----------------------
= 10,000 x 1.21
----------------------
= Rs. 12,100
(b) Discounting: ----------------------
These techniques involve the process, which is exactly opposite to that involved ----------------------
in the technique of compounding. This technique tries to find out the present
value of Re. 1, if received or spent after n years, provided that the interest rate ----------------------
of i can be earned on investment. The present value is calculated with the help ----------------------
of the following equation.
P = A ----------------------
(1 + i)n ----------------------
where, ----------------------
P = Present value of sum received or spent
----------------------

Notes A = Sum received or spent in fulure
i = Rate of interest
----------------------
n = Number of years
----------------------
E.g., If Mr. X is given the opportunity to receive Rs. 10,000 after two years,
---------------------- when he can earn interest of 10% p.a. on his investment, what amount should
he invest today so that he may be able to receive Rs. 10,000 after two years?
----------------------
It can be computed as:
---------------------- P = A
---------------------- (1 + i)n
---------------------- 10,000
=
(1+0.10)2
---------------------- = Rs. 8,264.46
---------------------- In other words, if Mr. X invests Rs. 8,264.46 today in the investment carrying
interest rate of 10% p.a. he may be able to receive Rs. 10,000 after two years or
---------------------- the present value or Rs. 10,000 if received after two years is only Rs. 8,264.46
---------------------- as on today if investment opportunities are available to earn the interest of 10%
p.a.
----------------------
Present Value Tables
---------------------- To simplify the computation of present value, use can be made of the present
value of rupee one for the various interest rates (i) and years (n) for computing
----------------------
the present value of a future lump sum, the said sum can be multiplied by
---------------------- choosing the interest factor/discounting factor/present value factor for the
relevant combination of i and n.
----------------------
E.g. To find out the present value of Rs. 4,000 received after 7 years, assuming
---------------------- interest rate to be 15%, we ascertain the present value factor to be 0.513. We
ascertain the present value to be
----------------------
Rs. 4000 x 0.513
---------------------- = Rs. 2,052
---------------------- Present value of series of cash flows
---------------------- In capital budgeting decisions, the cash flows, either cash outflow or cash
inflow, may occur at various points of time. For finding out the present value
---------------------- of this series of cash flows, it is necessary to find out the present value of each
future cash flow and then aggregate them.
----------------------
----------------------
----------------------
----------------------
----------------------

Illustration I Notes
A project involves cash inflows as below.
----------------------
Year Cash Inflows Rs.
----------------------
1 10,000
2 12,000 ----------------------
3 15,000
----------------------
4 20,000
Assuming interest rate to be 15%, find out the present value of cash inflows. ----------------------
Solution: Calculation of present value of cash inflows.
----------------------
Year Cash inflows Present Value Total Present value
Rs. Factor 15% Rs. ----------------------
1 10,000 0.870 8,700 ----------------------
2 12,000 0.756 9,072
3 15,000 0.658 9,870 ----------------------
4 20,000 0.572 11,440 ----------------------
39,082
----------------------
Illustration II
A machine costing Rs. 1,00,000 is to be purchased as below: ----------------------
Rs. 20,000 - Down payment out of own contribution. ----------------------

Rs. 80,000 - Borrowing by way of tearn loan. To be paid in 4 equal annual ----------------------
instalment along with the interest @ 15% p.a. The interest
being computed on openng outstanding balance. ----------------------
Calculate present value of the cash outflow. ----------------------
Solution:
----------------------
Calculation of present value of cash outflows
----------------------
Year Principal sum/ Intestest Total outflow PV. Factor Total PV
Own Contribution Rs. Rs. 15% Rs. ----------------------
Rs.
----------------------
0 20,000 - 20,000 1,000 20,000
1 20,000 12,000 32,000 0.870 27,840 ----------------------
2 20,000 9,000 29,000 0.756 21.924
----------------------
3 20,000 6,000 26,000 0.658 17,108
4 20,000 3,000 23,000 0.572 13,156 ----------------------
1,00,028 ----------------------
If a project involves uniform cash flows, the present value of the cash flows can
be calculated by a short cut method. Instead of calculating present value for ----------------------
each cash flow and then summing up the present values, the discounting factors ----------------------
(interest factor or present value factors) themselves can be summed up to find
out the Accumulated Discounting Factor for the various interest rates (i) and ----------------------

Notes years (n) and the multiplication of Accumulated Discounting Factor and cash
flow will give present value of cash flow.
----------------------
Illustration III
---------------------- A project involves the cash inflow of Rs. 20,000 per year for 4 years. Assuming
the interest rate of 15%, find out the present value of cash inflows.
----------------------
Accumulated Discounting factor at 15% for 4 years is 2.855.
----------------------
Present value of cash inflows Rs. 20,000 x 2.855
---------------------- = Rs. 57,100.
---------------------- Relevance in Capital Budgeting Decisions
---------------------- As discussed earlier, to make the value of cash outflows and cash inflows
comparable, it is necessary to reduce future cash outflows or cash inflows to
---------------------- their present value by discounting them by proper discounting factor or interest
factor or present value factor. Usually, weighted average cost of capital is
----------------------
considered as the discounting factor in capital budgeting decisions.
----------------------
----------------------
---------------------- 1. Discounting is one of the technique to calculate Time Value of Money.

2. Compounding in time valuation of money usually refers to Interest.
----------------------
----------------------
7.5 TECHNIQUES FOR EVALUATION OF CAPITAL
----------------------
EXPENDITURE PROPOSALS
----------------------
Various techniques are available for evaluation of capital expenditure proposals.
---------------------- They can be broadly categorised under two heads:
---------------------- (a) Techniques not considering time value of money:

1. Payback period:
----------------------
Payback period indicates the period within which the cost of the project will be
---------------------- completely recovered. In other words, it indicates the period within which the
total cash inflows equal to the total cash outflows. Thus,
----------------------
Cash outlay
Payback period = Annual cash inflow
----------------------
----------------------
----------------------
----------------------
----------------------

Illustration I: Notes
A project requires an outlay of Rs. 5,00,000 and earns, an annual cash inflow of
Rs. 1,00,000 for 8 years. Calculate payback period. ----------------------
Payback period for the project is ----------------------
Rs. 5,00,000
= 5 years ----------------------
Rs. 1,00,000
----------------------
If the project involves unequal cash inflows, the payback period can be computed
by adding up the cash inflow till the total is equal to cash outlay. ----------------------
Illustration II ----------------------
A project requires an outlay of Rs. 1,00,000 and earns, the annual cash inflow or
Rs. 25,000, Rs. 30,000, Rs. 20,000 and Rs. 50,000. Calculate payback period. ----------------------
If we add up cash inflows, we find that in the first 3 years, an amount of Rs. ----------------------
75,000 of the cash outlay is recovered. Fourth year generates the cash inflow
----------------------
of Rs. 50,000, whereas the amount of Rs. 25,000 only remains to be recovered.
Assuming that the cash inflows occur evenly during the year, the time required ----------------------
to recover Rs. 25,000 will be
----------------------
Rs. 25,000
x 12 months = 6 months.
Rs. 50,000 ----------------------
Thus, the payback period is 3 years and 6 months. ----------------------
Acceptance Rule: ----------------------
Payback period method can be used as an accept or reject criteria or as a method
----------------------
of ranking the project. If the payback period computed for a project is more than
maximum payback period estimated by the management it would be rejected ----------------------
or vice versa. As a ranking method, the projects having shortest payback period
will be ranked highest. ----------------------
Advantages: ----------------------
1. It is quite simple to calculate and easy to understand. It makes it quite clear
----------------------
that there are no profits on a project unless payback period is over.
2. It costs less. ----------------------
3. It may be a suitable technique where risk of obsolescence is high. In ----------------------
such cases, projects with shorter payback period may be preferred as the
changes in technology may make other projects obsolete before their costs ----------------------
are recovered. ----------------------
Disadvantages:
----------------------
1. It does not consider the returns from a project after its payback period
is over. Thus, one project A may have a payback period of 5 years while ----------------------
another project B may have a payback period of 3 years, thus making project
----------------------
B more preferable. But it is quite possible that project A may generate good
cash inflows after 5 years till the end of 10 years, while project B may stop ----------------------

Notes generating cash inflows after 3 years only. In such cases, project A may
prove to be more advantageous.
----------------------
2. It may not be a suitable method to evaluate the projects if they involve
---------------------- uneven cash inflows.
3. It ignores time value of money.
----------------------
4. To decide the acceptable payback period is a difficult task. There is no
---------------------- rational basis for deciding the maximum payback period. It is a subjective
decision.
----------------------
2. Accounting Rate of Return:
----------------------
Accounting rate of return (ARR) computes the average annual yield on the
---------------------- net investment in the project. ARR is computed by dividing the average
profits after depreciation and taxes by net investments in the project. Thus,
---------------------- ARR can be computed as:
---------------------- Total Profits
x 100
Net investment in project x No. of years of profits
----------------------
---------------------- Total
Illustration:
----------------------
A project involves the investment of Rs. 5,00,000, which yields profits after
---------------------- depreciation and tax as stated below:
---------------------- Years Profits after depreciation and tax
1 Rs. 25,000
----------------------
2 Rs. 37,500
---------------------- 3 Rs. 62,500
4 Rs. 65,000
----------------------
5 Rs. 40,000
---------------------- Rs. 2,30,000
---------------------- At the end of 5 years, the machineries in the project can be sold for Rs. 40,000.
Find the ARR.
----------------------
The total profits after depreciation and taxes are Rs. 2,30,000.
---------------------- The net investment in the project will be Original cost Less salvage value i.e.
---------------------- Rs. 5,00,000 – Rs. 40,000 = Rs. 4,60,000
ARR will be
----------------------
Rs. 2,30,000 x 100 = 10%
---------------------- Rs. 4,60,000 X 5 years
---------------------- Acceptance Rule:
---------------------- As payback period method, ARR also can be used as accept or reject criteria
or as a method for ranking the projects. As accept or reject criteria, the projects
---------------------- having the ARR more than minimum rate prescribed by the management will

be accepted and vice versa. As a ranking method, the projects having maximum Notes
ARR will be ranked highest.
----------------------
Advantages:
1. It is simple to calculate and easy to understand. ----------------------
2. It considers the profits from the project throughout its life. ----------------------
3. It can be calculated from the accounting data. ----------------------
Disadvantages:
----------------------
1. It uses profits after depreciation and taxes and not the cash inflows for
evaluating the projects. ----------------------
2. It ignores time value of money. ----------------------
(b) Techniques considering time value of money
----------------------
1. Discounted Payback Period:
----------------------
This is an improvement over the payback period method in the sense that it
considers time value of money. Thus, discounted payback period indicates that ----------------------
period within which the discounted cash inflows equal the discounted cash
outflows involved in a project. ----------------------
Illustration: ----------------------
A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows ----------------------
of Rs. 35,000, Rs. 40,000, Rs. 30,000 and Rs, 50,000. Calculate discounted pay
back assuming the discounting rate of 15%. ----------------------
Years Cash inflows Discounting Discounted Cumulative ----------------------

Discounted
----------------------
Rs. Factor Cash Inflow Cash Inflows
@15% Rs. Rs. ----------------------
1 35,000 0.870 30,450 30,450
----------------------
2 40,000 0.756 30,240 60,690
3 30,000 0.658 19,740 80,430 ----------------------
4 50,000 0.572 28,600 1,09,030
----------------------
Thus, payback period is after 3 years but before 4 years. Assuming that cash
inflows accrue evenly during the year, Pay Back Period will be 3 years and 250 ----------------------
days.
----------------------
1,00,000 - 80,430
x 365 = 250 days
28,600 ----------------------
Acceptance rule, advantages and disadvantages ----------------------

They are the same as in case of payback period method except the fact that it ----------------------
considers time value of money.
----------------------
----------------------

Notes 2. Net Present Value:
Net Present Value (NPV) is a method of calculating present value of cash
----------------------
inflows and cash outflows in an investment project, by using cost of capital as
---------------------- the discounting rate, and finding out net present value by subtracting present
value of cash outflows from present value of cash inflows. Thus,
----------------------
NPV = { Σ Discounted cash} Less
{Σ Discounted Cash}
---------------------- Inflows Outflows
Illustration:
----------------------
Calculate net present value of a project involving initial cash outflow Rs.1,00,000
---------------------- and generating annual cash inflows of Rs. 35,000, Rs. 40,000, Rs. 30,000 and
Rs. 50,000 Discounting rate is 15%.
----------------------
Years Cash inflows Discounting factor Present Value of cash
----------------------
Rs. 15% inflows Rs.
---------------------- 1 35,000 0.870 30,450
2. 40,000 0.756 30,240
----------------------
3. 30,000 0.658 19,740
---------------------- 4. 50,000 0.572 28,600
1,09,030
----------------------
Less: Investment outlay 1,00,000
---------------------- Net Present Value (NPV) 9,030
---------------------- Acceptance Rule:
---------------------- As accept or reject criteria, all the projects which involve positive NPV i.e.
NPV > 0 will be accepted and vice versa.
---------------------- As a ranking method, the projects having maximum positive NPV, will be
---------------------- ranked highest.
Advantages:
----------------------
1. It considers time value of money.
----------------------
2. It considers cash inflows from the project throughout its life.
---------------------- Disadvantages:
---------------------- 1. It is difficult to use, calculate and understand.
---------------------- 2. It presupposes that the discounting rate, i.e. cost of capital is known. But
cost of capital is difficult to measure in practice.
----------------------
3. It may give dissatisfactory results, if the alternative projects involve
---------------------- varying investment outlay. A project involving maximum positive NPV
may not be desirable if it involves huge investment.
----------------------
4. It presupposes that the cash inflows can be reinvested immediately to yield
---------------------- the return equivalent to the discounting rate, which may not be possible
always.
----------------------

3. Internal Rate of Return: Notes
Internal Rate of Return (IRR) is that rate at which the discounted cash inflows
----------------------
match with discounted cash outflows. The indication given by IRR is that this is
the maximum rate at which the company will be able to pay towards the interest ----------------------
on amounts borrowed for investing in the projects, without losing anything.
Thus, IRR may be called as the ‘break even rate’ of borrowing for the company. ----------------------
In simple words, IRR indicates that discounting rate at which NPV is zero. If ----------------------
by applying 10% as the discounting rate, the resultant NPV is positive, while
by applying 12% discounting rate, the resultant NPV is negative, it means that ----------------------
IRR, i.e. the discounting rate at which NPV is zero, falls between 10% and 12%.
----------------------
Thus, by applying the trial and error method, one can find out the discounting
rate at which NPV is zero. The process to compute IRR will be to select any ----------------------
discounting rate and compute NPV. If NPV is negative, a lower discounting rate
should be tried and the process should be repeated till the NPV becomes zero. ----------------------
The following illustration explains the process to calculate IRR.
----------------------
Illustration:
----------------------
A project cost Rs. 1,00,000 and generates annual cash flows of Rs 35,000, Rs.
40,000, Rs. 30,000 and Rs. 50,000 over its life of 4 years. Calculate the Internal ----------------------
Rate of Return.
----------------------
Using 15% as a discounting rate, the present value of cash inflows can be
calculated as below: ----------------------
Year Cash inflows Rs. PV factor 15% Total PV Rs. ----------------------
1 35,000 0.870 30,450
----------------------
2 40,000 0.756 30,240
3 30,000 0.658 19,740 ----------------------
4 50,000 0.572 28,600
----------------------
1,09,030
Using 18% as discounting rate, the present value of cash inflows can be ----------------------
calculated as below: ----------------------
Year Cash inflows Rs. PV factor 18% Total PV Rs.
----------------------
1 35,000 0.847 29,645
2 40,000 0.718 28,720 ----------------------
3 30,000 0.609 18,270 ----------------------
4 50,000 0.516 25,800
1,02,435 ----------------------
NPV 2,435 ----------------------
Using 20% as discounting rate, the present value of cash inflows can be
----------------------
calculated as below:
----------------------
----------------------

Notes Year Cash inflows Rs. PV factor 20% Total PV Rs.
1 35,000 0.833 29,155
----------------------
2 40,000 0.694 27,760
---------------------- 3 30,000 0.579 17,370
4 50,000 0.482 24,100
----------------------
98,385
---------------------- NPV 1,615
---------------------- Thus, at 18% discounting rate, NPV, is Rs. 2,435 and at 20% discounting rate,
NPV is (-) Rs. 1,615. Hence, IRR is between 18% and 20%, i.e. more than 18%
---------------------- but less than 20%. Difference between PV at 18% and 20% is Rs. 4,050 (i.e. Rs.
---------------------- 1,02,435 – Rs. 98,385 and the negative NPV of Rs. 1,615 has to be covered by
this amount to arrive as IRR.
---------------------- IRR = Discount at Higher Rate –
---------------------- NPV at Higher Rate
x Difference between Rates
Difference between PV at two rates
----------------------
1,615 X 2
---------------------- Thus, IRR will be = 20% – 4,050
----------------------
= 20% - 0.80%
---------------------- = 19.2% (Appr.)
---------------------- Acceptance Rule:
---------------------- The computed IRR will be compared with the cost of capital. If the IRR is more
than or at least equal to the cost of capital the project may be accepted (IRR >
---------------------- Cost of Capital – Accept). If the IRR is less than cost of capital, the project may
---------------------- be rejected. (IRR < Cost of Capital – Reject)
Advantages:
----------------------
1. It considers time value of money.
----------------------
2. It considers cash inflows from the project throughout its life.
---------------------- 3. It can be computed even in the absence of the knowledge about the firm’s
cost of capital. But in order to draw the final conclusion, the comparison
----------------------
with the cost of capital is a must.
---------------------- Disadvantages:
---------------------- 1. It is difficult to use, calculate and understand.
---------------------- 2. It presupposes that the cash inflows can be reinvested immediately to

yield the return equivalent to the IRR. NPV method, on the other hand,
---------------------- presupposes that the cash inflows can be reinvested to yield the return
equivalent to the cost of capital, which is more realistic.
----------------------
----------------------

4. Profitability Index (PI)/Benefit Cost Ratio (B/C Ratio) Notes
It is the ratio between total discounted cash inflows and total discounted cash
----------------------
outflows. Thus, the Profitability Index can be computed as:
Σ Discounted cash inflows ----------------------
PI =
Σ Discounted cash outflows
----------------------
PI can be computed as gross one, as stated above, or as net one, which means
gross minus one. ----------------------
Illustration ----------------------
A project requires an outlay of Rs. 1,00,000 and earns the annual cash inflows ----------------------
of Rs. 35,000, Rs. 40,000, Rs. 30,000 and Rs. 50,000. Calculate, Profitability
Index assuming the discounting rate of 15%. ----------------------
Year Cash flows Discounting factor Discounted Cash Inflows ----------------------
Rs. @15% Rs.
----------------------
1 35,000 0.870 30,450
2 40,000 0.756 30,420 ----------------------
3 30,000 0.658 19,740
----------------------
4 50,000 0.572 28,600
1,09,030 ----------------------
Profitability Index can be calculated as: ----------------------
= Σ Discounted cash inflows
----------------------
Σ Discounted cash outflows
----------------------
Rs. 1,09,030
Thus, PI (Gross) = 1.09 ----------------------
Rs. 1,00,000
----------------------
PI (Net) 1.09 – 1.00 = 0.09
----------------------
As accept or reject criteria, the projects having the Profitability Index of more
than one will be accepted and vice versa. As a ranking method, the projects ----------------------
having highest profitability index will be ranked highest.
----------------------
Final choice of evaluation method:
Between the basic two types of techniques as described above, the techniques ----------------------
considering time value of money are generally preferred for the obvious reasons.
----------------------
However, the choice of the evaluation technique depends upon the objective
of the management in the investment decisions. The objective is naturally in ----------------------
the form of maximisation of wealth of the shareholders. As such, only those
projects will be in the interest of the shareholders, which can earn more rate of ----------------------
return than other alternative investment opportunities.
----------------------
----------------------
----------------------

Notes
----------------------

1. Payback Period Method can be used as an accept or _______ criteria
----------------------
or as a method of ranking the project.
---------------------- 2. Accounting rate of return (ARR) computes the _______________ on
the net investment in the project.
----------------------
----------------------
---------------------- Activity 2
---------------------- A project requires an outlay of Rs. 10 lacs and earns an annual cash inflow
---------------------- of Rs. 2 lacs for 8 years. Calculate the payback period.
----------------------
7.6 LIMITATIONS OF CAPITAL BUDGETING
----------------------
The basic limitation of the capital budgeting process lies in this fact that it
---------------------- involves various estimations. These estimations are specifically in respect of
---------------------- (a) Cash outflow
---------------------- (b) Revenues / Saving and costs attached with projects

(c) Life of the projects
----------------------
Whereas the cash outflows can be estimated with a reasonable accuracy, the
---------------------- cash inflows and life of the projects cannot be estimated accurately. Further, the
changes in fiscal and taxation policies of the Government also have the impact
----------------------
on determination of cash inflows. If the techniques use the discounted flows to
---------------------- evaluate the projects, the cost of capital is used as discounting rate. Difficulties
in deciding the cost of capital prove to be the limitation of capital budgeting
---------------------- process.
----------------------
7.7 EVALUATION CRITERIA IN CERTAIN TYPICAL
---------------------- SITUATIONS
---------------------- (a) In certain cases, the capital expenditure may not involve any specific
---------------------- inflow of funds, but only outflow of funds. E.g. If a machine manufactures
such products which themselves cannot be marketed, there may not be
---------------------- any specific inflow of funds associated with such machines. Under such
situations, if the company is required to make the choice between two
---------------------- machines, the company should choose that machine which involves less
---------------------- amount of present value of outflow of funds.
----------------------

Illustration: Notes
A company has to make a choice between buying of two machines. Machine
----------------------
A would cost Rs. 1,00,000 and require cash running expenses of Rs. 32,000
p.a. Machine B would cost Rs. 1,50,000 and its cash running expenses would ----------------------
amount to Rs. 20,000 p.a. Both the machines have a life of 10 years with zero
salvage value. The company follows a straight-line depreciation and is subject ----------------------
to 50% tax on its income. The company’s required rate of return is 10%. Which
----------------------
machine should it buy?
Note: Present value of Re. 1 p.a. for 10% discount rate is Rs. 61,446. ----------------------
Solution: ----------------------
Machine A ----------------------
Particulars Pre-tax Post-tax Years PV factor Total PV
----------------------
Amt. Amt. @10%
Cost of Machine 1,00,000 1,00,000 0 1.0000 1,00,000 ----------------------
Running Expenses 32,000 16,000 1-10 6.1446 98,314
----------------------
Depreciation (-)10,000 (-) 5,000 1-10 6.1446 (-) 30,723
Net Cash Outflow 1,67,591 ----------------------
Machine B ----------------------
Particulars Pre-tax Post tax Years PV factor Total PV ----------------------
Amt. Rs. Amt. Rs. @10% Rs.
----------------------
Cost of Machine 1,50,000 1,50,000 0 1.0000 1,50,000
Running Expenses 20,000 10,000 1-10 6.1446 61,446 ----------------------
Depreciation (-) 15,000 (-) 7,500 1-10 6.1446 (-) 46,085
----------------------
Net Cash Outflow 1,65,361
As the PV of net outflow of funds is less in case of Machine B, investment in ----------------------
Machine B will be accepted. ----------------------
(b) In certain cases, the capital expenditure may involve replacement of an
existing machinery or equipment, which is likely to result into the savings ----------------------
of costs. Under such situations, the inflow of funds is in the form of savings ----------------------
arising from the investment which should be considered in the light of
costs and benefits associated with a new proposal vis-à-vis the costs and ----------------------
benefits associated with an existing proposal which will not be available in
future. ----------------------
Illustration: ----------------------
Shree Prakash Co. has been using a machine costing Rs. 15,000 for the past 5 ----------------------
years. The machine has 15 years of life. The current salvage value would be
Rs. 2,000 and the company has been paying 50% of its profits as taxes (i.e. it is ----------------------
subjected to 50% flat tax rate).
----------------------
Now, the management desires to replace it by a new machine costing Rs. 10,000
with salvage value of Rs. 2,000. The new machine has life of 10 years. Cost of ----------------------

Notes capital is 10% and the expected savings are likely to be Rs. 3,000 per annum.
(a) Should the company go for new machines?
----------------------
(b) What would be your advice if expected savings increase by 50% per annum
---------------------- and expected life decreases by 5 years?
---------------------- Rs.
---------------------- Purchase Price of new machine 10,000

Less: Salvage value of old machine 2,000
----------------------
Less: Tax saving @ 50% on the loss on sale of old machine* 4,000
----------------------
Net Cash Outflow 4,000
---------------------- Note: Loss on the sale of old machine is calculated as below:
---------------------- Cost of Old machine 15,000
---------------------- Less: Depreciation for 5 years 5,000

\ Written down value (WDV) 10,000
----------------------
Less: Salvage value 2,000
----------------------
\ Loss on sale of old machine 8,000
---------------------- Calculation of Cash Inflows:
---------------------- Particulars Pre-tax Post-tax Years PV factor Total PV
---------------------- Amt. Rs. Amt. Rs. @10% Rs.
Savings 3,000 1,500 1-10 6.145 9,218
---------------------- Difference in amount
---------------------- of depreciation (-) 200 (-) 100 1-10 6.145 (-) 615
Salvage value 2,000 2,000 10 0.386 772
---------------------- 9,375
---------------------- Hence NPV i.e. Rs. 9375 – Rs. 4,000 5,375
As NPV is positive, the company should go for a new machine.
----------------------
Note: Assuming that the depreciation is calculated on straight-line basis, which
---------------------- is acceptable for income tax purposes and that the salvage value of old machine
at the end of its life was nil, difference in the amount of depreciation is calculated
---------------------- as below:
---------------------- Old Machine (Rs.) New Machine (Rs.)
---------------------- Cost price 15,000 10,000
Less: Salvage value – 2,000
---------------------- 15,000 8,000
---------------------- Life in years 15 10
Annual depreciation 1,000 800
----------------------
Hence, amount of depreciation will be reduced by Rs. 200, if a new machine is
---------------------- purchased.

Part B Notes
Calculation of cash outflow will remain the same.
----------------------
Calculation of cash inflows:
----------------------
Particulars Pre-tax Post-tax Years PV factor Total PV
Amt. Rs. Amt. Rs. @10% Rs. ----------------------
Savings 4,500 2,250 1-5 3.791 8,530 ----------------------
Depreciation on 1600 800 1-5 3.791 3,033
new machine ----------------------
Depreciation on (-) 1,000 (-) 500 1-10 6.145 (-) 3,073 ----------------------
old machine
Salvage value 2,000 2,000 5 0.621 1,242 ----------------------
9,732
----------------------
Hence, NPV is Rs. 9,732- Rs. 4,000 5,732
----------------------
As NPV is positive, the company should go for new machine in the second case
also. ----------------------
7.8 PLANNING, ORGANISATION AND CONTROL OF ----------------------

CAPITAL EXPENDITURE ----------------------
It has already been discussed that the various proposals for incurring capital ----------------------
expenditure may be generated either at top management level or even at lower
management level though the latter is the rare possibility. The various proposals ----------------------
generated are evaluated with the help of various techniques as discussed above.
----------------------
The ultimate selection for proposals depends upon the evaluation made by these
techniques; however, the factors like urgency or availability of funds may also ----------------------
play an important role.
----------------------
The ultimate power to reject or accept various capital expenditure proposals
rests with the top management, which may be in the form of Board of Directors ----------------------
or Executive Committee or Management Committee. In some cases, the power
may rest with the Chairman or Managing Director. The proposals involving ----------------------
the outlay to a certain extent may fall within the powers of the chief executive ----------------------
also and the proposals involving the outlay beyond that extent will have to be
referred to top management as described above. If the actual implementation ----------------------
of the selected proposals involves the arrangement of funds from the financial
institutions or requires certain Government approvals, it is the responsibility of ----------------------
middle management to arrange for the same. ----------------------
If it is intended to exercise proper control on the capital budgeting process, an
organisation may be required to take the following steps. ----------------------
1. Planning: The capital expenditure has to be planned properly taking into ----------------------
consideration the present and future needs of the business. It should be
planned in such a way as to ensure the balanced development of all the ----------------------
sections of the organisation individually as well as of the organisation as a ----------------------

Notes whole. Usually, the plans in respect of capital expenditure are prepared in
the form of capital expenditure budget. Care should be taken to select the
---------------------- period for which capital expenditure budget should be prepared. Too long
a period may not be useful.
----------------------
2. Evaluation: Utmost care should be taken while evaluating the capital
---------------------- expenditure proposals. As the capital expenditure proposals involve long-
term and irreversible decisions, a wrong decision may disturb the entire
----------------------
financial structure of the organisation. The evaluation of various proposals
---------------------- should be done as rationally as possible. Proper weightage should be given
to the elements of risk and uncertainly.
----------------------
3. Control over progress: Usually, the implementation of capital expenditure
---------------------- proposals are spread over more than one year. As such proper control
is required to be exercised over issue of work orders/purchase orders,
---------------------- acquisition of material, labour force and other assets, supply of funds etc.
---------------------- 4. Periodic and post completion audit: These are required to be conducted
in order to confirm whether the proposal has been implemented as per
---------------------- the original plan or not. If some faults are pointed out regarding planning
process, they may be corrected while considering future projects. If some
----------------------
faults are pointed out during mid-term review of the projects, corrective
---------------------- actions may be taken during the remaining period of implementation.
---------------------- 5. Forms and procedures: In order to ensure proper control over capital
expenditure, certain forms and procedures may be prescribed. Care should
---------------------- be taken that the said forms are used and procedures are followed at each
and every stage of implementation of the capital expenditure proposals.
----------------------
---------------------- 7.9 CAPITAL RATIONING

---------------------- The various techniques available with the company for evaluating the capital
expenditure proposals facilitate the company to decide which of the projects may
---------------------- be accepted. If the company has sufficient funds to invest in all the acceptable
projects, the problem is very simple. However, it may not be the situation in
----------------------
practice. The company may not have enough funds to invest in all the acceptable
---------------------- projects. Or the company may not be willing to acquire necessary funds to invest
in all acceptable projects due to the external or internal reasons (E.g. Fixed
---------------------- budget for capital expenditure). Thus, capital rationing refers to a situation
where the company has more acceptable proposals requiring a greater amount
----------------------
of funds than is available with the company. As such, under capital rationing, it
---------------------- is not only necessary to decide profitable investments, but it is also necessary
to rank the acceptable proposals according to their relative profitabilities. With
---------------------- limited funds, the company must obtain the optimum combination of acceptable
investment proposals.
----------------------
The normal process that may be followed under the capital rationing situations
---------------------- may be:
---------------------- (1) To rank the projects according to some measure of profitability.

(2) To select projects in the descending order of profitability till the available Notes
funds are exhausted.
----------------------
However, the situation of capital rationing may involve the consideration of
other problems also. ----------------------
1. Project Indivisibility: Some projects may not be divided during execution.
----------------------
They can be either accepted or rejected in its entirety. These projects cannot
be undertaken partially or in pieces. ----------------------
Consider the following situation:
----------------------
The company has the following four acceptable proposals ranked according to
Profitability Index Method with the ultimate capital expenditure budget ceiling ----------------------
of Rs. 10,00,000. ----------------------
Project Project Cost Rs. Profitability Index Ranking
----------------------
A 5,00,000 1.25 1
B 3,50,000 1.20 2 ----------------------
C 2,50,000 1.18 3
----------------------
D 1,00,000 1.15 4
----------------------
According to capital rationing process, projects A and B can be executed
completely. Project C is costing Rs. 2,50,000 whereas funds available after the ----------------------
execution of projects A and B is only Rs. 1,50,000. If project C can be either
accepted or rejected completely, the problem is how to face such a situation? ----------------------
2. Avoidance of smaller projects: If the process of capital rationing is strictly ----------------------
followed, it may result into the exclusion of various smaller projects by
larger projects though the smaller projects may be competitively profitable ----------------------
when compared with the larger projects. Consider the following situation.
----------------------
The company has the following four acceptable proposals ranked according to
Profitability Index Method with the ultimate capital expenditure budget ceiling ----------------------
of Rs. 10,00,000
----------------------
Project Project Cost Rs. Profitability Index Ranking
----------------------
A 6,50,000 1.26 1
B 3,50,000 1.25 2 ----------------------
C 50,000 1.24 3
----------------------
D 40,000 1.23 4
If capital rationing process is to be applied strictly, projects A and B will be ----------------------
selected for execution, whereas projects C and D will be rejected though they ----------------------
are equally profitable like projects A and B.
----------------------
3. Mutually Dependent Project: The projects available before the company
may be basically of two types. Firstly, projects may be mutually exclusive ----------------------
i.e. the execution of one project rules out the possibility of execution of other
projects e.g. Five different machines are available for a company to carry ----------------------
out a job. If the company decides to purchase one machine, the possibility
----------------------

Notes of purchasing other four machines is ruled out. Secondly, projects may
be mutually dependent i.e. the execution of one project depends upon the
---------------------- execution of another project.
---------------------- Now under the capital rationing situation, if sufficient funds are available to
invest only in machine A but not in B when investment in both the machines is
---------------------- mutually dependent, then the problem is how to face such a situation?
---------------------- 4. Multi Period Projects: There may some projects the execution of which
cannot be completed in one accounting period, but their execution is spread
---------------------- over in various accounting periods. In such situations, the constraints of
capital rationing are required to be considered over all the subsequent
----------------------
periods also, which are required for the execution of the project.
----------------------
----------------------

---------------------- 1. Under capital rationing situations, projects are ranked on the basis of
profitability.
----------------------
2. Capital rationing refers to a situation where company has more
---------------------- acceptable proposals requiring equal amount of funds than is available.
----------------------
---------------------- Activity 3
----------------------
If a company has four acceptable proposals ranked according to profitability
---------------------- Index Method, which one will you select first? Justify your response.
----------------------
7.10 CAPITAL BUDGETING AND RISK
----------------------
The various techniques, as discussed above, for evaluating the capital
----------------------
expenditure proposals may be ideally applied in a riskless situation, which is
---------------------- a rare possibility. As stated above, the capital budgeting process involves the
estimation of various future aspects regarding future cash inflows, life of the
---------------------- project etc. The accuracy of these estimates and hence reliability of investment
decisions mainly depends upon the precision in the forecasting of these aspects.
----------------------
Howsoever carefully these aspects are forecast, there is always the possibility
---------------------- that the actual situations may not correspond with these estimates. As such, the
term risk with reference to investment decisions may be defined as the variability
---------------------- in the actual returns emanating from a project in future over its working life
in relation to the estimated return as forecast at the time of the initial capital
----------------------
budgeting decision.
---------------------- Several mathematical and non-mathematical methods have been developed to
consider the risk in capital budgeting decisions. We will consider mainly three
----------------------
methods that are commonly used.
1. Informal Method: Notes
This method does not follow any mathematical or statistical model to consider
----------------------
the risk factor. This is surely an informal or subjective method, which depends
on the knowledge and experience of the evaluator. The standard fixed to consider ----------------------
a project risky is strictly internal and is not specified.
----------------------
Illustration:
A company has under consideration two mutually exclusive projects for ----------------------
increasing its plant capacity, the management has developed pessimistic, most
----------------------
likely and optimistic estimates of the annual cash flows associated with each
project. The estimates are as follows: ----------------------
Project A Project B ----------------------
(Rs.) (Rs.)
Net Investment 30,000 30,000 ----------------------
Cash flow estimates: ----------------------
Pessimistic 1,200 3,700
----------------------
Most likely 4,000 4,000
Optimistic 7,000 4,500 ----------------------
(a) Determine the NPV associated with each estimate given for both the ----------------------
projects. The projects have 20 years life each and the company’s cost of
capital is 10%. ----------------------
(b) Which project do you consider should be selected by the company and ----------------------
why?
----------------------
P.V. Factor is 8.514
Solution: ----------------------
Calculation of NPV ----------------------
Pessimistic Most Optimistic ----------------------
Likely
Project A: ----------------------
Annual cash inflows 1,200 4,000 7,000 ----------------------
Present value of Annual cash flows
----------------------
(At PV factor for 20 years) 10,217 34,056 59,598
Outflow 30,000 30,000 30,000 ----------------------
NPV (-)19,783 4,056 29,598
----------------------
Project B:
Annual cash inflows 3,700 4,000 4,500 ----------------------
Present value of Annual cash inflows
----------------------
(At PV factor for 20 years) 31,502 34,056 38,313
Outflow 30,000 30,000 30,000 ----------------------
NPV 1,502 4,056 8,313
----------------------

Notes Conclusion:
It can be seen from the above calculations that in case of most likely cash
----------------------
inflows, both the projects are equally profitable.
---------------------- However, Project A involves more risk as the variation of NPV in pessimistic
conditions and optimistic conditions is more in case of Project A.
----------------------
As such, if risk involved with the projects is considered as the criteria, Project
---------------------- B will be selected.
---------------------- 2. Risk adjusted discounting rate:
---------------------- According to this method, the discounting rate is used not only to consider the
futurity of the returns from the project but also to consider the risk involved
---------------------- with the project. As such, in this method, the discounting rate is increased in
case of projects involving greater risk whereas it is reduced in case of projects
---------------------- involving lesser risk. This can be explained with the help of the following
---------------------- illustration.
Suppose that following two projects involving outflow of cash of Rs. 1200
----------------------
generate the cash inflows as below:
---------------------- Year Project A (Rs.) Project B (Rs.)
---------------------- 1 800 500
2 700 500
---------------------- 3 300 500
---------------------- 4 150 500
---------------------- Obviously, Project A is more risky than Project B. As such, the discounting
rate of 14% is applied in case of Project A whereas the discounting rate of 10%
---------------------- is applied in case of Project B, the difference of 4% being to take care of risk
involved in case of Project A.
----------------------
Thus, the computations of net present value are made as below:
----------------------
|Project A:
---------------------- Year Cash inflows Rs. PV factor 14% Total PV Rs.
1 800 0.877 701.60
----------------------
2 700 0.769 538.30
---------------------- 3 300 0.675 202.50
4. 150 0.592 88.80
---------------------- 1531.20
Less: Outflow 1200.00
---------------------- NPV 331.20
---------------------- Project B:
Years Cash Inflow PV factor 10% Total PV Rs.
---------------------- 1 to 4 500 per year 3.169 1,584.50
Less: Outflow 1,200.00
---------------------- NPV 384.50
----------------------

As project B involves greater NPV, it will be accepted. Notes
This method is advantageous in the sense that it is simple to understand
----------------------
and incorporates the risks attached with the future returns in case of capital
expenditure proposals. However, this method certainly suffers from some ----------------------
limitations.
----------------------
a. Additional discounting rate is considered to compensate for the risk
attached to a project as compared to any other riskless project. How much ----------------------
additional discounting rate will be sufficient to take care of this risk cannot
be decided accurately, say with the help of any statistical or mathematical ----------------------
formula. Charging additional discounting rate is a subjective concept to be
----------------------
decided by the evaluator of the proposals.
b. This method takes into consideration the risk factor by considering ----------------------
additional discounting rate, however the cash inflows forecasted for the
----------------------
future period are considered without taking into consideration the risk
factor. E.g. if the cash inflows of Rs. 50,000 are estimated to be received ----------------------
in a riskless situation, this method assumes that the amount of cash inflows
will be the same even in a risky situation. As such, only the discounting ----------------------
rate is increased to take care of the risk factor.
----------------------
c. This method presupposes that the investors are not willing to take the risk
and may demand the compensation for assuming the risk. However, it ----------------------
ignores the possibility of existence of risk-seekers who may be willing to ----------------------
pay premium for taking the risk.
3. Certainty-Equivalent Approach: ----------------------
According to this method, rather than adjusting the discounting rate to take ----------------------
care of the risk factor, the future cash inflows themselves are adjusted by
using the certainty equivalent co-efficient which can be calculated as: ----------------------
Certainty Cash Inflows ----------------------
Risky Cash Inflows
----------------------
E.g., cash inflows from a project are expected to be Rs. 25,000, however
generation of cash inflow of Rs. 20,000 is most certain. As such, the certainty ----------------------
equivalent co-efficient can be computed as: ----------------------
Rs. 20,000
= 0.80 ----------------------
Rs. 25,000
----------------------
Accordingly, depending upon the degree of risk, the certainty equivalent co-
----------------------
efficient is decided. Higher the risk, lower the certainty equivalent co-efficient
and vice versa. ----------------------
To explain this approach, the following illustration may be considered. ----------------------
----------------------
----------------------

Notes Year Cash Certainty Adjusted Cash PV factor Total PV
Inflows Equivalent Inflows @10% Rs.
----------------------
Rs. Co-efficient Rs.
---------------------- 1 6,000 0.90 5,400 0.909 4,908.60
2 4,000 0.80 3,200 0.826 2,643.20
----------------------
3 2,000 0.70 1,400 0.751 1,051.40
---------------------- 4 4,000 0.60 2,400 0.683 1,639.20
---------------------- 10,242.40
Less: Outflow 10,000.00
---------------------- NPV 242.40
----------------------
7.11 ILLUSTRATIVE PROBLEMS
----------------------
1. A company is considering an investment proposal to install new milling
---------------------- controls. The project will cost Rs. 50,000. The facility has a life expectancy
of 5 years and no salvage value. The company’s tax rate is 55%. The firm
----------------------
uses straight-line depreciation, which is allowed for income tax purposes.
---------------------- The estimated cash flows before tax (CFBT) from the proposed investment
proposals are as follows:
----------------------
Year CFBT
---------------------- Rs
1 10,000
----------------------
2 11,000
---------------------- 3 14,000
---------------------- 4 15,000
5 25,000
----------------------
Compute the following.
---------------------- i. Payback period
---------------------- ii. Average rate of return
---------------------- Solution:
The Cash inflows in respect of the project can be computed as below:
----------------------
Cash flows = CFBT – Taxes
----------------------
= PAT + Depreciation
---------------------- Year CFBT Depreciation Taxable Taxes Profits Cash
---------------------- income after taxes inflows
(1.5)
---------------------- (2-3) (4-5) or (6+3)
---------------------- 1 2 3 4 5 6 7
1 10,000 10,000 0 0 0 10,000
----------------------

2 11,000 10,000 1,000 550 450 10,450 Notes
3 14,000 10,000 4,000 2,200 1,800 11,800
----------------------
4 15,000 10,000 5,000 2,750 2,250 12,250
5 25,000 10,000 15,000 8,250 6,750 16,750 ----------------------
11,250 61,250
----------------------
Thus, the pay back period is after 4 years before 5 years. Pay back period – 4
years 4 months (Approx.) ----------------------
50,000 - 44,500 ----------------------
X 365 = 120 days
16,750 ----------------------
i. Pay Back Period ----------------------
Assuming that cash inflows accrue evenly during the year, the payback ----------------------
period i.e. the period within which the cost of the machine will be recovered
by cash inflows can be computed as below: ----------------------
Year Cash inflows Rs. Cumulative Cash inflows Rs. ----------------------
1 10,000 10,000
----------------------
2 10,450 20,450
3 11,800 32,250 ----------------------
4 12,250 44,500
----------------------
5 16,750 61,250
Thus, the payback period is after 4 years before 5 years. Payback period approx. ----------------------
4 years 4 months. ----------------------
50,000 - 44,500
X 365 = 120 days ----------------------
16,750 ----------------------
ii. Average Rate of Return
----------------------
It can be computed as –
Total profits (after depreciation and taxes) ----------------------
= X 100 ----------------------
Net Investment in machine X No. of years of profits
Rs. 11,250 ----------------------
= X 100 ----------------------
Rs. 50,000 X 5
----------------------
= 4.5%
----------------------
2. A company has an investment opportunity costing Rs. 40,000 with the
following expected net cash flow (i.e. after taxes and before depreciation). ----------------------
----------------------
----------------------

Notes Year Net cash flows Rs.
1 7,000
----------------------
2 7,000
---------------------- 3 7,000
4 7,000
----------------------
5 7,000
---------------------- 6 8,000
---------------------- 7 10,000
8 15,000
---------------------- 9 10,000
---------------------- 10 4,000
Using 10% as the cost of capital (rate of discount) determine the following:
----------------------
(a) Payback period.
----------------------
(b) Net Present Value of 10% discounting factor.
---------------------- (c) Profitability index at 10% discounting factor.
---------------------- (d) Internal rate of return with the help of 10% discounting factor and 15%
discounting factor.
----------------------
Solution:
----------------------
(a) Pay Back Period
----------------------
Year Cash inflows Cumulative cash inflow Rs.
---------------------- 1 7,000 7,000
----------------------
2 7,000 14,000
3 7,000 21,000
---------------------- 4 7,000 28,000
---------------------- 5 7,000 35,000
6 8,000 43,000
----------------------
7 10,000 53,000
---------------------- 8 15,000 68,000
---------------------- 9 10,000 78,000
10 4,000 82,000
----------------------
Thus, the pay back is more than 5 years and less than 6 years. The fraction can
---------------------- be computed as:
---------------------- Rs. 5000 X 12
= 7.5 months
---------------------- Rs. 8,000
---------------------- Thus, payback period is 5 years and 7 and 1/2 months.
----------------------

(b) NPV Method Notes
Year Cash inflows PV Factor Total PV ----------------------
Rs. 10% 15% 10% 15%
1 7,000 0.909 0.870 6,363 6,090 ----------------------
2 7,000 0.826 0.756 5,782 5,292 ----------------------
3 7,000 0.751 0.658 5,257 4,606
4 7,000 0.683 0.572 4,781 4,004 ----------------------
5 7,000 0.621 0.497 4,347 3,479 ----------------------
6 8,000 0.564 0.432 4,512 3,456
7 10,000 0.513 0.376 5,130 3,760 ----------------------
8. 15,000 0.467 0.327 7,005 4,905 ----------------------
9 10,000 0.424 0.284 4,240 2,840
10 4,000 0.386 0.247 1,544 988 ----------------------
48,961 39,420 ----------------------
Less: Outflow 40,000 40,000
----------------------
NPV 8,961 (-) 580
Hence, NPV at 10% Rs. 8,961 ----------------------
at 15% (-) Rs. 580
----------------------
(c) Profitability Index
It can be calculated as: ----------------------
----------------------
∑ Discounted cash inflows
∑ Discounted cash outflows ----------------------
At 10% Discounting rate ----------------------
48,961 ----------------------
PI = = 1.224
40,000 ----------------------
At 15% Discounting rate
----------------------
39,420
PI = = 0.9855 ----------------------
40,000
----------------------
(d) Internal Rate of Return
----------------------
At 10% discounting rate, NPV is Rs. 48,961 and at 15%, discounting rate NPV
is Rs. 39,420. Hence, IRR is between 10% and 15% i.e. more than 10% but ----------------------
less than 15%. Difference between NPV at 10% and 15% is Rs. 9,541 (i.e. Rs.
48,961 – Rs. 39,420) and the negative NPV of Rs. 580 has to be covered by this ----------------------
amount to arrive at IRR. ----------------------
----------------------
----------------------

Notes 580 X 5
Thus, IRR will be = 15% –
9541
----------------------
= 15% – 0.30 %
---------------------- = 14.70% [ Two decimal]
---------------------- 3. A Ltd. proposes to buy a machine for Rs. 1,00,000, which has a working
---------------------- life of 4 years after which it can be sold for Rs. 20,000. It will increase the
sales by Rs. 200,000 but cost of sales and other operating expenses will
---------------------- also increase by Rs. 160,000. If corporate tax rate is 50%, compute internal
rate of return.
----------------------
Solution:
---------------------- Calculation of cash inflows
---------------------- Year Net Depre- Profits Tax @ Profits Cash
---------------------- Revenue ciation before tax 50% after tax Inflow
Rs. Rs. Rs. Rs. Rs. Rs.
---------------------- 1 2 3 4 5 6 7 (3+6)
1 40,000 20,000 20,000 10,000 10,000 30,000
----------------------
2 40,000 20,000 20,000 10,000 10,000 30,000
---------------------- 3 40,000 20,000 20,000 10,000 10,000 30,000
---------------------- 4 40,000 20,000 20,000 10,000 10,000 30,000
---------------------- Discounting the cash inflows at 10%, 12% and 15%.

Year Cash PV factor Total PV
----------------------
inflows 10% 12% 15% 10% 12% 15%
---------------------- Rs. Rs. Rs. Rs.
1-4 30,000 3.170 3.037 2.855 95,100 91,110 85,650
----------------------
4 20,000 0.683 0.636 0.572 13,660 12,720 11,440
---------------------- 1,08,760 1,03,830 97,090
Less: Outflows 1,00,000 1,00,000 1,00,000
----------------------
NPV 8,760 3,830 (-) 2,910
---------------------- Thus, IRR is between 12% and 15%, i.e. more than 12% but less than 15%.
---------------------- Difference between PV at 12% and 15% is Rs. 6,740 (i.e. Rs. 103,830 – Rs.
97,090) and the negative NPV of Rs. 2,910 has to be covered by this amount to
---------------------- arrive at IRR.
---------------------- Thus, IRR will be

2,910 X 3
---------------------- 15% –
6,740
----------------------
= 15% – 1.30%
---------------------- = 13.70%
----------------------

4. A Ltd. is considering purchase of a new machine costing Rs. 5,85,000. An Notes
additional investment will be required for the following reasons.
----------------------
i. Installation cost Rs. 15,000 ii. Working capital Rs. 1,00,000
The machine has a working life of 5 years and salvage value will be Rs. 1,00,000. ----------------------
The working capital will also be released after 5 years.
----------------------
The estimated cash inflows (before depreciation and tax) are estimated to be as
below: ----------------------
Years Cash inflows Rs. ----------------------

1 1,00,000
----------------------
2 1,80,000
3 2,50,000 ----------------------
4 2,00,000 ----------------------
5 1,50,000
----------------------
You can assume straight-line method for charging depreciation, cost of capital of
15% and corporate tax rate of 50%. Should the company purchase the machine? ----------------------
Computation of cash outflow
----------------------
Cost of machine Rs. 5,85,000
----------------------
Installation charges Rs. 15,000
----------------------
Net Investment outlay Rs. 6,00,000
Add: Working capital required Rs. 1,00,000 ----------------------
Rs. 7,00,000 ----------------------
Computation of cash inflows ----------------------
Year Cash Depre- Profit Tax @ Profits Cash ----------------------
Inflows ciation* before tax 50% after tax inflow
Rs. Rs. Rs. Rs. Rs. Rs. ----------------------
1 2 3 4 5 6 7 (3+6) ----------------------
1 1,00,000 1,00,000 0 0 0 1,00,000
2 1,80,000 1,00,000 80,000 40,000 40,000 1,40,000 ----------------------
3 2,50,000 1,00,000 1,50,000 75,000 75,000 1,75,000 ----------------------
4 2,00,000 1,00,000 1,00,000 50,000 50,000 1,50,000
5 1,50,000 1,00,000 50,000 25,000 25,000 1,25,000 ----------------------
*Note: Annual Depreciation is computed as below: ----------------------

Cost of machine + installation charges – salvage value ----------------------
Estimated working life of the machine
----------------------
5,85,000 + 15,000 - 1,00,000 = 1,00,000
----------------------
5
----------------------

Notes Present value of net cash inflows
---------------------- Year Net cash inflows Rs. PV factor at 15% Total PV Rs.
1 1,00,000 0.870 87,000
---------------------- 2 1,40,000 0.756 1,05,840
---------------------- 3 1,75,000 0.658 1,15,150
4 1,50,000 0.572 85,800
---------------------- 5 1,25,000 0.497 62,125
---------------------- 5 @ 2,00,000 0.497 99,400
5,55,315
---------------------- Less: Outflows 700,000
---------------------- NPV (-) 1,44,685
@ Indicating salvage value and working capital released.
----------------------
Decision:
----------------------
As NPV is negative, the machine should not be purchased.
---------------------- Notes:
---------------------- As the installation charges form a part of the cost of machine itself, the benefits
available on the basis of cost of machine viz. depreciation will be available on
----------------------
the cost after considering the installation charges.
---------------------- 5. Electronics Industries Ltd. is considering purchase of a new machine.
Two alternative models are under consideration. Following information is
----------------------
available.
---------------------- Model A Model B
---------------------- Cost of Machine Rs. 3,00,000 Rs. 5,00,000
Estimated life 10 years 12 years
----------------------
Estimated saving in scrap per year Rs. 20,000 Rs. 30,000
---------------------- Additional cost of supervision per year Rs. 24,000 Rs 32,000
Additional cost of maintenance per year Rs. 14,000 Rs. 22,000
----------------------
Additional cost of indirect Material per Rs. 12,000 Rs. 16,000
---------------------- year
Estimated savings in wages per year Rs. 1,80,000 Rs. 2,40,000
----------------------
Rate of taxation may be regarded as 50%
---------------------- of profits
----------------------
----------------------
----------------------
----------------------
----------------------

Solution Notes
Statement of Profitability
----------------------
Statement of Profitability
----------------------
Model A Model B
----------------------
Rs. Rs. Rs. Rs.
(A) Estimated savings ----------------------
Scrap 20,000 30,000
----------------------
Wages 1,80,000 2,40,000
2,00,000 2,70,000 ----------------------
(B) Estimated Additional costs
----------------------
Supervision 24,000 32,000
Maintainance 14,000 22,000 ----------------------
Indirect materials 12,000 16,000 ----------------------
50,000 70,000
(C) Saving before depreciation 1,50,000 2,00,000 ----------------------
(A – B) ----------------------
(D) * Depreciation 30,000 41,667
(E) Saving after depreciation 1,20,000 1,58,333 ----------------------
(C – D) ----------------------
(F) Tax on savings @ 50% 60,000 79,167
(G) Net savings per year 60,000 79,166 ----------------------
(H) Annual Cash inflow 90,000 1,20,833 ----------------------
(G + D)
----------------------
Calculation of payback period ----------------------
Cost of machine Rs. 3,00,000
Model A: = ----------------------
Annual cash inflow Rs. 90,000
----------------------
= 3 years 4 months
Cost of machine Rs. 5,00,000 ----------------------
Model B: =
Annual cash inflow Rs. 1,20,833 ----------------------
= 4 years 2 months (Approximately) ----------------------
Hence, model A is more profitable.
----------------------
Cost of machine
* Depreciation is computed as = ----------------------
Estimated life in years
----------------------
6. An equipment costing Rs. 5,00,000 with a five-year life can be leased
for 5 years for payment of Rs. 1,20,000 per year at the end of each year. ----------------------
Alternatively, you can borrow Rs. 5,00,000 and buy the equipment, 6%
----------------------

Notes interest is payable on the outstanding balance at the end of each year, the
principal being repayable in 5 equal installments.
----------------------
You are to compute depreciation @ 20% on the original cost p.a. Corporate tax
---------------------- is to be reckoned at 50% and a fair return of 10% after tax is expected on the
business funds. The present value factors for discounting at 10% are as below.
----------------------
Year1 0.909
---------------------- Year 2 0.826
Year 3 0.751
----------------------
Year 4 0.683
---------------------- Year 5 0.621
---------------------- Present your choice with competitive analysis:
Solution:
----------------------
Calculation of NPV of outflows – Leasing Option
----------------------
Year Lease Rent Tax saving Net outflow NPV
---------------------- Rs. @ 50% at 10%
Rs.
----------------------
1 1,20,000 60,000 60,000 54,540
---------------------- 2 1,20,000 60,000 60,000 49,560
3 1,20,000 60,000 60,000 45,060
----------------------
4 1,20,000 60,000 60,000 40,980
---------------------- 5 1,20,000 60,000 60,000 37,260
2,27,400
----------------------
---------------------- Calculation of NPV of outflows – Buying Option
---------------------- Year Principal Repayment Interest Total Payment

Rs. Rs. Rs.
---------------------- 1 1,00,000 30,000 1,30,000
---------------------- 2 1,00,000 24,000 1,24,000
3 1,00,000 18,000 1,18,000
---------------------- 4 1,00,000 12,000 1,12,000
---------------------- 5 1,00,000 6,000 1,06,000
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

The company will be entitled to tax saving on account of both interest and Notes
depreciation. As such, net outflow will be as below:
----------------------
Year Interest + Tax saving Net NPV at
Depreciation @50% outflow 10% ----------------------
Rs. Rs.
1 1,30,000 65,000 65,000 59,085 ----------------------
2 1,24,000 62,000 62,000 51,212 ----------------------
3 1,18,000 59,000 59,000 44,309
----------------------
4 1,12,000 56,000 56,000 38,248
5 1,06,000 53,000 53,000 32,913 ----------------------
2,25,767
----------------------
As the NPV of outflows is less in case of the buying option, the company will
prefer the buying option. ----------------------
----------------------
Summary
----------------------
• This chapter introduces the important concept of Capital Budgeting and its
process. Capital Budgeting includes analysis of various proposals regarding ----------------------
capital expenditure to evaluate their impact on the financial situation of
the company and to choose the best out of the various alternatives. The ----------------------
process of capital budgeting generally involves project generation, project ----------------------
evaluation, project selection, project execution.
----------------------
• There are two broad categories of techniques of evaluation of capital
expenditure proposals. ----------------------
• Techniques not considering time value of money: It includes a) Payback
----------------------
period- payback period indicates the period within which the cost of the
project will be completely recovered. b) Accounting Rate of Return – it ----------------------
computes the average annual yield on the net investment in the project.
----------------------
• Techniques considering time value of money: It includes a) Discounted
Payback period – it indicates that period within which the discounted cash ----------------------
inflows equal to the discounted cash outflows involved in the project. b)
Net Present Value – it is a method of calculating present value of cash ----------------------
inflows and cash outflows in an investment project. c) Internal Rate of ----------------------
Return – it is that rate at which the discounted cash inflows match with
discounted cash outflows. d) Profitability index / Benefit Cost Ratio – it is ----------------------
the ratio between total discounted cash inflows and total discounted cash
outflows. ----------------------
• Capital rationing refers to a situation where the company has more ----------------------
acceptable proposals requiring a greater amount of funds than is available
with the company. ----------------------
----------------------
----------------------

Notes Keywords
----------------------
• Capital: The amount invested in fixed assets for undertaking a project
---------------------- • Budgeting: Is taking a decision as to whether money should be invested in
long-term projects
----------------------
• Evaluation: Considering a project from its various angles to know the
---------------------- pros and cons
----------------------
----------------------
1. What are the advantages of risk adjusted discounting rates? What is the
----------------------
major problem in using this approach to handle risk in capital budgeting?
---------------------- 2. What is meant by capital rationing? State and explain the problems involved
in it.
----------------------
3. Write a detailed note on organisation for planning and controlling capital
---------------------- expenditure.
---------------------- 4. “Payback period, as a method of evaluating investment proposals, suffers
from a number of serious limitations.” Discuss.
----------------------
5. Enumerate the major criteria of selecting investment projects under
---------------------- uncertain conditions.
---------------------- 6. Write short notes.
a. Net present value method
----------------------
b. Capital Rationing
----------------------
c. Internal Rate of Return method
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

PROBLEMS Notes
1. (a) A project of Rs. 2,00,00,000 yielded annually a profit of Rs. 3,00,000 ----------------------
after depreciation @ 12.5% and is subject to income tax @ 50%.
Calculate payback period. ----------------------
(b) No project is acceptable unless the yield is 10%. Cash inflows of a ----------------------
certain project along with cash outflows are given below:
----------------------
Year Outflows Rs. Inflows Rs.
0 1,50,000 — ----------------------
1 30,000 20,000 ----------------------
2 — 30,000
3 — 60,000 ----------------------
4 — 80,000 ----------------------
5 — 30,000
----------------------
5 — 40,000 (being salvage value
at end of 5 years) ----------------------
Calculate Net present value. ----------------------
2. Following details are available for five independent Projects:
----------------------
Projects Initial Outlay Annual cash Inflows Life in years
A 5,00,000 1,20,000 8 ----------------------
B 1,25,000 12,000 15 ----------------------
C 95,000 16,000 18
----------------------
D 6,000 2,000 5
E 45,000 7,000 10 ----------------------
If cost of capital is 12% and corporate tax rate is 50%, rank the above projects ----------------------
as per the following methods.
----------------------
(a) Payback period
----------------------
(b) Accounting rate of return
(c) Net present value ----------------------
(d) Profitability index ----------------------
(e) Internal rate of return ----------------------
3. The project cash flows from two mutually exclusive projects A and B are
----------------------
as under:
Period Project A Project B ----------------------
0 (outflow) Rs. 22,000 Rs. 27,000 ----------------------
1 to 7 (inflow) Rs. 6,000 each year Rs. 7,000 each year
Project life 7 years 7 years ----------------------
(a) Advise on the project selection with reference to internal rate of return. ----------------------

Notes (b) Will it make any differences in project selection if the cash flow from
project B is 8 years instead of 7 years @ Rs. 7,000 each year?
----------------------
PV factor at For 7 years For 8 years
---------------------- 15% 4.16 4.49
---------------------- 16% 4.04 4.34
17% 3.92 4.21
----------------------
18% 3.81 4.08
---------------------- 19% 3.71 3.95
20% 3.60 3.84
----------------------
4. Bright Metals Ltd. is considering two different investment proposals. The
---------------------- details are as under:
---------------------- Proposal A Proposal B

Rs. Rs.
----------------------
Investment cost 9,500 20,000
---------------------- Estimated income at end of
Year I 4,000 8,000
----------------------
Year II 4,000 8,000
---------------------- Year III 4,500 12,000
---------------------- (a) Suggest the most attractive proposal on the basis of net present value
method considering that future incomes are discounted at 12%.
----------------------
(b) Also find out the Internal Rate of Return of the two proposals.
---------------------- 5. A company has to select one of the two alternative projects, the particulars
in respect of which are given below:
----------------------
Project A Project B
----------------------
Rs. Rs.
---------------------- Initial outlay 1,20,000 1,10,000
Net Cash Flow
----------------------
End of Year 1 70,000 20,000
---------------------- 2 50,000 40,000
3 30,000 50,000
----------------------
4 20,000 40,000
---------------------- 5 10,000 20,000
6 Nil 10,000
----------------------
The company can arrange funds at 15%. Compute the Net Present Value and
---------------------- Internal Rate of Return of each project and comment on the result.
---------------------- 6. A Company has the choice to select any one of the projects X and Y, which
involves outflow of Rs. 40,000 and Rs. 30,000 respectively. The inflows
---------------------- before depreciation and tax are as below:
----------------------

Year Project X Rs. Project Y Rs. Notes
1 8,000 8,000
----------------------
2 10,000 9,000
3 15,000 10,000 ----------------------
4 15,000 10,000
----------------------
5 4,000 2,000
You can assume that depreciation is charged on straight-line basis, cost of ----------------------
capital is 12% and corporate tax rate is 50%. ----------------------
Which project should be selected if the following criteria are used?
----------------------
(a) Payback period.
----------------------
(b) Internal rate of return.
(c) Net present value. ----------------------
(d) Profitability Index. ----------------------

7. Following details are available in respect of two projects: You can assume ----------------------
that
----------------------
Project X Project Y
Initial outlay Rs. 1,00,000 Rs. 1,50,000 ----------------------
Salvage value Nil Rs. 20,000 ----------------------
Working capital required Rs. 25,000 Rs. 40,000
Flows before depreciation and ----------------------
tax – year 1 Rs. 28,000 Rs. 45,000 ----------------------
2 Rs. 30,000 Rs 45,000
3 Rs.20,000 Rs 45,000 ----------------------
4 Rs. 25,000 Rs. 45,000 ----------------------
5 Rs. 30,000 Rs. 45,000
----------------------
i. Depreciation is charged on straight-line basis.
----------------------
ii. Cost of Capital is 12%.
----------------------
iii. Corporate tax rate is 50%.
iv. Working capital will be released after the working life of 5 years is ----------------------
over.
----------------------
Which project should be selected if the following criteria are used?
----------------------
(a) Payback period.
(b) Internal rate of return. ----------------------
(c) Net present value. ----------------------

(d) Profitability index. ----------------------
----------------------

Notes 8. A Ltd. is considering purchase of a machine costing Rs. 8,00,000 having
an estimated life of 10 years. It will increase the sales by Rs. 4,00,000 per
---------------------- year and operating costs by Rs. 2,00,000 per year. The machine will be
subjected to straight-line depreciation and will have a salvage value or Rs.
---------------------- 40,000 at the end of its life. If the cost of capital is 10% and corporate tax
---------------------- rate is 50%, compute.
(a) Annual cash inflow.
----------------------
(b) Payback period.
----------------------
(c) Internal rate of return.
---------------------- (d) Net present value.
---------------------- 9. M/s. Lalvani and Co. has Rs. 2,00,000 to invest. The following proposals
are under consideration. The cost of capital for the company is estimated
---------------------- to be 15%.
---------------------- Project Initial Outlay Annual cash flow Life of projects
Rs. Rs. (years)
----------------------
A 1,00,000 25,000 10
---------------------- B 70,000 20,000 8
---------------------- C 30,000 6,000 20
D 50,000 15,000 10
---------------------- D 50,000 12,000 20
---------------------- Rank the above projects on the basis of
---------------------- i. Payback method.

ii. NPV method.
----------------------
iii. Profitability index method.
----------------------
Present value of annuity of Re. 1 received in steady stream discounted at
---------------------- the rate of 15%. 8 years –
---------------------- 8 years – 4.6586

10 years – 5.1790
----------------------
20 years – 6.3345
----------------------
10. After conducting a survey that cost Rs. 2,00,000, Zeal Ltd. decided to
---------------------- undertake a project for putting a new product in the market. The Company’s
cut off rate is 12%. It was estimated that the project would have a life of 5
---------------------- years. The project would cost Rs. 40 lakh in plant and machinery in addition
to working capital of Rs. 10 lakh. The scrap value of plant and machinery at
----------------------
the end of 5 years is estimated at Rs. 5,00,000. After providing depreciation
---------------------- on straight-line basis, profits after tax were estimated as follows.
----------------------
----------------------

Year Rs. Notes
1 3,00,000
----------------------
2 8,00,000
3 13,00,000 ----------------------
4 5,00,000
----------------------
5 4,00,000
----------------------
Ascertain the net present value of the project.
----------------------
----------------------
----------------------
Fill in the Blanks.
----------------------
1. The process of capital budgeting involves proposal to reduce cost without
affecting scale of operation. ----------------------
2. The process of evaluation of the projects necessarily involves Cost Benefit
----------------------
Analysis.

1. True ----------------------
2. True
----------------------
----------------------
Fill in the Blanks.
1. Payback Period Method can be used as an accept or reject criteria or as a ----------------------
method of ranking the project. ----------------------
2. Accounting rate of return (ARR) computes the average annual yield on the
net investment in the project. ----------------------

1. True
----------------------
2. False
----------------------
Suggested Reading ----------------------
1. Khan & Jain. Financial Management ----------------------

2. Christine Robertson. Financial Management: Review of Education’s Grant ----------------------
Back Account
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Working Capital Management
UNIT
8
Structure:
8.1 Introduction
8.2 Working Capital – The Term
8.3 Principles of Working Capital Management
8.4 Factors affecting Working Capital Requirement
8.5 Financing of Working Capital Requirement
8.6 Control over Working Capital
Summary
Keywords
Problems
Suggested Reading
Working Capital Management 159

Notes
Objectives
----------------------
----------------------
• Explain the concept of working capital and its management
----------------------
• Identify the factors affecting working capital requirement
---------------------- • Specify various sources of finance for working capital
---------------------- • Appreciate the recommendations of different committees appointed by
RBI for control over working capital finance
----------------------
----------------------
8.1 INTRODUCTION
----------------------
In the previous units, we have seen that whatever funds are raised by a company
----------------------
can be applied for two purposes:
---------------------- a. To acquire fixed assets, the technical terminology used being Capital
Budgeting.
----------------------
b. To invest in the current assets, technical terminology used being Working
---------------------- Capital Management.
---------------------- Working capital management is considered one of the most important functions
of finance, as a very large amount of funds is blocked in current assets in
---------------------- practical circumstances. Unless working capital is managed properly, it may
---------------------- lead to the failure of business.
---------------------- 8.2 WORKING CAPITAL – THE TERM

---------------------- The term ‘Working Capital’ may mean Gross Working Capital or Net Working
Capital. Gross Working Capital means Current Assets. Net Working Capital
----------------------
means Current Assets less Current Liabilities. Unless otherwise specified,
---------------------- Working Capital means Net Working Capital. As such, Working Capital
Management refers to proper management of Current Assets and Current
---------------------- Liabilities.
---------------------- The term current assets refers to those assets held by a business which can be
converted in the form of cash or used during the course of normal operations
---------------------- within a short span of time say one year, without any reduction in value. Current
---------------------- assets change the shape very frequently. The current assets ensure smooth and
fluent business operations and are considered the life-blood of the business. In
---------------------- case of a manufacturing organisation, current assets may be found in the form
of stocks, receivables, cash and bank balances and sundry loans and advances.
----------------------
The term current liabilities refers to those liabilities, which are to be paid off
---------------------- during the course of business, within a short span of time say one year. They
are expected to be paid out of current assets or the earnings of the business.
----------------------

Current liabilities consist of sundry creditors, bills payable, bank overdraft or Notes
cash credit, outstanding expenses etc.
----------------------

1. Unless otherwise specified, Working Capital always means Net ----------------------
Working Capital.
----------------------
2. The basic objective of Working Capital Management is to avoid
investment in Current Assets. ----------------------
----------------------
Activity 1 ----------------------
----------------------
Observe any manufacturing process and list out the factors, which comprise
part of the working capital needs of that manufacturing process. ----------------------
----------------------
8.3 PRINCIPLES OF WORKING CAPITAL MANAGEMENT
----------------------
The basic objective of Working Capital Management is to avoid over investment
----------------------
or under investment in Current Assets, as both the extremes involve adverse
consequences. Over investment in Current Assets may lead to the reduced ----------------------
profitability due to cost of funds blocked, extra storing space required, extra
efforts for follow up and recovery required, possibility of malpractice etc. The ----------------------
objective of Working Capital Management is to ensure Optimum Investment in
----------------------
Current Assets. In other words, Working Capital Management intends to ensure
that the investment in Current Assets is reduced to the minimum possible extent. ----------------------
However, the normal operations of the organisation should not be affected
adversely. If the normal operations of the organisation are affected adversely, ----------------------
reducing the investment in Current Assets is fruitless.
----------------------
Why does the need for Working Capital arise?
----------------------
Generally, it will not be possible for any organisation to operate without the
working capital. Let us assume that a manufacturing organisation commences ----------------------
its business with a certain amount of cash. This cash will be invested to buy
the raw material. The raw material purchased will be processed with the help ----------------------
of various infrastructural facilities like labour, machinery etc. to convert the
----------------------
same in the form of finished products. These finished products will be sold
in the market on credit basis whereby the receivables get created. And when ----------------------
receivables make the payment to the organisation, cash is generated again. As
such, there is a cycle in which cash available to the organisation is converted ----------------------
back in the form of cash. This cycle is referred to as Working Capital Cycle.
----------------------
----------------------

Notes
Cash
----------------------
----------------------
Raw
Debtors Materials
----------------------
----------------------
----------------------
Finished
WIP
Goods
----------------------
----------------------
In between each of these stages, there is some time gap involved. The entire
---------------------- requirement of working capital arises due to this time gap. As this time gap
is unavoidable, requirement of working capital is unavoidable. The finance
---------------------- professional is interested in reducing this time gap to the minimum possible
extent in order to manage the working capital properly.
----------------------
---------------------- 8.4 FACTORS AFFECTING WORKING CAPITAL REQUIREMENT

---------------------- a. Nature of business
---------------------- Some businesses are such that due to their very nature, their requirement
of fixed capital is more rather than working capital. These businesses may
---------------------- sell services and not the commodities and that too on cash basis. As such,
no funds are blocked in piling the inventories and no funds are blocked in
----------------------
receivables. E.g. Public utility services like railways, electricity boards,
---------------------- infrastructure oriented projects etc. Their requirement of working capital is
less. Whereas if the organisation is a trading organisation, the requirement
---------------------- of working capital will be on the higher side, as huge amount of funds get
blocked in mainly two types of current assets, stock and receivables.
----------------------
b. Size of the organisation
----------------------
In small-scale organisations, requirement of working capital is quite high
---------------------- due to high amount of overheads, high buying costs and high selling costs.
As such, medium sized organisations have an edge over the small-scale
---------------------- organisations. However, if the business grows beyond a certain limit, the
---------------------- requirement of working capital may be adversely affected by the increasing
size.
---------------------- c. Phase of trade cycles
---------------------- During the inflationary conditions, the working capital requirement will
be on the higher side as the company may like to buy more raw material,
----------------------
may increase the production to take the advantage of favourable market
---------------------- conditions and due to increased sales more funds are blocked in stocks and
receivables. During the depression, the requirement of working capital will
---------------------- be on the lower side due to reduced operations but more working capital

may be required due to piling up of inventories and due to non-payment of Notes
dues by customers in time. As such, in both the extreme situations of trade
cycles, requirement of working capital may be high. ----------------------
d. Trading terms ----------------------
The terms on which the organisation makes the purchases and sales affect
----------------------
the requirement of working capital in a big way. If the purchases are
required to be made on cash basis and sales are to be made on credit basis ----------------------
to cope with competition existing in the market, it will result into high
requirement of working capital. Whereas, if the purchases can be made ----------------------
on credit basis and sales can be made on cash basis, it will reduce the
----------------------
requirement of working capital, as a part of working capital requirement
can be financed out of credit offered by the suppliers. ----------------------
e. Length of production cycle
----------------------
The term production cycle refers to the time duration from the stage raw
material is acquired till the stage the finished product is manufactured. ----------------------
The principle will be “longer the duration of production cycle, higher the ----------------------
requirement of working capital”. In some businesses like machine tool
industry, the time gap between the acquisition of raw material till the ----------------------
completion of production is quite high. As such, more amount is blocked in
raw materials or work in progress or finished goods and even in receivables. ----------------------
Requirement of working capital is always very high in this case, whereas in ----------------------
case of the industries like paper industry or sugar industry, the production
cycle is very short. As such, the requirement of working capital, at least for ----------------------
stocks, may be very less.
----------------------
f. Profitability
----------------------
High profitability reduces the strain on working capital as the profit to the
extent they are earned in cash can be used for financing the requirement ----------------------
of working capital. However, the profit that reduces the strain on working
capital is the post-tax profit (i.e. the profit earned after paying off the tax ----------------------
liability) and post-dividend profit (i.e. the profit remaining in the business
----------------------
after paying the dividend on the shares.)
----------------------
----------------------
Fill in the Blanks.
1. The working capital requirement in respect of Public Utility Services ----------------------
such as railways, electricity is ________ than that required in a ----------------------
production unit.
2. If purchases are on Cash basis and sales are made on credit basis, it ----------------------
will result into __________ working capital requirement. ----------------------
3. _______ profitability reduces the strain on working capital.
----------------------

Notes 8.5 FINANCING OF WORKING CAPITAL REQUIREMENT
---------------------- Before we go ahead with the discussions on the various methods available for
financing the working capital requirement, the term working capital needs to be
---------------------- viewed from one more angle.
---------------------- a. Fixed or Permanent Working Capital
---------------------- b. Variable or Temporary Working Capital

Fixed Working Capital is the minimum working capital required to be maintained
----------------------
in the business on permanent or uninterrupted basis. The requirement for this
---------------------- type of working capital is unaffected due to the changes in the level of activity.
Variable working capital is the working capital required over and above the
----------------------
fixed or permanent working capital and changes with the fluctuations in the
---------------------- level of activity as a result of changes in production and sales. The relationship
between fixed and variable working capital can be shown with the help of the
---------------------- following diagram.
----------------------
Amount of
----------------------
Working
Capital
Temporary
----------------------
----------------------
Permanent
----------------------
---------------------- The basic principle of finance states that the permanent requirement of working
capital should be financed out of long-term or permanent sources viz. own
---------------------- generation of funds, cash profits, shares or debentures etc.
---------------------- For financing temporary requirement of working capital, the organisation can
go for various sources, which can be discussed as below:
----------------------
a. Spontaneous Sources
----------------------
b. Inter-Corporate Deposits
---------------------- c. Commercial Papers
---------------------- d. Banks
---------------------- a. Spontaneous Sources

Spontaneous Sources for financing the working capital requirement arise
---------------------- during the course of normal business operations. During the course of
---------------------- business operations, the company may be able to buy certain goods or
services for which the payment is to be made after a certain time gap.
---------------------- As such, the company is able to buy goods or services without making
payment for the same. These spontaneous sources are unsecured in nature
---------------------- and vary with the level of sales. These spontaneous sources do not have any
---------------------- explicit cost attached to the same. They are generally known as ‘Current
Liabilities.’
Following forms of current liabilities may be used as spontaneous sources Notes
for financing the working capital requirement.
----------------------
1. Trade Credit:
If the company buys the raw material from the suppliers on credit basis, ----------------------
it gets the raw material for utilisation immediately with the facility
----------------------
to make the payment at a delayed time. By accepting the delayed
payment, the suppliers of raw material finance the requirement of ----------------------
working capital. For using this source, certain factors may play an
important role – ----------------------
• Trends in the industry ----------------------
• Liquidity position of the company ----------------------
• Earnings of the company over a period of time
----------------------
• Record of payment by the company to the suppliers over a period
of time ----------------------
• Relationship of the company with the suppliers. ----------------------
2. Outstanding Expenses
----------------------
All the services enjoyed by the company are not required to be paid
for immediately. They are paid for after a certain time gap. As such, ----------------------
the company is able to get the benefit of these services without paying ----------------------
for the same immediately, thus getting the finance for working capital
purposes. These are called ‘outstanding expenses’. This may apply ----------------------
to salaries, wages, telephone expenses, electricity expenses, water
charges etc. ----------------------
b. Inter-Corporate Deposits (ICD) ----------------------
Intercorporate Deposits indicate the amount of funds borrowed by one ----------------------
company from another company, usually both the companies being under
the same management but not necessarily so. Point to be noted here is that ----------------------
ICDs are not considered deposits as per the provisions of Section 58-A of
the Companies Act, 1956 and as such, the regulations applicable to the ----------------------
public deposits do not apply to ICDs. ----------------------
Intercorporate Deposits as a source for financing the working capital
----------------------
requirement has the following characteristic features.
1. ICDs are for a very short period of time, viz. three months or six ----------------------
months.
----------------------
2. ICDs is an unsecured source for raising the funds required for working
capital purposes. ----------------------
3. ICDs, as a source, is not regulated by any law. As such, the rate of ----------------------
interest, period of ICD etc. can be decided by the company on its own.
----------------------
4. ICDs is a relationship based borrowing made by the company.
----------------------

Notes c. Commercial Papers
In the recent past, Commercial Papers (CPs) have become one of the best
----------------------
methods for financing the working capital requirements of the companies.
---------------------- The companies trying to raise the funds by issuing the CP are regulated
by Guidelines for issue of Commercial Papers (CPs), 2000 issued by
----------------------
Reserve Bank of India on October 10, 2000. These guidelines apply to
---------------------- the companies trying to raise the funds by issuing the CPs. As per these
guidelines, a company means a company as defined in Section 45-I (aa)
---------------------- of Reserve Bank of India Act, 1934. Section 45-I (aa) of Reserve Bank
Act, 1934 defines a company as the company as defined in section 3 of the
----------------------
Companies Act, 1956.
---------------------- What is a CP:
---------------------- Commercial Paper is an unsecured promissory note issued at a discount. The
rate of discount is required to be decided by the issuer and is not regulated. E.g.,
---------------------- ACP of Rs. 100 may be issued at Rs. 98, indicating that the investor has to pay
---------------------- Rs. 98 while at the time of maturity, he will get Rs. 100. It means that difference
between Rs. 98 and Rs. 100 i.e. Rs.2 is in the form of interest on investment
---------------------- made by the investor.
---------------------- Who can issue the CP:
A company will be eligible to issue the CP provided:
----------------------
a. The tangible net worth of the company as per latest audited balance sheet
---------------------- is not less than Rs. 4 Crore.
---------------------- Note: Tangible net worth means share capital plus free reserves duly
reduced by intangible assets like accumulated losses, deferred revenue
---------------------- expenditure etc. Free Reserves include share premium and debenture
---------------------- redemption reserve but do not include revaluation reserve.
b. Company has been sanctioned working capital limits by banks.
----------------------
c. Borrowed amount of the company is classified as a standard asset by the
---------------------- bank.
---------------------- Before the company issues the CPs, it is required to obtain satisfactory credit
rating from an approved credit rating agency. Presently, following credit rating
---------------------- agencies have been approved by RBI for this purpose.
---------------------- a. Credit Rating Information Services of India Ltd. (CRISIL)
b. Investment Information and Credit Rating Agency of India Ltd. (ICRA)
----------------------
c. Credit Analysis and Research Ltd. (CARE)
----------------------
d. FITCH Rating India (P) Ltd.
---------------------- The minimum credit rating required is P-2 of CRISIL. If the rating is given by
---------------------- any other agency, equivalent minimum rating will be required. The rating so
obtained by the company should be current and should not have fallen due for
---------------------- review.

Who can invest in CP: Notes
Following persons can invest in the CP
----------------------
a. Individuals
----------------------
b. Banks
c. Corporate Bodies incorporated in India ----------------------
d. Unincorporated Bodies ----------------------
e. Non-resident Indians ----------------------
f. Foreign Institutional Investors
----------------------
Nature of a CP:
----------------------
a. A CP can be issued for the maturity period of 7 days to one year.
b. A CP has the denomination of Rs. 5 Lakh and every single investor should ----------------------
invest minimum Rs. 5 Lakh in the CP. ----------------------
c. Every issue of CP, including the renewal, will be considered to be the fresh
issue. ----------------------
d. The amount of CP shall be within the overall limit sanctioned by the Board ----------------------
of Directors. It can be issued as a ‘stand alone’ product. Banks will be free
----------------------
to adjust the working capital limits after considering the CPs issued by the
company. ----------------------
It will not be out of place to mention here that CP is not treated as a deposit as
----------------------
per the provisions of Section 58-A of the Companies Act, 1956.
Procedure for issuing the CPs: ----------------------
Every company issuing the CP should appoint a scheduled bank as the Issuing ----------------------
and Paying Agent (IPA). IPA will satisfy itself that the company has obtained
satisfactory credit rating. It shall also verify the documents submitted by the ----------------------
issuing company and issue a certificate that the documents are in order. IPA ----------------------
should also certify that it has a valid agreement with the issuing company.
The issuing company shall arrange to place the CPs on private placement basis ----------------------
with the investors. The issuing company shall disclose to the potential investor ----------------------
its financial position. After the deal is confirmed, the issuing company shall
issue physical certificates to the investor. Investors shall be given a copy of IPA ----------------------
certificate to the effect that the issuing company has a valid agreement with the
IPA and documents are in order. ----------------------
Every issue of CP should be reported to RBI through the IPA within three days ----------------------
from the date of completion of the issue.
----------------------
Advantages of Commercial Papers:
----------------------
a. As CPs are required to be rated, good rating reduces the cost of capital for
the company. ----------------------
b. CP is one of the best possible ways available to the company to take the
----------------------
advantage of short-term interest fluctuations in the market.

Notes c. CP being the negotiable instrument, it provides the exit option to the
investor to quit the investment.
----------------------
d. As CPs are unsecured, no charge is required to be created on the assets of
---------------------- the issuing company.
Disadvantages of Commercial Papers:
----------------------
a. CP is a source for short-term financing available only to a few selected blue
---------------------- chip and profitable companies.
---------------------- b. By issuing CP, the credit available from the banks may get reduced.
---------------------- c. Issue of CP is very closely regulated by the RBI guidelines.

d. Banks
----------------------
In the Indian circumstances, banks play a very major role in financing the
---------------------- working capital requirement of the organisations. We will consider the bank
as a source for financing the working capital requirement of the organisations
----------------------
under the following heads:
---------------------- a. What should be the amount of assistance?
---------------------- b. What should be the form in which working capital assistance is extended?
---------------------- c. What security should be obtained for working capital assistance?

d. What are the various applicable regulations to be considered by the banks
---------------------- while extending the working capital assistance?
---------------------- 1. Amount of Assistance
---------------------- To obtain the bank credit for financing the working capital requirements, the
company is required to estimate the working capital requirement properly.
---------------------- To estimate the requirement of working capital requirement properly, the
company will be required to estimate its level of current assets and current
----------------------
liabilities properly, as working capital is the difference between current
---------------------- assets and current liabilities. For this, the techniques like ratio analysis,
trend analysis etc. can be used by the company. More accurate the estimation
---------------------- of the level of current assets and current liabilities, more accurate will be
estimation of the requirement of working capital. Then, the company will
----------------------
have to approach the bank along with the necessary supporting data. On the
---------------------- basis of the estimates submitted by the company, the bank may decide the
amount of assistance that can be extended. While extending the working
---------------------- capital assistance, the bank may prescribe the margin money requirement.
The margin money stipulation is made by the banks in order to ensure the
----------------------
borrowing company’s own stake in the business and also to provide the
---------------------- cushion against the possible reduction in the value of security offered to
the bank. The percentage of margin money stipulation may depend upon
---------------------- the credit standing of the borrowing company, fluctuations in the price
of the security and the directives of RBI from time to time. The general
----------------------
principle applicable will be, “the dicier the nature of security, the higher
---------------------- will be the margin money stipulations.”

2. Form of Assistance: Notes
After deciding the amount of overall assistance to be extended to the
----------------------
company, the bank can disburse the amount in any of the following forms:
Non-Fund Based Lending ----------------------
In case of Non-Fund Based Lending, the lending bank does not commit any ----------------------
physical outflow of funds. As such, the funds position of the lending bank
remains intact. The Non-Fund Based Lending can be made by the banks in two ----------------------
forms:
----------------------
a. Bank Guarantees:
----------------------
The mechanism of bank guarantees is described below:
Suppose Company A is the selling company and Company B is the purchasing ----------------------
company. Company A does not know Company B and as such is concerned ----------------------
whether Company B will make the payment or not. In such circumstances,
D who is the Bank of Company B, opens the Bank Guarantee in favour of ----------------------
Company A in which it undertakes to make the payment to Company A, if
Company B fails to honour its commitment to make the payment in future. As ----------------------
such, interests of Company A are protected as it is assured to get the payment, ----------------------
either from Company B or from its Bank D. As such, Bank Guarantee is the
mode, which will be found typically in the seller’s market. As far as Bank D ----------------------
is concerned, while issuing the guarantee in favour of Company A, it does not
commit any outflow of funds. As such, it is a Non-Fund Based Lending for Bank ----------------------
D. If on due date, Bank D is required to make the payment to Company A due ----------------------
to failure on account of Company B to make the payment, this Non-Fund Based
Lending becomes the Fund based Lending for Bank D which can be recovered ----------------------
by Bank D from Company B. For issuing the Bank Guarantee, Bank D charges
the Bank Guarantee Commission to Company B, which is decided on the basis ----------------------
of two factors, viz. the amount of Bank Guarantee and the period of validity ----------------------
of Bank Guarantee. In case of this conventional form of Bank Guarantee, both
Company A as well as Company B is benefited. Company A is benefited as it ----------------------
is assured to get the payment. Company B is benefited, as it is able to make the
credit purchases from Company A without knowing Company A.As such, Bank ----------------------
Guarantee transactions will be applicable in case of credit transactions. ----------------------
In some cases, interests of purchasing company are also to be protected. Suppose
----------------------
that Company A which manufactures capital goods takes some advance from
the purchasing Company B. If Company A fails to fulfill its part of the contract ----------------------
to supply the capital goods to Company B, there needs to be some protection
available to Company B. In such circumstances, Bank C, which is the banker ----------------------
of Company A, opens a Bank Guarantee in favour of Company B in which
----------------------
it undertakes that if Company A fails to fulfill its part of the contract, it will
reimburse any losses incurred by Company B due to this non-fulfillment of ----------------------
contractual obligations. Such Bank Guarantee is technically referred to as
Performance Bank Guarantee and is ideally found in the buyer’s market. ----------------------
----------------------

Notes b. Letter of Credit:
The non-fund based lending in the form of Letter of Credit (LC) is very
----------------------
regularly found in the international trade. In this case, the exporter and importer
---------------------- are unknown to each other. Under these circumstances, the exporter is worried
about getting the payment from importer and the importer is worried as to
---------------------- whether he will get the goods or not. In this case, the importer applies to his
bank in his country to open a letter of credit in favour of the exporter whereby
----------------------
the importer’s bank undertakes to pay the exporter or accept the bills or drafts
---------------------- drawn by the exporter on the exporter fulfilling the terms and conditions
specified in the letter of credit. Thus, there are essentially three parties in the
---------------------- case of a letter of credit:
---------------------- a. The Importer
b. The Issuer who is the bank of the importer
----------------------
c. The Exporter who is the beneficiary in case of Letter of Credit
----------------------
In practical circumstances, there may be some other parties involved in case of
---------------------- Letter of Credit.
---------------------- a. Advising Bank – This bank is in the exporter’s country, which notifies the
exporter about opening of Letter of Credit.
----------------------
b. Confirming Bank – If the exporter is not satisfied about the security offered
---------------------- by the importer, he may insist that the letter of credit be confirmed by any
other bank, other than the issuing bank. In this case, both the banks are
---------------------- liable to honour the bills of exchanges.
---------------------- The letter of credit may be of different varieties.
a. Revocable or Irrevocable – In case of revocable letter of credit, the issuing
----------------------
bank can cancel or change the obligation to make the payment or honour
---------------------- the bills or drafts drawn upon it. In case of irrevocable letter of credit, the
issuing bank agrees not to cancel or modify the terms of Letter of Credit.
----------------------
b. Confirmed or Unconfirmed – If the exporter is not satisfied with the security
---------------------- offered by the importer, he insists upon the confirmation of a bank, other
than the issuing bank which guarantees the payment and/or acceptance of
---------------------- the drafts or bills drawn by the exporter. In case of unconfirmed letter of
---------------------- credit, there is no such confirmation.
The combination of irrevocable and confirmed letter of credit can be considered
---------------------- to be a guaranteed payment on the part of the exporter.
---------------------- The mechanism of letter of credit proves to be beneficial for the exporter as well
as the importer.
----------------------
Advantages to the Exporter:
----------------------
a. Exporter is assured to get the payment for the goods exported by him, if
---------------------- he satisfies all the terms and conditions specified in the letter of credit.
This eliminates the risk of dealing with an unknown importer in a different
---------------------- country.

b. If the exporter has fulfilled all the terms and conditions of the letter of Notes
credit, he can approach his local bank and get the advance pending against
export proceeds receivable from the importer. ----------------------
Advantages to the Importer: ----------------------
a. The issuing bank specifies various terms and conditions in the letter of
----------------------
credit, which are required to be fulfilled by the exporter, compliance of
which is carefully examined by the issuing bank. As such, the importer is ----------------------
assured to get a proper supply of the goods.
----------------------
b. As the letter of credit assures the payment to the exporter, the importer can
bargain for better trading terms with the exporter. ----------------------
It should be noted here that the mechanism of letter of credit could be equally ----------------------
applicable in case of domestic trade also.
Fund based lending ----------------------
In case of Fund Based Lending, the lending bank commits the physical outflow ----------------------
of funds. As such, the funds position of the lending bank does get affected. The
Fund Based Lending can be made by the banks in the following forms: ----------------------
i. Loan: In this case, the entire amount of assistance is disbursed at one ----------------------
time only, either in cash or by transfer to the company’s account. It is a
----------------------
single advance. The loan may be repaid in installments, the interest will be
charged on outstanding balance. ----------------------
ii. Overdraft: In this case, the company is allowed to withdraw in excess
----------------------
of the balance standing in its Bank account. However, a fixed limit is
stipulated by the Bank beyond which the company will not be able to ----------------------
overdraw the account. Granting of the assistance in the form of overdraft
presupposes the opening of a formal current account. Legally, overdraft is ----------------------
a demand assistance given by the bank i.e. bank can ask for the repayment
----------------------
at any point of time. Overdraft is given by the bank for a very short period,
at the end of which the company is supposed to repay the same. Interest ----------------------
is payable on the actual amount drawn and is calculated on daily product
basis. ----------------------
iii. Cash Credit: In practice, the operations in cash credit facility are similar ----------------------
to those of overdraft facility except the fact that the company need not have
a formal current account. Here also a fixed limit is stipulated beyond which ----------------------
the company is not able to withdraw the amount. Legally, cash credit also ----------------------
is a demand facility, but in practice, it is on continuous basis. Here also,
the interest is payable on actual amount drawn and is calculated on daily ----------------------
product basis.
----------------------
iv. Bills Purchased / Discounted: This form of assistance is comparatively
of recent origin. This facility enables the company to get the immediate ----------------------
payment against the credit bills/invoices raised by the company. The bank
holds the bills as a security till the payment is made by the customer. The ----------------------
entire amount of bill is not paid to the company. The company gets only ----------------------

Notes the present worth of the amount of the bill, the difference between the
face value of the bill and the amount of assistance being in the form of
---------------------- discount charges. However, on maturity, the bank collects the full amount
of bill from the customer. While granting this facility to the company, the
---------------------- bank inevitably satisfies itself about the credit worthiness of the customer
---------------------- and the genuineness of the bill. A fixed limit is stipulated in case of the
company, beyond which the bills are not purchased or discounted by the
---------------------- bank.
---------------------- v. Working Capital Term Loans: To meet the working capital needs of the
company, banks may grant the working capital term loans for a period of 3
---------------------- to 7 years, payable in yearly or half yearly installments.
---------------------- vi. Packing Credit: This type of assistance may be considered by the bank to
take care of specific needs of the company when it receives some export
---------------------- order. Packing credit is a facility given by the bank to enable the company
to buy/manufacture the goods to be exported. If the company holds a
----------------------
confirmed export order placed by the overseas buyer or an irrevocable
---------------------- letter of credit in its favour, it can approach the bank for packing credit
facility. Basically, packing credit facility may take two forms:
----------------------
a) Pre-shipment Packing Credit: To take care of needs of the company
---------------------- before the goods are shipped to the overseas buyer.
---------------------- b) Post-shipment Packing Credit: To take care of needs of the company

from the shipment of goods to the overseas buyer till the date of
---------------------- collection of dues from him.
---------------------- Necessarily, both these facilities are short-term facilities. The company may
be required to repay the same within a predecided span or out of the export
---------------------- proceeds of the goods exported.
---------------------- 3. Security for Assistance:
The bank may provide the assistance in any of the modes as stated above.
----------------------
But normally no assistance will be available unless the company offers
---------------------- some security in any of the following forms.
1) Hypothecation
----------------------
Under this mode of security, the bank extends the assistance to the
---------------------- company against the security of movable property, usually inventories.
---------------------- Under this mode of security neither the property not the possession of
the goods hypothecated is transferred to the bank. But the bank has the
---------------------- right to sell the goods hypothecated to realise the outstanding amount
of assistance granted by it to the company.
----------------------
2) Pledge
---------------------- Under this mode of security, the bank extends the assistance to the
---------------------- company against the security of movable property, usually inventories.
But unlike in case of hypothecation, possession of the goods is with the
---------------------- Bank and the goods pledged are in the custody of the bank. As such, it

is the duty of the bank to take care of the goods in its custody. In case Notes
of default on the part of company to repay the amount of assistance,
the bank has the right to sell the goods to realise the outstanding ----------------------
amount of assistance.
----------------------
3) Lien
----------------------
Under this mode of security, the bank has a right to retain the goods
belonging to the company until the debt due to the bank is paid. ----------------------
Lien can be of two types. i) Particular Lien: It is valid till the claims
pertaining to specific goods are fully paid. ii) General Lien: It is valid ----------------------
till all the dues payable to the bank are paid. Normally, banks enjoy
----------------------
general Lien.
4) Mortgage ----------------------
This mode of security pertains to immovable properties like land and ----------------------
buildings. It indicates transfer of legal interest in a specific immovable
property as security for the payment of debt. Under this mode, the ----------------------
possession of the property remains with the borrower while the bank ----------------------
gets full legal title there, subject to borrower’s right, to repay the
debt. The party who transfers the interest (i.e. the company) is called ----------------------
mortgager and the party in whose favour the interest is so transferred
(i.e. the bank) is called mortgagee. ----------------------
----------------------
----------------------
Multiple Choice Multiple Response. ----------------------
1. For financing temporary requirement of working capital, various
----------------------
sources available are:
i. Spontaneous Sources ----------------------
ii. Inter-Corporate Deposits
----------------------
iii. Commercial Papers
iv. Banks ----------------------
v. Term Lending Institutions ----------------------
vi. Refinancing Institutions
----------------------
2. Usually, Trade Credit is required to be extended because of
i. Trends in the industry ----------------------
ii. Liquidity position of the company ----------------------
iii. Earnings of the company over a period of time
----------------------
iv. Relationship of the company with the suppliers
v. Defective quality of the products ----------------------
vi. Manufacturer wants to dump the products in the market ----------------------
----------------------

Notes
Activity 2
----------------------
---------------------- In view of the fact that Commercial Papers (CPs) have become best methods
for financing the working capital requirements of the companies, study
---------------------- some CPs and list down special features of CPs.
----------------------
---------------------- 8.6 CONTROL OVER WORKING CAPITAL

---------------------- It can be seen from the preceding discussions that the commercial banks play a
very significant role in financing working capital needs. These working capital
---------------------- needs used to be met mainly in the form of cash credit facilities and these
advances used to be totally security oriented rather than end-use oriented. As
----------------------
such, the units which were able to provide securities to the banks were able to get
---------------------- main chunk of the finances provided by the banks whereas others experienced
shortage of inputs, lower capacity utilisation, high cost of production and
---------------------- ultimately threat of closure. Reserve Bank of India has attempted to identify
major weakness in the system of financing of working capital needs by Banks
----------------------
in order to control the same properly. These attempts were mainly in the form
---------------------- of appointment of following committees:
---------------------- (a) Dahejia Committee:

This committee was appointed in October 1968 to examine the extent to which
---------------------- credit needs of industry and trade are likely to be inflated and how such trends
---------------------- could be checked.
Findings: The committee found out that there was a tendency of industry to
---------------------- avail of short-term credit from Banks in excess of growth rate in production for
---------------------- inventories in value terms. Secondly, it found out that there was a diversion of
short-term bank credit for the acquisition of long-term assets. The reason for
---------------------- this is that generally banks granted working capital finance in the form of cash
credit, as it was easy to operate. Banks took into consideration security offered
---------------------- by the client rather than assessing financial position of the borrowers. As such,
---------------------- cash credit facilities granted by the banks was not utilised necessarily for short-
term purposes.
----------------------
Recommendations: The committee, firstly, recommended that the banks
---------------------- should not only be security oriented, but they should take into consideration
total financial position of the client. Secondly, it recommended that all cash
---------------------- credit accounts with banks should be bifurcated in two categories.
---------------------- i. Hard core which would represent the minimum level of raw materials,
finished goods and stores which any industrial concern is required to hold
---------------------- for maintaining certain level of production.
---------------------- ii. Short-term component, which would represent of funds for temporary
purposes i.e. Short-term increase in inventories, tax, dividend and bonus
---------------------- payments etc.

It also suggested that hard-core part in case of financially sound companies Notes
should be put on a term loan basis subject to repayment schedule. In other
cases, borrowers should be asked to arrange for long-term funds to replace bank ----------------------
borrowings.
----------------------
In practice, recommendations of the committee had only a marginal effect on
the pattern and form of banking. ----------------------
(b) Tandon Committee: ----------------------
In August 1975, Reserve Bank of India appointed a study group under the ----------------------
Chairmanship of Mr. P. L. Tandon, to make the study and recommendations on
the following issues: ----------------------
i. Can the norms be evolved for current assets and for debt equity ratio to ----------------------
ensure minimum dependence on bank finance?
----------------------
ii. How the quantum of bank advances may be determined?
iii. Can the present manner and style of lending be improved? ----------------------
iv. Can an adequate planning, assessment and information system be evolved ----------------------
to ensure a disciplined flow of credit to meet genuine production needs and
its proper supervision? The observations and recommendations made by ----------------------
the committee can be considered as below:
----------------------
1. Norms: The committee suggested the norms for inventory and accounts
receivables for as many as 15 industries excluding heavy engineering ----------------------
industry. These norms suggested, represent maximum level of inventory ----------------------
and accounts receivables in each industry. However if the actual levels are
less than the suggested norms, it should be continued. ----------------------
The norms were suggested in the following forms: ----------------------
• For Raw Materials: Consumption in months.
----------------------
• For Work in Progress: Cost of production in months.
----------------------
• For Finished Goods: Cost of Sales in months.
• For Receivables: Sales in months. ----------------------
It was clarified that the norms suggested cannot be absolute or rigid and the ----------------------
deviations from the norms may be allowed under certain circumstances.
----------------------
Further, it suggested that the norms should be reviewed constantly.
----------------------
It was suggested that the industrial borrowers having an aggregate limits
of more than Rs. 10/- Lakh from the Banks should be subjected to these ----------------------
norms initially and later it can be extended even to the small borrowers.
----------------------
2. Methods of Borrowings: The committee recommended that the amount of
bank credit should not be decided by the capacity of the borrower to offer ----------------------
security to the banks but it should be decided in such a way to supplement
the borrower’s resources in carrying a reasonable level of current assets ----------------------
in relation to his production requirement. For this purpose, it introduced
----------------------
the concept of working capital gap i.e. the excess of current assets over

Notes current liabilities other than bank borrowings. It further suggested three
progressive methods to decide the maximum limits according to which
---------------------- banks should provide the finance.
---------------------- Method I: Under this method, the committee suggested that the Banks should
finance maximum to the extent of 75% of working capital gap, remaining 25%
---------------------- should come from long-term funds i.e. own funds and term borrowings.
---------------------- Method II: Under this method, the committee suggested, that the borrower
should finance 25% of current assets out of long-term funds and the banks
---------------------- provide the remaining finance.
---------------------- Method III: Under this method, the committee introduced the concept of core
current assets to indicate permanent portion of current assets and suggested that
---------------------- the borrower should finance the entire amount of core current assets and 25%
of the balance current assets out of long-term funds and the banks may provide
----------------------
the remaining finance.
---------------------- To explain these methods in further details, let us consider the following data:
---------------------- Current Assets Rs. 400
---------------------- Core Current Assets Rs. 100
Current Liabilities Rs. 80
----------------------
(Except bank borrowings)
----------------------
The maximum amount of bank finance can be decided as below:
---------------------- Method I
---------------------- Current Assets 400
---------------------- Less: Current Liabilities (except bank borrowings) 80
Working Capital Gap 320
---------------------- 25% of above from Own Sources 80
---------------------- Maximum Permissible Bank Finance (MPBF) 240
Current Ratio = 400 1.25
---------------------- 320
----------------------
Method II
----------------------
Current Assets 400
----------------------
25% of above from Own Sources 100
---------------------- 300
Less: Current Liabilities (except bank borrowings) 80
----------------------
Working Capital Gap 220
---------------------- Maximum Permissible Bank Finance (MPBF) 220
----------------------
300
----------------------

Method III Notes
Current Assets 400
----------------------
Less: Core Current Assets from Own Sources 100
Other Current Assets 300 ----------------------
25% of above from Own Sources 75 ----------------------
225
Less: Current Liabilities (except bank borrowings) 80 ----------------------
Maximum Permissible Bank Finance (MPBF) 145 ----------------------
225 ----------------------
It can be observed from above that the gradual implementation of these methods ----------------------
will reduce the dependence of borrowers on bank finance and improve their
current ratio. The committee suggested that the borrowers should be gradually ----------------------
subjected to these methods of borrowings from first to third.
----------------------
However, if the borrower is already in second or third method of lending,
he should not be allowed to slip back to first or second method of lending ----------------------
respectively.
----------------------
It was further suggested that if the actual bank borrowings are more than the
maximum permissible bank borrowings, the excess should be converted into ----------------------
a term loan to be amortized over a suitable period depending upon the cash
----------------------
generating capacity.
3. Style of Lending: The committee suggested changes in the manner of ----------------------
financing the borrower. It suggested that the cash credit limit should be
bifurcated into two components i.e. Minimum level of borrowing required ----------------------
throughout the year should be financed by way of a term loan and the ----------------------
demand cash credit to take care for fluctuating requirements. It was
suggested that both these limits should be reviewed annually and that the ----------------------
term loan component should bear a slightly lower rate of interest so that the
borrower will be motivated to use the least amount of demand cash credit. ----------------------
The committee also suggested that within overall eligibilities, a part of the
----------------------
limits may be in the form of bill limits (to finance the receivables) rather
than in the form of cash credit. ----------------------
4. Credit Information Systems: In order to ensure the receipt of operational
----------------------
data from the borrowers to exercise control over their operations properly,
the committee recommended the submission of a quarterly reporting ----------------------
system, based on actual as well as estimations, so that the requirements
of working capital may be estimated on the basis of production needs. As ----------------------
such, borrowers enjoying total credit limits aggregating Rs. 1 Crore and
above were required to submit certain statements in addition to monthly ----------------------
stock statements and projected balance sheet and profit and loss account at ----------------------
the end of the financial year. The working capital limits sanctioned were
to be reviewed on annual basis. Within the overall permissible level of ----------------------
borrowing, the day-to-day operations were to be regulated on the basis of
drawing power. ----------------------

Notes 5. Follow up, Supervision and Control: In order to assure that the assumptions
made while estimating the working capital needs still hold good and that
---------------------- the funds are being utilised for the intended purpose only, it was suggested
that there should be a proper system of supervision and control. Variations
---------------------- between the projected figures and actuals may be permitted to the extent of
---------------------- 10%, but variations beyond that level will require prior approval. After the
end of the year, credit analysis should be done in respect of new advances
---------------------- when the banks should re-examine terms and conditions and should make
necessary changes. For the purpose of proper control, it suggested the
---------------------- system of borrower classification in each bank within a credit rating scale.
---------------------- 6. Norms for Capital Structure: As regards the capital structure or debt
equity ratio, the committee did not suggest any specific norms. It opined
---------------------- that debt equity relationship is a relative concept and depends on several
---------------------- factors. Instead of suggesting any rigid norms for debt equity ratio, the
committee opined that if the trend of debt equity ratio is worse than the
---------------------- medians, the banker should persuade the borrowers to strengthen the equity
base as early as possible.
----------------------
Action taken by RBI
---------------------- According to the notification of RBI dated 21st August, 1975, RBI accepted
---------------------- some of the main recommendations of the committee.
1. Norms for Inventories and Receivables: Norms suggested by the
---------------------- committee were accepted and banks were instructed to apply them in case
---------------------- of existing and new borrowers. If the levels of inventories and receivables
are found to be excessive than the suggested norms, the matters should
---------------------- be discussed with the borrower. If excessive levels continue without
justification, after giving reasonable notice to the borrowers, banks may
---------------------- charge excess interest on that portion which is considered as excessive.
---------------------- 2. Coverage: Initially, all the industrial borrowers (including small-scale
industries) having aggregate banking limits of more than Rs. 10/- Lakh
---------------------- should be covered, but it should be extended to all borrowers progressively.
---------------------- 3. Methods of Borrowing: RBI instructed the banks that all the covered
borrowers should be placed in method I as recommended by the committee.
---------------------- However, all those borrowers who are already complying with requirements
---------------------- of Method II should not slip back to Method I. As far as Method III is
concerned, RBI has not taken any view. However, in case of the borrowers
---------------------- already in Method II, matter of application of Method III may be decided
on case-to-case basis.
----------------------
4. Style of Credit: As suggested by the committee, instead of granting entire
---------------------- facility by way of cash credit, banks may bifurcate the limit in two: i. Term
loan to take care of permanent requirement and ii. fluctuating cash credit.
---------------------- Within the overall limits, bill limits may also be considered.
---------------------- 5. Information system: Suggestions made by the committee regarding the
information system were accepted by RBI and were made applicable to all
---------------------- the borrowers having the overall banking limits of more than Rs. 1 crore.

(c) Chhore Committee: Notes
In April 1979, Reserve Bank of India appointed a study group under the
----------------------
chairmanship of Mr. K.B. Chhore to review mainly the system of cash credit
management policy by banks. ----------------------
The observations and recommendations made by the committee can be discussed
----------------------
as below:
1. The committee has recommended increasing role of short-term loans and ----------------------
bill finance and curbing the role of cash credit limits.
----------------------
2. The committee has suggested that the borrowers should be required to
enhance their own contribution in working capital. As such, they should be ----------------------
placed in Second Method of lending as suggested by Tandon Committee.
----------------------
If the actual borrowings are in excess of maximum permissible borrowings
as permitted by Method II, the excess portion should be transferred to ----------------------
Working Capital Term Loan (WCTL) to be repaid by the borrower by half
yearly installments maximum within a period of 5 years. Interest on WCTL ----------------------
should normally be more than interest on cash credit facility.
----------------------
3. The committee has suggested that there should be the attempts to inculcate
more discipline and planning consciousness among the borrowers, their ----------------------
needs should be met on the basis of quarterly projections submitted by
----------------------
them. Excess or under utilisation beyond tolerance limit 10% should be
treated as irregularity and corrective action should be taken. ----------------------
4. The committee has suggested that the banks should appraise and fix
separate limits for normal non-peak levels and also peak levels. It should ----------------------
be done in respect of all borrowers enjoying the banking credit limits of ----------------------
more than Rs. 10 Lakh.
5. The committee suggested that the borrowers should be discouraged from ----------------------
approaching the banks frequently for ad hoc and temporary limits in ----------------------
excess of limits to meet unforeseen contingencies. Requests for such limits
should be considered very carefully and should be sanctioned in the form ----------------------
of demand loans or non-operating cash credit limits. Additional interest of
1% p.a. should be charged for such limits. ----------------------
(d) Marathe Committee ----------------------

In 1982, Reserve Bank of India appointed a study group known as Marathe ----------------------
Committee to review the Credit Authorisation Scheme (CAS), which was in
existence since 1965. Under CAS, the banks were required to take the prior ----------------------
approval of RBI for sanctioning the working capital limits to the borrowers. As
----------------------
per Marathe Committee recommendations, in the year 1988, CAS was replaced
by Credit Monitoring Arrangement (CMA) according to which the banks were ----------------------
supposed to report to RBI, sanctions or renewals of the credit limits beyond the
prescribed amounts for the post-sanction scrutiny. ----------------------
(e) Nayak Committee and Vaz Committee: ----------------------
Recently, RBI has accepted the recommendations made by Nayak Committee. ----------------------

Notes This was with the intention to recognise the contribution made by the SSI Sector
to the economy.
----------------------
According to Nayak Committee recommendations, for evaluating working
---------------------- capital requirements of village industries, tiny industries and other SSI units
having the total fund based working capital limits up to Rs. 50 Lakh, the norms
---------------------- for inventory and receivables as suggested by Tandon Committee will not
apply. The working capital requirement of these units will be considered to be
----------------------
25% of their projected turnover (for both new as well as existing units), out of
---------------------- which 20% is supposed to be introduced by the units as their margin money
requirements and remaining 80% can be financed by the bank. In other words,
---------------------- there are four working capital cycles assumed in every year.
---------------------- Vaz Committee has extended the recommendations of Nayak Committee to all
the business organisations. This has also been accepted by RBI.
----------------------
As a result of Nayak Committee and Vaz Committee recommendations,
---------------------- projected turnover of the borrowers is the basis for evaluating the working
capital requirement. Out of the projected turnover, 5% is supposed to be
---------------------- introduced by the borrower in the form of own contribution and remaining 20%
can be financed by the bank. The requirement of working capital has nothing to
----------------------
do with the level of current assets and current liabilities, which was the basis of
---------------------- Tandon Committee and Chhore Committee recommendations.
---------------------- Evaluation of working capital requirements by the banks relaxed with the
intention to give greater autonomy to the banks while evaluating working capital
---------------------- requirement, RBI has officially withdrawn the concept of MBPF with effect
from 15th April, 1997. As a result of this, now the banks are free to have their
---------------------- own methods for evaluating the working capital requirement of the borrowers.
----------------------
----------------------
---------------------- Match the Following.
---------------------- i. Daheja Committee a. 4 working capital cycles assumed in every

year
---------------------- ii. Tandon Committee b. To review the system of Cash Credit
management policy by banks
----------------------
iii. Chhore Committee c. To see how the quantum of bank advances
---------------------- may be determined
iv. Nayak Committee d. To examine the extent to which credit
---------------------- needs of industry and trade are likely to
---------------------- be inflated and how such trends could be
checked
----------------------
----------------------
----------------------

Notes
Activity 3
----------------------
Study the manufacturing activity of a Small Scale Unit and identify the ----------------------
cycle of its working capital requirement.
----------------------
8.7 ILLUSTRATIVE PROBLEMS ----------------------
----------------------
1. A proforma cost sheet of a company provides the following particulars:
Elements of cost Amount per unit ----------------------
Raw material 80 ----------------------
Direct Labour 30
Overheads 60 ----------------------
Total Cost 170 ----------------------
Profit 30
----------------------
Selling Price 200
The following further particulars are available: ----------------------
Raw materials are in stock for one month. ----------------------
Credit allowed by suppliers is one month.
----------------------
Credit allowed to customers is two months.
Lag in payment of wages 1.5 weeks. ----------------------
Lag in payment of overheads one month. ----------------------
Materials are in process for an average of half month.
----------------------
Finished Goods are in stock for an average of one month.
----------------------
¼ output is sold against cash.
Cash in hand and at bank is expected to be Rs. 25,000. You are requested to ----------------------
prepare a statement showing the working capital needed to finance a level of ----------------------
activity of 1,04,000 units of product.
You may assume that production is carried on evenly throughout the year. ----------------------
Wages and overheads accrue similarly and a period of 4 weeks is equivalent to ----------------------
a month.
Solution: ----------------------
(A) Current Assets ----------------------

1) Raw Material 2000 units X Rs. 80 X 4 weeks 6,40,000 ----------------------
2) Work in Process* 2000 units X Rs. 125 X 2 weeks 5,00,000
3) Finished Goods 2000 units X Rs. 170 X 4 weeks 13,60,000 ----------------------
4) Debtors 1500 units X Rs. 170 X 8 weeks 20,40,000
----------------------
(Cost Equivalent)
5) Cash Balance 25,000 ----------------------

Notes * For WIP, cost is taken at 50% in respect of labour and 45,65,000
overheads
---------------------- (B) Current Liabilities
---------------------- 1) Creditors 2000 units X Rs. 80 X 4 weeks 6,40,000
2) Outstanding wages 2000 units X Rs. 30 X 1.5 weeks 90,000
---------------------- 3) Outstanding 2000 units X Rs. 60 X 4 weeks 4,80,000
---------------------- Overheads
12,10,000
---------------------- (C) Net Working Capital Required (A-B) 33,55,000
---------------------- Working Notes:
1. It is assumed that the total units during the year are distributed over total
---------------------- number 52 weeks. As total units sold during the year are 1,04,000, weekly
sales work out to 2,000 units.
----------------------
2. Calculation of Debtors: 1/4th of total units are sold in cash. As such, out of
---------------------- weekly sales of 2,000 units, only 1500 units are sold on credit, each unit
---------------------- having the cost of Rs. 170 and the balance is outstanding for 2 months i.e.
8 weeks. As such, amount blocked in debtors works out to
---------------------- 1500 Units X Rs. 170 X 8 weeks i.e. Rs. 20,40,000.
----------------------
2. Raju Brothers Private Limited sells goods on a gross profit of 25%.
---------------------- Depreciation is considered in cost of production. The following are the
annual figures given to you.
----------------------
Rs.
----------------------
Sales (Two month’s credit) 18,00,000
---------------------- Materials consumed (one month’s credit) 4,50,000
Wages paid (one month lag in payment) 3,60,000
----------------------
Administration expenses (one month lag in payment) 1,20,000
---------------------- Sales Promotion expenses (paid quarterly in advance) 60,000
Income tax payable in 4 equal instalments 1,50,000
----------------------
Cash manufacturing exp. (one month lag in payment) 4,80,000
---------------------- The company keeps one month’s stock each of raw materials and finished goods.
It also keeps Rs. 1,00,000 in cash. You are required to estimate the working
----------------------
capital requirements of the company on cash basis assuming 15% safety margin.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Solution: Notes
Estimated Working Capital Requirements of Raju Brothers Pvt. Ltd.
----------------------
Rs.
(A) Current Assets ----------------------
Sundry Debtors (1/6th of cash cost) 2,45,000 ----------------------
Sales Promotion Expenses (Paid in Advance) 15,000
----------------------
Stock of Raw Material (Rs. 450,000/12) 37,500
Stock of Finished Goods (Rs. 12,90,000/12) 1,07,500 ----------------------
Cash in hand 1,00,000
----------------------
5,05,000
(B) Current Liabilities ----------------------
Sundry Creditors (Rs. 4,50,000/12) 37,500
----------------------
Outstanding Expenses
- Wages 30,000 ----------------------
- Manufacturing Expenses 40,000
----------------------
- Administrative Expenses 10,000
Income Tax Payable 37,500 ----------------------
1,17,500
----------------------
(C) Working Capital (A-B) 3,87,500
Add: 15% Safety Margin 58,125 ----------------------
Working Capital Requirement 4,45,625 ----------------------
Working Notes
----------------------
(1) Manufacturing Expenses
Rs. ----------------------
Sales 18,00,000 ----------------------
Less Gross Profit @ 25% 4,50,000
----------------------
∴ Manufacturing Cost 13,50,000 …A
Known Components of Manufacturing cost are ----------------------
Material 4,50,000
----------------------
Wages 3,60,000
Cash Manufacturing Expenses 4,80,000 ----------------------
∴ Cash Manufacturing Cost 12,90,000 ...B
----------------------
Hence,
Manufacturing Cost (A) 13,50,000 ----------------------
Less: Cash Manufacturing Cost (B) 12,90,000
----------------------
∴ Depreciation 60,000
----------------------
----------------------
----------------------

Notes (2) Total Cash Cost
Cash Manufacturing Cost
----------------------
(As per B above) 12,90,000
---------------------- Administrative Expenses 1,20,000
Sales Promotion Expenses 60,000
----------------------
∴ Total cash cost 14,70,000
---------------------- (3) Income Tax liability of the company will not be considered as a part of
the cost.
----------------------
3. From the following information, make an assessment of working capital
---------------------- required by a firm X and Co. The firm has approached bank A who have
agreed to sanction the working capital limits based on the data furnished
----------------------
by the firm. Retaining margins are as under.
---------------------- Raw Materials – 25%
---------------------- Stocks in Process – 33.33%
Finished goods – 25%
----------------------
Debtors – 20%
----------------------
You are also required to work out the working capital limits proposed to be
---------------------- sanctioned by the bank.
---------------------- Estimates for 2007-08 Rs.

Monthly Sales 1,00,000
----------------------
Monthly cost of production 72,000
---------------------- (including raw material consumption)
---------------------- Monthly raw material consumption 50,000
Envisaged stocking pattern:
---------------------- Raw material – 1 month
---------------------- Stock in process – 15 days
Finished goods – 15 days
----------------------
While the firm may extend a credit of 1 month to its customers, it is hopeful of
----------------------
getting 15 days credit from its suppliers.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Solution: Notes
Statement Showing Requirement of Working Capital
----------------------
(A) Current Assets Rs.
----------------------
Raw Material 50,000
Work in Process (50,000 + 22,000) 30,500 ----------------------
2
2 ----------------------
Finished Goods 36,000 ----------------------
Sundry Debtors 1,00,000
2,16,500 ----------------------
(B) Current Liabilities ----------------------
Sundry Creditors 25,000
----------------------
(C) Working Capital (A - B) 1,91,500
Working Capital Limits Proposed from Bank ----------------------
Security Margin Margin Margin Bank Finance ----------------------

% Rs. Rs.
----------------------
Raw Material 25% 12,500 37,500
Stocks in Process 33.33% 10,167 20,333 ----------------------
Finished Goods 25% 9,000 27,000 ----------------------
Sundry Debtors 20% 20,000 80,000
----------------------
4. The management of Royal Industries has called for a statement showing
the working capital needs to finance a level of activity of 1,80,000 units of ----------------------
output for the year. The cost structure for the company’s product for the
above mentioned activity level is detailed below. ----------------------
Cost per Unit (Rs.) ----------------------

Raw Materials 20
----------------------
Direct Labour 5
Overheads (including depreciation of Rs. 5 per unit) 15 ----------------------
40
----------------------
Profit 10
Selling Price 50 ----------------------
Additional Information: ----------------------
(a) Minimum desired cash balance is Rs. 20,000.
----------------------
(b) Raw materials are held in stock on an average for two months.
----------------------
(c) Work in progress (assume 50% completion stage in respect of labour and
overheads) will approximate to half a month’s production. ----------------------
(d) Finished goods remain in warehouse on an average for a month. ----------------------
(e) Suppliers of materials extend a month’s credit and debtors are provided
two month’s credit. Cash sales are 25% of total sales. ----------------------

Notes (f) There is a time lag in payment of wages of a month and half and a month
in case of overheads.
----------------------
From the above facts, you are required to:
---------------------- (i) Prepare a statement showing working capital needs.
---------------------- (ii) Determine the maximum working capital finance available under first two
methods suggested by Tandon Committee:
----------------------
Solution:
---------------------- Estimated Requirement of Working Capital
---------------------- Rs.
---------------------- (A) Current Assets
Raw Materials 15000 units x Rs. 20 x 2 months 6,00,000
---------------------- Work-in-Progress 15000 units x Rs. 27.50 x 1/2 2,06,250
---------------------- month
Finished Goods 15000 units x Rs. 35 x 1 month 5,25,000
---------------------- Sundry Debtors 15000 units x Rs. 35 x 2 months 7,87,500
x 75%
----------------------
Cash Balance 20,000
---------------------- 21,38,750
---------------------- (B) Current Liabilities:
Sundry Creditors 15000 units x Rs. 20 x 1 month 3,00,000
---------------------- Outstanding Wages 15000 units x Rs. 5 x 1 month 75,000
---------------------- Outstanding Overheads 15000 units x Rs. 10 x 1/2 month 75,000
4,50,000
---------------------- (C) Working Capital (A - B) 16,88,750
---------------------- Calculation of Maximum Permissible Bank Borrowing
---------------------- (A) Method I:
Current Assets 21,38,750
----------------------
Less: Current Liabilities 4,50,000
---------------------- Working Capital Gap 16,88,750
Own contribution (i.e. 25% of Working Capital Gap) 4,22,187.50
----------------------
Maximum Permissible Bank Finance 12,66,562.50
---------------------- (B) Method II:
Current Assets 21,38,750
----------------------
Less: Own Contribution 5,34,687.50
---------------------- (i.e. 25% of Current Assets)
Working Capital Gap 16,04,062.50
----------------------
Less: Current Liabilities 4,50,000.00
---------------------- Maximum Permissible Bank Finance 11,54,062.50
----------------------

Working Notes: Notes
It is assumed that the year consists of 360 days and that sales are evenly
----------------------
distributed throughout the year. As such, monthly sales will be 15000 units.
----------------------
Summary
----------------------
• Working capital refers to the funds invested in current assets, i.e. investment
in stocks, sundry debtors, cash and other current asset. The objective of ----------------------
working capital management is to ensure Optimum Investment in current ----------------------
assets.
----------------------
• There are certain factors affecting working capital requirement such as
nature of business, size of organisation, trading terms, length of production ----------------------
cycle, profitability, etc.
----------------------
• The sources of working capital can be: Spontaneous sources: These
sources arise during the course of normal business operations such as the ----------------------
company is able to buy goods or services on credit for example: trade
creditors and outstanding expenses, Intercorporate deposits: Intercorporate ----------------------
Deposits indicate the amount of funds borrowed by one company from
----------------------
another company only, Commercial Papers: A Commercial Paper is an
unsecured promissory note issued at a discount and Banks: Banks provide ----------------------
the source of finance to working capital on two broad basis, i.e. non-fund
based lending and fund based lending: Non-fund based lending includes ----------------------
the Bank Guarantee and Letter of Credit in which there is no physical
----------------------
outflow of funds. Fund-based lending includes Loans, Overdraft, Cash
Credit, working capital term loans etc. in which there is physical outflow ----------------------
of funds.
----------------------
• Reserve Bank of India has attempted to identify major weakness in the
system of financing of working capital needs by Banks in order to control ----------------------
the same properly. These attempts were mainly in the form of appointment
of various committees namely Dahejia committee, Tandon committee, ----------------------
Chhore Committee, Marathe Committee, Nayak Committee and Vaz
----------------------
Committee. These committees have suggested various norms for Working
Capital Finance. ----------------------
----------------------
Keywords
----------------------
• Working Capital: The Gross Working Capital or Net Working Capital
• Trade Credit: If the company buys raw material on credit from supplier, ----------------------
supplier gives trade Credit ----------------------
• Commercial Paper: Commercial paper is an unsecured promissory note
----------------------
issued at a discount.
• Fund Based Lending: When the lending organisation commits the ----------------------
physical outflow of funds, it is fund based lending.
----------------------

Notes
----------------------
1. What do you mean by working capital? Why does the need for working
---------------------- capital arise for a manufacturing company?
2. State the various factors affecting the requirement of working capital.
----------------------
3. How do you calculate the amount of working capital needed by a company?
---------------------- Enumerate the various sources for financing these working capital needs.
---------------------- 4. Explain the main recommendations of various committees appointed by
Reserve Bank of India to regulate the banks financing working capital
---------------------- needs of a company.
---------------------- 5. Write short notes.
---------------------- a. Trade Credit and Outstanding Expenses
b. Intercorporate Deposits
----------------------
c. Commercial Papers
----------------------
d. Bank Guarantees
---------------------- e. Letter of Credit
---------------------- f. Cash Credit
---------------------- g. Packing Credit
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

PROBLEMS Notes
1. You are required to calculate the average amount of working capital from ----------------------
the following information:
----------------------
Estimates for year Rs.
(a) Average amount locked up for — ----------------------
Stock of finished goods Rs. 5,000 ----------------------
Stock of stores/materials Rs. 8,000
(b) Average Credit given — ----------------------
Inland sales — 6 weeks credit 3,12,000 ----------------------
Export sales — 1.5 weeks credit 78,000
Estimates for year Rs. ----------------------
Estimates for year Rs. ----------------------
(c) Lag in payment of —
----------------------
Wages - 1.5 weeks 2,60,000
Stores/materials etc. — 1.5 months 48,000 ----------------------
Rent, Royalties etc. — 6 months 10,000
----------------------
Staff Salary — 1/2 month 62,400
Manager’s Salary – 1/2 month 4,800 ----------------------
Miscellaneous Expenses – 1.5 months 48,000
----------------------
(d) Payment in advance –
Sundry Expenses (Paid Quarterly in advance) 8,000 ----------------------
2. Following is the Balance Sheet of M/s. Fairdeal & Co. as on 31.3.2008 ----------------------
Liabilities Rs. Assets Rs. ----------------------

Capital 10,00,000 Fixed Assets 4,00,000
----------------------
Trade Creditors 1,40,000 Stock 3,00,000
Profit and Loss A/c 60,000 Debtors 1,50,000 ----------------------
Cash and bank 3,50,000 ----------------------
12,00,000 12,00,000
----------------------
Estimates up to 31.3.2009 are
(i) Purchases Rs. 15,20,000 ----------------------
(ii) Sales Rs. 21,20,000 ----------------------
(iii) Additions to Fixed Assets Rs. 1,00,000
----------------------
(Subjected to depreciation @ 10%)
----------------------
Time lag for payment to trade creditors for purchase and receipts from sales is
one month. The business earns a gross profit of 30% on turnover. The expenses ----------------------
against gross profits amount to 10% of turnover. The amount of depreciation is
not included in these expenses. ----------------------
----------------------

Notes Draft a Balance Sheet as on 31.3.2009 assuming that creditors are all trade
creditors for purchases and debtors for sales and there is no other item of current
---------------------- assets and liabilities other than stock and Cash/Bank balances.
---------------------- 3. Following details are available in case of a company.
Projected Profitability Statement
----------------------
Sales Rs. 21,00,000
----------------------
Cost of Sales
---------------------- Material Consumed Rs. 8,40,000
Wages and Expenses Rs. 6,25,000
----------------------
Depreciation Rs. 2,35,000
---------------------- Rs. 17,00,000
Less: Stock of Finished Goods Rs. 1,70,000
----------------------
Rs. 15,30,000
---------------------- Gross Profit Rs. 5,70,000
Administration Expenses Rs. 1,40,000
----------------------
Selling Expenses Rs. 1,30,000
---------------------- Rs. 2,70,000
---------------------- Profit before tax Rs. 3,00,000
Provision for tax Rs. 1,00,000
----------------------
The above figures relate only to finished goods and not to work in progress,
---------------------- which is equal to 15% of the year’s production in terms of physical units. Work
in progress constitutes 100% of material cost and 40% of other expenses. Raw
---------------------- material in stock is for 2 months’ consumption. All expenses are paid one month
in arrears. Suppliers of material give 1.5 month’s credit. 20% sales are in cash,
----------------------
rest is at 2 months’ credit. 70% of the income tax to be paid in advance in
---------------------- quarterly installments.
You are required to compute working capital requirements after adding 10% for
----------------------
contingencies.
---------------------- 4. PQR and Co. have approached their bankers for their working capital
---------------------- requirement who have agreed to sanction the same by retaining the margins
as under:
---------------------- Raw Materials - 20%
---------------------- Stock-in-process - 30%
Finished goods - 25%
----------------------
Debtors - 10%
----------------------
----------------------
----------------------
----------------------

From the following projections for 2007-08, you are required to work out: Notes
(a) The working capital required by the company.
----------------------
(b) The working capital limits likely to be approved by bankers.
----------------------
Estimates for 2007-08 Rs.
Annual Sales 14,40,000 ----------------------
Cost of Production 12,00,000 ----------------------
Raw Material Purchases 7,05,000
Monthly Expenditure 25,000 ----------------------
Anticipated Opening Stock of Raw Materials 1,40,000 ----------------------
Anticipated Closing Stock of Raw Materials 1,25,000
Inventory Norms ----------------------
Raw Material 2 months ----------------------
Work in Progress 15 days
----------------------
Finished Goods 1 month
The firm enjoys a credit of 15 days on its purchases and allows one month’s ----------------------
credit on its supplies. On sales orders, the company has received an advance of
----------------------
Rs. 15,000.
State your assumptions if any. ----------------------
5. The management of Gayatri Ltd. has called for a statement showing the ----------------------
working capital needed to finance a level of activity of 3,00,000 units of
output for the year. The cost structure for the company’s product for the ----------------------
above mentioned activity level is detailed below. ----------------------
Cost per unit Rs.
----------------------
Raw materials 20
Direct Labour 5 ----------------------
Overheads 15 ----------------------
Total 40
Profit 10 ----------------------
Selling Price 50 ----------------------
(a) Experience indicates that raw materials are held in stock, on an
average, for two months. ----------------------
(b) Work in progress (100% complete in regard to materials and 50% ----------------------
for labour and overheads) will approximately be half a month’s
production. ----------------------
(c) Finished goods remain in the warehouse on an average for a month. ----------------------
(d) Suppliers of materials extend a month’s credit. ----------------------
(e) Two month’s credit is allowed to debtors. Calculation of debtors may
----------------------
be made on selling price.
(f) A minimum cash balance of Rs. 25,000 is expected to be maintained. ----------------------

Notes (g) The production pattern is assumed to be even during the year. Prepare
the statement of working capital requirement.
----------------------
6. Mr. Firdaus wishes to commence a new trading business and has given the
---------------------- following information.
---------------------- (a) Annual Expenses (Rs.)

Wages 78,000
---------------------- Stores and Materials 14,400
---------------------- Office salaries 18,720
Rent 3,000
---------------------- Other Expenses 14,400
---------------------- (b) Average amount of stock to be maintained (Rs.)
Stock of finished goods 1500
---------------------- Stock of materials and stores 2400
---------------------- (c) Expenses paid in advance (Rs.)
Quarterly advance 2400 p.a.
----------------------
(d) Annual sales (Rs.)
---------------------- In the region 93,600
Out of the region 23,400
----------------------
(e) Lag in payment of expenses
---------------------- Wages 1.5 weeks
Stores and materials 1.5 months
----------------------
Office salaries 0.5 months
---------------------- Rent 6 months
Other expenses 1.5 months
----------------------
(f) Credit allowed to customers
---------------------- In the region 6 weeks
Out of the region 1.5 weeks
----------------------
Calculate his working capital requirement
---------------------- 7. From the following information, prepare a statement in columnar form
---------------------- showing the working capital requirement.
Budgeted sales (Rs. 10 per unit) Rs. 2,60,000.
----------------------
Analysis of one rupee of sales
---------------------- Rs.
---------------------- Raw Materials 0.30
Direct Labour 0.40
----------------------
Overheads 0.20
---------------------- Total cost 0.90
Profit 0.10
----------------------
Sales 1.00
----------------------

It is estimated that: Notes
(a) Raw materials are carried in stock for three weeks and finished goods for
----------------------
two weeks.
(b) Factory processing will take two weeks. ----------------------
(c) Suppliers will give full five weeks credit. ----------------------
(d) Customers will require eight weeks credit. ----------------------
It may be assumed that production and overheads accrue evenly throughout the
year. ----------------------
----------------------
----------------------
----------------------
1. True ----------------------
2. False ----------------------
1. The working capital requirement in respect of Public Utility Services such
as railways, electricity is less than that required in a production unit. ----------------------
2. If purchases are on Cash basis and sales are made on credit basis, it will ----------------------
result into high working capital requirement.
----------------------
3. High profitability reduces the strain on working capital.
----------------------
Multiple Choice Multiple Response ----------------------
1. For financing temporary requirement of working capital, various sources ----------------------
available are:
----------------------
i. Spontaneous Sources
ii. Inter-Corporate Deposits ----------------------
iii. Commercial Papers ----------------------

iv. Banks ----------------------
2. Usually, Trade Credit is required to be extended because of ----------------------
i. Trends in the industry
----------------------
ii. Liquidity position of the company
----------------------
iii. Earnings of the company over a period of time
iv. Relationship of the company with the suppliers ----------------------
----------------------

Notes Check your Progress 4
----------------------
i. d
----------------------
ii. c
---------------------- iii. b
---------------------- iv. a
----------------------
Suggested Reading
----------------------
1. John P. Quinn, Joseph A. Bailey (Jr.), David E. Gaulin. Law Firm
---------------------- Accounting and Financial Management.
---------------------- 2. George H. Stalcup. Financial Management.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

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FINANCIAL MANAGEMENT

(FOR PRIVATE CIRCULATION ONLY)

Published by Symbiosis Skills and Professional University (SSPU), Pune 2023

Copyright © 2023 Symbiosis Open Education Society

Dr. Satish Inamdar

Unit No. TITLE Page No.

---------------------- 1.1 INTRODUCTION

---------------------- 1.2 APPROACHES TO THE TERM FINANCE

Check your Progress 1 ----------------------

---------------------- Prepare a flow chart showing widening scope of finance function.

---------------------- 1.3 SCOPE OF FINANCE FUNCTION

Investment Decisions ----------------------

i. Working capital management decisions ----------------------

ii. Employees ----------------------

iii. Board of Directors ----------------------

iv. None of the above ----------------------

---------------------- 1.5 ORGANISATION OF FINANCE FUNCTION

Multiple Choice Single Response. ----------------------

3. Vice President Finance ----------------------

---------------------- 1. Classify the following duties of finance executive into recurring or

Match the Following. ----------------------

Answers to Check your Progress ----------------------

Check your Progress 1 ----------------------

Multiple Choice Single Response. ----------------------

ii. Application of funds ----------------------

---------------------- Suggested Reading

Forms of Business Organisations 19

2. Proprietary is a difficult and expensive form of business organisation. ----------------------

Forms of Business Organisations 21

c. Partnership firm is also an unlimited liability organisation. In the ----------------------

d. It is not possible to transfer the ownership of the business to somebody ----------------------

Forms of Business Organisations 23

In non-technical language, operations of a private limited company affect ----------------------

Forms of Business Organisations 25

---------------------- Check your Progress 2

Forms of Business Organisations 27

---------------------- 3. Common seal is a signature of the company.

Forms of Business Organisations 29

---------------------- Answers to Check your Progress

---------------------- Check your Progress 1

---------------------- ii. No legal status

Forms of Business Organisations 31

Cost theory of capitalisation considers the amount of capitalisation on ----------------------

---------------------- ii. It is the cost of capital.

---------------------- Fill in the Blanks.

---------------------- 5. ______ surplus will be a part of capitalisation if the management wants

As against the indication of overcapitalisation, the situation of ----------------------

---------------------- State True or False.

---------------------- 3.5 OVERCAPITALISATION VS. UNDERCAPITALISATION

3.6 WATERED STOCK/WATERED CAPITAL ----------------------

---------------------- Suggested Reading

---------------------- 1. Eugene Brigham, Michael Ehrhardt. Financial Management: Theory &

Sources of Long-Term and Medium-Term Finance 47

Sources of Long-Term and Medium-Term Finance 49

Sources of Long-Term and Medium-Term Finance 51

---------------------- Check your Progress 1

---------------------- iv. Optionally Convertible Debentures

Disadvantages of Debentures ----------------------

Sources of Long-Term and Medium-Term Finance 55

Fill in the Blanks. ----------------------

Sources of Long-Term and Medium-Term Finance 57

Sources of Long-Term and Medium-Term Finance 59

Check your Progress 3 ----------------------

Sources of Long-Term and Medium-Term Finance 61

---------------------- 1. Classify the following duties of finance executive into recurring or

---------------------- 1. Eugene Brigham, Michael Ehrhardt. Financial Management: Theory &