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1st Edition: 2023
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meeting held on 11/08/2023 Vide item no. 1015 and subsequently Executive
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u Unit I-V are edited versions of study material prepared for the courses
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Contents
PAGE
UNIT-I
Lesson 1 : Financial Management
1.1 Learning Objectives 3
1.2 Introduction 3
1.3 Scope of Financial Management 5
1.4 Objectives of Financial Management 10
1.5 Basic Principles of Financial Management 16
1.6 Time Value of Money 19
1.7 Valuation Techniques 20
1.8 Concept of Risk and Return 30
1.9 Summary 36
1.10 Answers to In-Text Questions 36
1.11 Self-Assessment Questions 36
1.12 Suggested Readings 37
UNIT-II
Lesson 1 : Capital Budgeting
1.2 Introduction 41
1.3 Significance of Capital Budgeting Decisions 43
1.4 Capital Budgeting Process 44
1.5 Capital Budgeting Techniques 47
1.6 The Payback Period 47
1.7 Acceptance Rule 51
1.8 Discounted Cash Flow Techniques (DCF) 52
PAGE i
B.COM. (PROGRAMME)/B.COM. (HONS.)
PAGE
1.9 Summary 60
UNIT-III
Lesson 1 : Cost of Capital-I
1.2 Introduction 65
1.3 Understand the Meaning, Concept and Significance of Cost of Capital 66
1.4 Classification of Cost 68
1.5 Problems in determining the Cost of Capital 69
1.6 Computation of Specific Source of Finance 71
1.7 Summary 81
Lesson 2 : Cost of Capital-II

2.2 Introduction 85
2.3 Computation of Weighted Average Cost of Capital 86
2.4 Marginal Cost of Capital 88
2.5 Cost of Equity Using Capital Asset Pricing Model (CAPM) 90
2.6 Summary 94
ii PAGE
Contents
PAGE
Lesson 3 : Capital Structure Theories

3.2 Introduction 97
3.3 Concept of Capital Structure 98
3.4 Optimal Capital Structure 98
3.5 Objects of Appropriate Capital Structure 99
3.6 Importance of Capital Structure 100
3.7 Theories of Capital Structure 102
3.8 Summary 114
Lesson 4 : Capital Structure: Planning and Designing

4.2 Capital Structure Management or Planning the Capital Structure 117
4.3 Essential Features of a Sound Capital Mix 118
4.4 Factors Determining the Capital Structure 119
4.5 Profitability and Capital Structure: EBIT - EPS Analysis 124
4.6 Liquidity and Capital Structure: Cash Flow Analysis 126
4.7 Illustration 128
4.8 Summary 129
Lesson 5 : Financing Decision: EBIT– EPS Analysis

5.2 Introduction 133
5.3 Constant EBIT with Different Financing Patterns 133
PAGE iii
PAGE
5.4 Varying EBIT with Different Financing Patterns 135

5.5 Financial Break-Even Level 137
5.6 Indifference Break-Even Level 138
5.7 Shortfalls in EBIT-EPS Analysis 141
5.8 Summary 142
Lesson 6 : Financing Decision – Leverage Analysis

6.3 Operating Leverage 146
6.4 Significance of Operating Leverage 147
6.5 Financial Leverage 148
6.6 Combined Leverage 149
6.7 Illustrations in Leverage Analysis 149
6.8 Summary 156
UNIT-IV
Lesson 1 : Dividend Decision and Valuation of the Firm
1.3 Concept and Significance 162
1.4 Dividend Decision and Valuation of Firms 163
1.5 Illustrations 171
1.6 Summary 184
iv PAGE
Contents
PAGE

UNIT-V
Lesson 1 : Working Capital: Management and Finance
1.3 Classification or Kinds of Working Capital 191
1.4 Importance or Advantages of Adequate Working Capital 192
1.5 Excess or Inadequate Working Capital 193
1.6 Need or Objects of Working Capital 194
1.7 Factors Determining Working Capital Requirements 195
1.8 Management of Working Capital Principles 197
1.9 Determining Working Capital Financing Mix 199
1.10 Summary 201
Lesson 2 : Working Capital: Estimation and Calculation

2.3 Working Capital as % of Net Sales 205
2.4 Working Capital as % of Total Assets or Fixed Assets 205
2.5 Working Capital Based on Operating Cycle 205
2.7 Summary 218
PAGE v
PAGE
Lesson 3 : Financing of Working Capital

3.3 Financing of Permanent/Fixed or Long-Term Working Capital 221
3.4 Financing of Temporary or Working Capital 223
3.5 New Trend in Financing Working Capital by Banks 229
3.6 Summary 233
Lesson 4 : Management of Cash

4.3 Nature of Cash 237
4.4 Motives for Holding Cash 238
4.5 Cash Management 239
4.6 Managing Cash Flows 241
4.7 Methods of Accelerating Cash Inflows 241
4.8 Methods of Slowing Cash Outflows 242
4.9 Determining Optimum Cash Balance 244
4.10 Baumol’s Model 245
4.11 Miller-Orr Model 245
4.12 Investment of Surplus Funds 246
4.14 Summary 249
vi PAGE
Contents
PAGE
Lesson 5 : Receivables Management

5.3 Meaning of Receivables 253
5.4 Costs of Maintaining Receivables 253
5.5 Factors Influencing the Size of Receivables 254
5.6 Meaning and Objectives of Receivable Management 256
5.7 Dimensions of Receivable Management 256
5.9 Summary 266
Lesson 6 : Inventory Management

6.3 Meaning and Nature of Inventory 270
6.4 Purpose/Benefits of Holding Inventory 271
6.5 Risks/Costs of Holding Inventory 271
6.6 Inventory Management 273
6.7 Objects of Inventory Management 273
6.8 Tools and Techniques of Inventory Management 274
6.9 Risks in Inventory Management 281
6.10 Summary 281
Glossary 285
PAGE vii
UNIT - I
PAGE 1
L E S S O N
1
Financial Management
Manju Gupta
STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3 Scope of Financial Management
1.4 Objectives of Financial Management
1.5 Basic Principles of Financial Management
1.6 Time Value of Money
1.7 Valuation Techniques
1.8 Concept of Risk and Return
1.9 Summary
1.10 Answers to In-Text Questions
1.11 Self-Assessment Questions
1.12 Suggested Readings

After studying this chapter students may be able to understand:–
u The Importance of Financial Management.
u Objectives of Financial Management.
u Time Value of Money.
u Valuation Techniques.
1.2 Introduction
As we all know that finance is the life blood of an organization. Finance is the art and
science of management and arrangement of funds. If the organization want to survive,
grow or expand it require funds. This is because in the modem money-oriented economy,
PAGE 3
Notes finance is one of the basic foundations of all kinds of economic activities.
It has rightly been said that business needs finance to generate more
funds. However, it is also true that money produces more money, only
when it is properly managed. Hence, efficient management of every
business enterprise is closely linked with efficient management of its
finances. Almost all business activities, directly or indirectly, involve the
acquisition and usage of funds. For example, recruitment and promotion
of employees in production is clearly a responsibility of the production
department; but it requires payment of wages and salaries and other
monetary benefits of employment, and thus, involves finance. Similarly,
buying a new machine or replacing an old machine for the purpose of
increasing productive capacity affects the flow of funds.
The importance of finance can be better explained with this true fact.
One participant in a course titled, ‘Finance for Non-Finance Executives’
made a very interesting observation during the discussion. He said, “There
are no executive development programs titled ‘Production Management
for Non- Production Executives’ or ‘Marketing Management for Non-
Marketing Executives’ and so on. Then, how come books and Executive
Development Programs titled ‘Finance for Non-Finance Executives’ are
so popular among managers of all functions like marketing, production,
personnel, R&D, etc.”. The answer is very simple. The common thread
running through all the decisions taken by the various managers is all
about funds and there is hardly any manager working in any organization
to whom money does not matter.
The term financial management can be defined as the management of
flow of funds in a firm and it deals with the financial decision making
of the firm. It encompasses the procurement of the funds in the supreme
economic & practical manner and employment of these funds in the best
way to maximize the return for the owner. Since raising of funds and their
best utilization is the key to the success of any business organization, the
financial management as a functional area has developed a place of prime
relevance. It is concerned with overall managerial decision making in a
general way and with the management of economic resources in particular.
All business decisions have financial implications and therefore, financial
management is inevitably related to almost every aspect of business
4 PAGE
FINANCIAL MANAGEMENT
operations. Broadly speaking, the financial management includes any kind Notes
of decisions made by investors that has an effect on its financial sources.
According to Soloman, “Financial management is concerned with
the efficient use of an important economic resource, namely, Capital
Funds.” Phillippatus has given a more elaborate definition of the term
financial management and i.e. “Financial management is concerned with
the managerial decisions that result in the acquisition and financing of
long-term and short-term credits for the firm. As such it deals with the
situations that require selection of specific assets (or combination of
assets), the selection of specific liability (or combination of liabilities) as
well as the problem of size and growth of an enterprise. The analysis of
these decisions is based on the expected inflows and outflows of funds
and their effects upon managerial objectives.”
Thus, financial management is mainly concerned with the proper management
of funds. The finance manager must see that the procurement of funds in
such a manner that the risk, cost and control should be properly balanced
in a given situation which resulted in optimum utilization of funds.
1.3 Scope of Financial Management

Traditionally, the scope of financial management was very narrow. Initially,
the finance manager was concerned only about requirement, procurement
and utilization of funds. The financial manager was formally given a target
amount of funds to be raised and had the responsibility for procuring of
these funds. So, the main function of the financial manager was limited to
raise funds as and when the need arises. Once the funds were procured,
his function was over.
In other words, the scope of the finance function was narrow according
to the traditional approach and it was limited to procurement of funds by
corporate enterprises to meet their financing needs. The term ‘procurement’
was used in a broader sense so as to include the whole gamut of raising
funds externally. Thus defined, the field of study dealing with finance
was treated as encompassing three interrelated aspects of raising and
administering resources from outside: (i) the institutional arrangement
in the form of financial institutions which comprise the organisation of
PAGE 5
Notes the capital market; (ii) the financial instruments through which funds are
raised from the capital markets and the related aspects of practices and the
procedural aspects of capital markets; and (iii) the legal and accounting
relationships between a firm and its sources of funds.
The traditional approach to the scope of the finance function evolved
during the 1920s and 1930s and dominated academic thinking during
the forties and through the early fifties. It has now been discarded as
it suffers from serious limitations. The weaknesses of the traditional
approach were as under:
1. The first argument against the traditional approach was based on
that it gave emphasis on issues relating to the procurement of funds
by corporate enterprises. This approach was challenged during the
period when the approach dominated the scene itself. Further, the
traditional treatment of finance was criticised because the finance
function was equated with the issues involved in raising and
administering funds, the theme was woven around the viewpoint of
the suppliers of funds such as investors, investment bankers and so
on, that is, the outsiders. It implies that no consideration was given
to viewpoint of those who had to take internal financial decisions.
The traditional treatment was, in other words, the outsider-looking-
in approach. The limitation was that internal decision making (i.e.,
insider-looking-out was completely ignored):
2. The second ground of criticism of the traditional treatment was that
the focus was on financing problems of corporate enterprise. To that
extent the scope of financial management was confined only to a
segment of the industrial enterprises, as non-corporate organizations
lay outside its scope.
3. Another basis on which the traditional approach was challenged was
that the treatment as built too closely around episodic events, such
as promotion incorporation, merger, consolidation, reorganization
and so on. Financial management was confined to a description
of these infrequent happenings in the life of an enterprise. As a
result, the day-to-day financial problems in a normal company did
not receive much attention.
6 PAGE
4. Finally, the traditional treatment was found to have a gap to the extent Notes
that the focus was on long-term financing. Its natural implication
was that the issues involved in working capital management were
not in the purview of the finance function.
In other words, its weaknesses were more fundamental. The conceptual
and analytical shortcoming of this approach arose from the fact that it
confined financial management to issues involved in procurement of
external funds; it did not consider the important dimension of allocation
of capital. The conceptual framework of the traditional treatment
ignored what Solomon aptly described as the central issues of financial
management. These issues were reflected in the following fundamental
questions which a finance manager should address. Should an enterprise
commit capital funds to certain purposes? Do the expected returns meet
financial standards of performance? How should these standards be set
and what is the cost of capital funds to the enterprises? How does the
cost vary with the mixture of financing methods used? In the absence
of the coverage of these crucial aspects, the traditional approach implied
a restricted scope for financial management. The modern approach may
provide a solution to these shortcomings.
u Modern Approach
The modern approach broadens the responsibility of finance manager. It
views the term financial management in a broader sense and provides
a conceptual and analytical framework for financial decision making.
According to it, the finance function covers both acquisitions of funds
as well as their allocations. Thus, apart from the issues involved in
acquiring external funds, the main concern of financial management is
the efficient and wise allocation of funds to various uses. The financial
manager is required to look into the financial implications of any decision
in the firm. Thus, it can be defined in a broad sense, as an integral part
of overall management.
The new approach is an analytical way of viewing the financial problems
of a firm. The major focuses of this approach are: What is the total
volume of funds an enterprise should require? What specific assets
should an enterprise acquire? How should the funds required be financed?
PAGE 7
Notes Alternatively, the principal contents of the modern approach to financial

management can be (1) Procuring the required quantum of funds as and
when necessary, at the lowest cost, (2) Investing these funds in various
assets in the most profitable way, and (3) Distributing returns to the
shareholders in order to satisfy their expectations from the firm.
These three functions of the finance manager encompass most of the
financial events in any firm. The three main questions raised above cover
between them the major financial problems of a firm. In other words, the
financial management, according to the new approach, is concerned with
the solution of three major problems relating to the financial operations
of a firm, corresponding to the three questions of investment, financing
and dividend decisions.
The functions related to finance requires good planning, control and
execution of a firm’s activities. Finance decisions can be taken in such
a form that maximizes the shareholders wealth thus, while performing
the finance managers should do all their efforts towards increase in the
market value of shares.
u Investment Decision
Investment decisions are the decision related to asset composition of
the firm. Firm has to decide where it will make the investment. The
investment can be fall into two major groups: (i) long-term assets which
yields a return over a period of time in future, (ii) short-term or current
assets, defined as those assets which in the normal course of business are
convertible into cash without reduction in value, usually within a year.
The first category of asset is popularly known in financial literature as
capital budgeting. The aspect of financial decision making with reference
to current assets or short-term assets is popularly termed as working
capital management.
Capital Budgeting: Capital budgeting are related with fixed assets of
the firm. It is probably the most crucial financial decision of firm. It
co-ordinates between the selection of an asset or investment proposal or
course of action whose benefits are likely to be available in future over
the lifetime of the project. The long- term assets can be either new or
old existing ones. The earnings of the firm are basically caused by fixed
assets composition. The Capital Budgeting decisions are more crucial for
any firm. A finance manager may be asked to decide about (1) which
8 PAGE
asset should be purchased out of different alternative options. (2) To buy Notes
an asset or to get it on lease. (3) To produce a part of the final product
or to procure it from some other supplier. (4) To buy or not another firm
as a running concern. (5) Analysis of risk and uncertainty.
The objective of Capital Budgeting decisions is to identify those assets
which have more worth than their cost. A financial manager therefore
has to take utmost care in dealing with these decisions.
In brief, the main elements of capital budgeting decisions are: (i) the
long-term assets and their composition, (ii) the business risk complexion
of the firm and (iii) the concept and measurement of the cost of capital.
u Working Capital Management
Working capital management deals with the management of current assets
of the firm. It is an important and integral part of financial management
as short-term survival is a prerequisite for long-term success. One aspect
of working capital management is the tradeoff between profitability and
risk (liquidity). There is a conflict between profitability and liquidity. If
a firm does not have adequate working capital that is, if firm does not
invest sufficient fund in current assets, it creates rigidity in the financial
system because liquidity is at zero level and consequently may not have
the ability to meet its current obligations and, thus, invite the risk of
bankruptcy. If the current assets are too large profitability is adversely
affected. A finance manager has to ensure sufficient and adequate working
capital to the firm. He has to take various decisions in this respect. These
decisions may include how much and what inventory to be maintained
and whether and how much credit be given to customers etc.
u Financing Decision
Financing decision is the second important function to be performed by
the financial manager. Broadly, he or she must decide when, where from
and how to acquire funds to meet the firm’s investment needs. There are
two main sources of finance for any firm, the shareholders’ funds and
the borrowed funds. These sources have their own peculiar features and
characteristics. The central issue before the business/firm/corporate is
to determine the appropriate proportion of equity and debt. The mix of
debt and equity is known as the firm’s capital structure. The financial
manager must try to obtain the best financing mix or the optimum capital
PAGE 9
Notes structure of the business/firm/corporate. The capital structure is considered

optimum when the market value of shares is maximized. In the absence
of debt, the shareholders’ return is equal to the firm’s return. The use
of debt affects the return and risk of shareholders, it may increase the
return on equity funds, but on the other side it always increases risk as
well. The change in the shareholders’ return caused by the change in the
profits is called the financial leverage. The financial managers have to
maintain a proper balance between return and risk.
u Dividend Decision
The third major decision which the financial manager has to take is
dividend decision. The dividend decision should be analysed in relation
to the financing decision of a firm. The financial manager must decide
whether the firm should distribute all profits, or retain them, or distribute
a portion and retain the balance. The proportion of profits distributed as
dividends is called the dividend-payout ratio and the retained portion of
profits is known as the retention ratio.
The final decision relating to dividend decision will depend upon the
preference of the shareholders and investment opportunities available within
the firm. When firm have investment opportunities, it’s better to retain
the profit as they are the cost free and risk-free source of finance. The
second major aspect of the dividend decision is the factors determining
dividend policy of a firm in practice.
1.4 Objectives of Financial Management

The objectives provide a framework for optimum financial decision making.
The financial manager must have a well-defined objectives in the light
of which he has to take various decisions. A goal of the firm may be
defined as a target against which the firm’s operating performance can
be measured. The objective specifies what the decision maker is trying to
accomplish and, by doing so provides a framework for analyzing different
decision rules. In most cases, the objective may be stated in terms of
maximizing some functions or variables like profit, size, value, social
welfare etc. or minimize some functions or variables (risk, cost etc.) In
case of multiple objectives, however, the situation would be like serving
10 PAGE
several masters at a time and the decision maker may end up meeting Notes
none of these multiple objectives.
A clear understanding of the objectives of financial management is a
perquisite, as the objectives provide a framework for optimum decision
making. Objectives of financial management provide a selection criterion
for the relevant decision fields.
Shareholders are the major stakeholder of the firm; therefore, the
maximization of shareholders wealth is usually taken as main objective
of the firm. In addition, profit maximization is also considered as the
objective of the firm.
u Maximization of Profits
Profit maximization is the implied objective of the firm. The profit is
regarded as a yard stick for the economic efficiency of any firm. If all
business firm of society are working towards profit maximization then
the economic resources of society as a whole would have been most
efficiently, economically and profitably used. The profit maximization
by one firm and if targeted by all, will ensure the maximization of the
welfare of society. So, the profit maximization as objective of financial
management will result in efficient allocation of resources not only from
the point of view of the firm but, also for the society as such.
Various parties have stake in the firm. Though the stake of the shareholders
is of prime relevance, yet the interest of other parties such lenders,
creditors, society etc. cannot be ignored. The finance manager has to face
a tough task of reconciling the interest of all these parties. The profit
maximization over- looks the interest of other parties than the shareholders.
It is also argued that profit maximisation, as a business objective developed
in the early 19th century when the characteristic features of the business
structure were self-financing, private property and single entrepreneurship.
The only aim of the single owner then was to enhance his or her
individual wealth and personal power, which could easily be satisfied by
the profit maximisation objective. The modern business environment is
characterised by limited liability and a divorce between management and
ownership. Shareholders and lenders today finance the business firm but
it is controlled and directed by professional management.
PAGE 11
Notes The other important stakeholders of the firm are customers, employees,
government and society. In practice, the objectives of these stakeholders
or constituents of a firm differ and may conflict with each other. The
manager of the firm has the difficult task of reconciling and balancing
these conflicting objectives. In the new business environment, profit
maximisation is regarded as unrealistic, difficult, inappropriate and immoral.
Objections To Profit Maximization
1. When the firm undertakes profit maximization as objective, it ignores
the risk. In other words, the management undertakes all profitable
investment opportunities regardless of associated risk.
2. The profit maximization concentrates on the profitability only and
ignores the financial aspect of that decision and the risk associated
with that financing. For example, in order finance a profitable
investment, a firm may even borrow beyond capacity.
3. It ignores the timings of costs and returns and thereby, ignores the
time value of money.
4. The profit maximization as an objective is vague and ambiguous.
Profit refers to short term profit or long-term profit; after tax profit
or profit before tax etc. is not clear.
A variant of the objective of profit maximization is often suggested as
the maximization of the return on investment. The firm would undertake
all those investment opportunities which have the percentage return in
excess of percentage cost of funds. But, in this case also, the financial
decisions will be directed in same way as profit maximization. So, profit
maximization criterion is inappropriate and unsuitable as an operational
objective of financial management. The alternative to profit maximization
is wealth maximization of shareholders wealth.
u Liquidity
Liquidity is also one of important the objective of financial management.
Liquidity and profitability are very closely related, when one increases,
the other decreases. Apparently liquidity and profitability goals conflict
in most of the decisions which the finance manager takes. For example,
if higher inventories are kept in anticipation of increase in price of raw
materials, profitability goal is approached but the liquidity of the firm is
at high risk level. Similarly, the firm by following a liberal credit policy
may be in a position to push up its sales but its liquidity will decrease.
12 PAGE
There is also a direct relationship between higher risk and higher return. Notes
Higher risk on the one hand dangerous for the liquidity of the firm;
higher return on the other hand increases its profitability. A company may
increase its profitability by having a very high debt-equity ratio. However,
when the company raises funds from outside sources, it is committed to
make the payment of interest, etc., at fixed time and in fixed amounts
and hence to that extent its liquidity is reduced.
u Wealth Maximization
Wealth maximization is also known as value maximization or net present
wealth maximization. Value maximization is universally accepted as
operational decision criteria for financial management as it remove the
technical limitations of profit maximization. The measure of wealth which
is used in financial management is the concept of economic value. The
economic value is defined as the present value of the future cash flows
generated by a decision, discounted at appropriate rate of discount which
reflects the degree of associated risk. Higher discount rate is the result
of higher risk and longer time period. This measure of economic value
is based on cash flows rather than profit. The economic value concept
is objective in its approach and also takes into account the timing of
cash flows and the level of risk through the discounting process. The
shareholders wealth is represented by the present value of all the future
cash flows in the form of dividends or other benefits expected from the
firm. The market price of share reflects this present value. Therefore,
the economic value of the shareholders wealth is the market price of
the share which is the present value of all future dividends and benefits
expected from the firm.
Since, each shareholder’s wealth at any time is equal to the market value
of all his holdings in shares; an increase in the market price of firm’s
shares should increase the shareholder’s wealth.
Therefore, maximization of shareholders wealth implies that the financial
decisions will be taken in such a way that shareholders receive highest
combination of dividends and the increase in market price of the share.
The assumption in this approach is that shares are traded in efficient
market where the effect of a decision is truly reflected price of share.
The goal of maximization of shareholders wealth makes the interest of
the shareholders compatible with that of management. With this objective
PAGE 13
Notes in sight, the management will allocate the available economic resources
in the best possible way within the given constraints of risk. But, this
objective is also not free from defects. There are certain problems with
the implementation of the goal of maximization of shareholders wealth is
the underlying assumption that market is efficient. The market price of a
share is influenced by the overall economic and political scenario in the
country. But, more often than not, the market price of a share may also
fluctuate because of speculation activities. Still this objective is considered
more viable, uncontroversial in comparison to profit maximization.
u Social Responsibility
Another issue that deserves consideration is social responsibility: should
businesses operate strictly in their stockholders’ best interests, or are
firms also responsible for the welfare of their employees, customers, and
the communities in which they operate? Certainly, firms have an ethical
responsibility to provide a safe working environment, to avoid polluting the
air or water, and to produce safe products. However, socially responsible
actions have costs, and not all businesses would voluntarily incur all such
costs. If some firms act in a socially responsible manner while others
do not, then the socially responsible firms will be at a disadvantage in
attracting capital. To illustrate, suppose all firms in a given industry
have close to “normal” profits and rates of return on investment, that
is, close to the average for all firms and just sufficient to attract capital.
If one company attempts to exercise social responsibility it will have to
raise prices to cover the added costs. If other firms in its industry do
not follow suit, their costs and prices will be lower.
The socially responsible firm will not be able to compete, and it will be
forced to abandon its efforts. Thus, any voluntary socially responsible
acts that raise costs will be difficult, if not impossible, in industries that
are subject to keen competition.
Does all this mean that firms should not exercise social responsibility?
No but, it does mean that most significant cost-increasing actions will
have to be put on a mandatory rather than a voluntary basis to ensure
that the burden falls uniformly on all businesses. Thus, such social
benefit programs as fair hiring practices, minority training, product safety
pollution abatement, and anti-trust actions are most likely to be effective
14 PAGE
if realistic roles are established initially and then enforced by government Notes
agencies. Of course, it is critical that industry and government cooperate
in establishing the rules of corporate behaviour, and that the costs as well
as the benefits of such actions be estimated accurately and then taken
into account.
On the whole, the maximization of the shareholders wealth seems to be a
normative goal towards which the firm should strive. A financial manager
though operating with the objective of maximization of shareholders
wealth need not undermine the importance of other goals. He must take
decisions after weighing the relevant considerations.
u Agency Problems: Managers Versus Shareholders Goals
In large companies, there is a divorce between management and ownership.
The decision-taking authority in a company lies in the hands of managers.
Shareholders as owners of a company are the principals and managers
are their agents. Thus, there is a principal-agent relationship between
shareholders and managers. In theory, managers should act in the best
interest of shareholders; that is, their actions and decisions should lead
to shareholder’s wealth maximisation. In practice, managers may not
necessarily act in the best interest of shareholders, and they may pursue
their own personal goals. Managers may maximise their own wealth
(in the form of high salaries and perks) at the cost of shareholders or
may play safe and create satisfactory wealth for shareholders than the
maximum. They may avoid taking high investment and financing risks
that may otherwise be needed to maximize shareholders wealth. Such
“satisfying” behaviour of managers will discourage the objective of
shareholder’s wealth maximisation as a normative guide. It is in the
interests of managers that the firm survives over the long run. Managers
also wish to enjoy independence and freedom from outside interference,
control and monitoring. Thus, their actions are very likely to be directed
towards the goals as of survival and self-sufficiency. Further, a company
is a complex organisation consisting of multiple stakeholders such as
employees, debt-holders, consumers, suppliers, government and society.
Managers in practice may, thus, perceive their role as reconciling conflicting
objectives of the stakeholders. This stakeholders’ view of managers’ role
may comprise with the objective of shareholder’s wealth maximisation.
PAGE 15
Notes The conflict between the interests of shareholders and managers is referred
to as agency problem and it results into agency costs. Agency costs include
the less than optimum share value for shareholders and costs incurred
by them to monitor the actions of managers and control their behaviour.
The agency problems vanish when managers own the company. Thus one
way to mitigate the agency problems is to give ownership rights through
stock options to managers. Shareholders can also offer attractive monetary
and non-monetary incentives to managers to act in their interests. A close
monitoring by other stakeholders, board of directors and outside analysts
also may help in reducing the agency problems.
IN-TEXT QUESTIONS
1. In traditional approach, the finance manager was concerned and
called upon at the advent of ______________.
2. The modern approach _________ the responsibility of finance
manager.
3. Investment decisions are the decision relating to asset composition
of the firm. (True/False)
4. Profit maximization is the implied objective of the firm.
(True/False)
5. The socially responsible firm will not be able to compete, and
it will be forced to abandon its efforts. (True/False)
1.5 Basic Principles of Financial Management

Financial management principles are the basic foundations behind the
decision made by financial managers. At the first instance, the finance
function looks like a collection of unrelated decision rules. But this is
not true. In fact, decisions are based on some fundamental principles.
Principle 1: The Risk-Return Trade-Off-we won’t take on additional risk
unless we expect to be compensated with additional return:
At some point, we have all saved some money. Why have we done this?
The answer is simple: to expand our future consumption opportunities-
for example, save for a house, a car, or retirement. Investors demand a
minimum return for delaying consumption that must be greater than the
anticipated rate of inflation. If they didn’t receive enough to compensate
16 PAGE
for anticipated inflation, investors would purchase whatever goods they Notes
desired ahead of time or invest in assets that were subject to inflation
and earn the rate of inflation on those assets. There isn’t much incentive
to postpone consumption if your savings are going to decline in terms
of purchasing power.
Investment alternatives have different amounts of risk and expected
returns. Investors sometime choose to put their money in risky investments
because these investments offer higher expected returns. The more risk
an investment has, the higher will be its expected return. Therefore, we
won’t take on additional risk unless we expect to be compensated with
additional return.
Principle 2: The Time Value of Money-A rupee received today is worth
more than a rupee received in the future.
A fundamental concept in finance is that money has a time value associated
with it: A rupee received today is worth more than a rupee received a
year from now. Because we can earn interest on money received today,
it is better to receive money earlier rather than later. In economics, this
concept of the time value of money is referred to as the opportunity cost
of passing up the earning potential of a rupee today.
In financial management our focus is on the creation and measurement of
wealth. To measure wealth or value, we will use the concept of the time
value of money to bring the future benefits and costs of a project back to
the present. Then, if the benefits outweigh the costs, the project creates
wealth and should be accepted; if the costs outweigh the benefits, the
project does not create wealth and should be rejected. Without recognizing
the existence of the value of money, it is impossible to evaluate projects
with future benefits and costs in a meaningful way.
To bring future benefits and costs of a project back to the present we
must assume an opportunity cost of money, or interest rate.
Principle 3: Cash-Not Profits-Is King
In measuring wealth or value, we will use cash flows, not accounting
profits, as our measurement tool. That is, we will be concerned with when
the money hits our hands, when we can invest it and start earning interest
on it, and when we can give it back to the shareholders in the form of
dividends. Remember, it is the cash flows, not profits that are actually
PAGE 17
Notes received by the firm and can be reinvested. Accounting profits, on the
other hand, appear when they are earned rather than when the money is
actually in hand. As a result, a firm’s cash flows and accounting profits
may not be the same.
Principle 4: Efficient Capital Markets-The markets are quick and the
prices are right.
Our goal as financial managers is the maximization of shareholder wealth.
It is the value of the shares that the shareholders hold. In efficient markets
stock price reflect all publicly available information regarding the value
of the company. This means we can implement our goal of maximization
of shareholder wealth by focusing on the effect each decision should have
on the stock price if everything else were held constant. That is, over
time good decisions will result in higher stock prices and bad ones, lower
stock prices. Earnings manipulations through accounting changes will
not result in price changes. Stock splits and other changes in accounting
methods that do not feet cash flows are not reflected in prices. Market
prices reflect expected cash flows available to shareholders.
Principle 5: The Agency Problem-Managers won’t work for owners unless
it’s in their best interest.
Although the goal of the firm is the maximization of shareholder wealth,
in reality, the agency problem may interfere with the implementation of
this goal. The agency problem results from the separation of management
and the ownership of the firm. For example, a large firm may be run
by professional managers who have little or no ownership in the firm.
Because of this separation of the decision makers and owners, managers
may make decisions that are not in line with the goal of maximization
of shareholder wealth. They may approach work less energetically and
attempt to benefit themselves in terms of salary and perquisites at the
expense of shareholders.
Managers can be monitored by auditing financial statements managers’
compensation packages. The interests of managers and shareholders
aligned by establishing management stock options, bonuses, and perquisites
directly tied to how closely their decisions coincide with the interest of
shareholders. The agency problem will persist unless an incentive structure
is set up that aligns the interest of managers and shareholders. In other
18 PAGE
words, what’s good for shareholders must also be good for managers? If Notes
that is not the case, managers will make decisions in their best interests
rather than maximizing shareholder wealth.
Principle 6: All Risk Is Not Equal-Some risk can be diversified away,
and some cannot.
You are probably already familiar with the concept of diversification. There
is an old saying: “don’t put all of your eggs in one basket.” Diversification
allows good and bad events or observations to cancel each other out,
thereby reducing total variability without affecting expected return.
Principle 7: The objectives should be clear.
The last but most important principle of financial management is clear
information to all the managerial heads about organizational objectives.
The objectives may vary but, the most important is the maximization of
shareholders wealth. Time to time as per the requirement of organization
the financial manager has to change his route for achieving that objective.
For example if in any year the objective is liquidity, he has to maintain
it by reducing credit.
1.6 Time Value of Money

To keep pace with the increasing competition, companies have to go in
for new ideas implemented through new projects be it for expansion,
diversification or modernization. A project is an activity that involves
investing a sum of money now in anticipation of benefits spread over a
period of time in the future. How do we determine whether the project is
financially viable or not? Our immediate response to this question will be
to sum up the benefits accruing over the future period and compare the
total value of the benefits with the initial investment. If the aggregate value
of the benefits exceeds the initial investment, the project is considered
to be financially viable. While this approach prima facie appears to be
satisfactory, we must be aware of an important assumption that underlies.
We have assumed that irrespective of the time when money is invested
or received, the value of money remains the same. Put differently, we
have assumed that: value of one rupee now = value of one rupee at the
end of year 1 = value of one rupee at the end of year 2 and so on. We
PAGE 19
Notes know intuitively that this assumption is incorrect because money has time
value. How do we define this time value of money and build it into the
cash flows of a project?
We intuitively know that Rs. 1000 in hand now is more valuable than
Rs. 1,000 receivable after a year. In other words, we will not part with
Rs. 1,000 now in return for a firm assurance that the same sum will be
repaid after a year. But, we might part with Rs. 1,000 now if we are
assured that something more than Rs. 1,000 will be paid at the end of
the first year. This additional compensation required for parting with
Rs. 1,000 now is called ‘interest’ or the time value of money. Normally,
interest is expressed in terms of percentage per annum.
Money has time value because of following reasons:
u Individual generally prefer current consumption over future consumption
of goods and services though this preference may be subjective and
differ from one person to another.
u Most individuals prefer present cash to future cash because of the
available investment opportunities to which they can put present
cash to earn additional cash. This opportunity to get return will not
be available if the money is not invested now.
u The most important reason for time value of money is that future
is uncertain and therefore, financial manager should prefers cash
in present than cash in future.
u In inflationary conditions prices goes rise. As the price rise, the
value of money goes down and the purchasing power of rupee is
also going down.
1.7 Valuation Techniques

There is a preference of having money at present than at a future point
of time. This automatically means that a person will have to pay in future
more for a rupee received today and a person may accept less for a rupee
to be received in future.
The above statement relates to two different concepts:
1. Compound Value Concept
2. Present Value Concept
20 PAGE
1. Compound Value Concept: In case of this concept, the interest earned Notes
on the initial principal becomes a part of principal at the end of the
compounding period. For example, if Rs. 100 is invested at 10% compound
interest for two years, the return for first year will be Rs. 10 and for
the second-year interest will be received on Rs. 110 (i.e., 100+10). The
total amount due at the end of second year will become Rs. 121 (i.e.,
100+10+11). This can be understood better with the following illustration:
Example: Rs. 1,000 is invested at 10% compounded annually for three
years. Calculate the compounded value after three years.
Solution: Amount at the end of 1st year will be:
1,000 + (1,000 × 10) = Rs. 1100
Amount at the end of 2nd year will be:
1100 + (1,100 × 10) = Rs. 1210
Amount at the end of 3rd year will be:
1,210 + (1,210 × 10) = Rs. 1331
The return from an investment is generally spread over a number of
years. In the above illustration, the interest has been compounded only
for three years. However, if interest is calculated for five-six-years, the
method stated above would become tedious. The general equation used
to calculate the compounded value after ‘n’ years is given below:
where A = P(1+i)n
A = Amount at the end of period n
P = Principal amount at the beginning of the period
i = Interest rate
n = Number of years.
The term (1+i)n is the Compound Value Factor (CVF) of a lump sum
Re. 1, and it always has a value greater than 1 for positive i, indicating
that CVF increases as i and an increase. The compound value can be
computed for any lump sum amount. Computation by this formula can
also become very time consuming if the number of years become large,
say 10, 15 or more. In such cases compound value tables can be used.
PAGE 21
Notes Compound Value of Re. 1

Period 1% 25% 3% 4% 5% 6% 7% 8% 9% 10% 12% 14% 15%
1 1.010 1.020 1.30 1.040 1.050 1.060 1.070 1.080 1.090 1.100 1.120 1.140 1.150
2 1.020 1.040 1.062 1.082 1.102 1.124 1.145 1.166 1.188 1.210 1.254 1.300 1.322
3 1.030 1.061 1.93 1.125 1.158 1.121 1.225 1.263 1.295 1.331 1.404 1.482 1.521
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464 1.574 1.689 1.749
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.530 1.611 1.762 1.925 2.011
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772 1.974 2.195 2.313
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949 2.211 2.502 2.560
8 1.183 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144 2.476 2.853 3.518
9 1.094 1.125 1.305 1.423 1.551 1.689 1.388 1.999 2.172 2.358 2.773 3.252 3.518
10 1.105 1.219 1.334 1.480 1.629 1.791 1.967 2.159 2.367 2.94 3.106 3.707 4.046
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853 3.479 4.226 4.652
12 1.127 1.268 1.426 1.601 1.796 2.012 2.52 2.518 2.813 3.138 3.896 4.818 5.350
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452 3.363 4.492 6.153
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797 4.887 6.261 7.076
15 1.61 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177 5.474 7.138 8.137
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595 6.130 8.137 9.358
17 1.184 1.400 1.653 1.948 2.92 2.693 3.159 3.700 4.328 5.054 6.866 9.276 10.761
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.396 4.717 5.560 7.690 10.575 12.375
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116 8.613 12.056 14.232
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.728 9.646 13.733 16.637
25 1.282 1.641 2.0938 2.666 3.386 4.292 5.247 6.848 8.623 0.835 17.000 26.426 32.919
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449 29.960 50.960 66.212
Using the above table, for example, we get the same result.
A = P (1 + i)n
A = 1000 (1+.10)3
The compound value of Re. 1 at 10% for 3 years period is 1.331.
A = 1000 × 1.331 = 1331
Non-Annual Compounding
Interest can be compounded more than once in a year. Saving institutions,
particularly compound the interest semi-annually, quarterly and even monthly
basis. When the interest is compounded semi-annually, means interest is
paid twice a year. The interest rate will be half. In other words, there are
two periods of six months. Similarly, in case of quarterly compounding
interest rate will be ¼th of annual rate and there are four quarters years.
The formula for calculating the compound value is
where A = P(1+i/m)m×n
A = Amount at the end of period
P = Principal at the beginning of the period
22 PAGE
i = Interest rate Notes

n = Number of years
m = number of times per year compounding is made.
Example: A deposit of Rs. 10,000 is made in a bank for a period of 3
year. The bank offers to receive interest 10% half-yearly. Calculate the
compound value.
Solution:
A = P(1+i/m)mxn
A = 10000(1 + .10/2)2×3
A = 10000(1 + .5)6
A = 10000 × 1.340
A = 11340.
The compound value of Re.1 at 5% interest for six years is 1.340 therefore,
the compound value of 10000 after 3 years at 10% is 11340.
Compound Value for Series of Cash Flow
Usually an investor invest money in instalments and wish to know the
value of his saving after a period of time, then the compound value
for series of cash flow is calculated. To simplify it, we assume that the
compounding time period is one year and payment is made at the end
of each year.
Example: Mr. X deposits each year Rs. 500, Rs 1,000. Rs. 1,500. Rs.
2,000 and Rs. 2,500 in his saving bank account for 5 years. The interest
rate is 5 per cent. He wishes to find the future value of his deposits at
the end of the 5th year.
Solution:
End of Amount deposited Number of years Compounded Future value
year compounded interest factor
1 Rs. 500 4 1.216 Rs. 608.00
2 Rs. 1,000 3 1.158 Rs. 1,158.00
3 Rs. 1,500 2 1.103 Rs. 1,654.50
4 Rs. 2,000 1 1.050 Rs. 2,100.00
5 Rs. 2,500 0 1.000 Rs. 2,500.00
Rs. 8,020.50
PAGE 23
Notes Future Value of An Annuity

Annuity is a fixed payment (or receipt) each year for a specified number
of years. The formula for this is
where Sn = A × (Vi, n)
Sn = Compound amount of annuity
A = The value of one payment
Vi, n = The table value of annuity corresponding to rate of interest
and number of years.
Let us illustrate the computation of the compound value of an annuity.
Example: A constant sum of Rs. 100 is deposited in a savings account
at the end of each year for four years at 5 per cent interest. Calculate
the amount at the end of fourth year.
Solution: This implies that Rs. 100 deposited at the end of the first year
will grow for 3 years, Rs. 100 at the end of second year for 2 years, Rs.
100 at the end of the third year for 1 year and Rs. 100 at the end of the
fourth year will not yield an interest. Using the concept of the annuity,
the compound value is
Sn = A × (Vi, n)
Sn = 100 × (5% for four years)
Sn = 100 × 4.310*
* The value of Re. 1 as per the annuity table invested for four years at
the rate of 5%
Sn = 431.
Compound Value of Re. 1
Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.000 1.000 1.00 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.20 1.030 1.040 2.050 2.060 2.070 2.080 2.90 2.100
3 3.030 3.60 3.91 3.122 3.152 3.184 3.215 3.246 3.278 3.10
4 4.060 4.122 4.184 4.26 4.310 4.375 4.440 4.506 5.573 4.641
5 5.101 5.204 5.309 4.546 4.526 5.637 5.751 5.867 5.958 6.105
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 7.000 8.142 8.654 8.923 9.200 9.487
8 8.286 8.53 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11,436
9 9.368 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579
10 10.462 10.50 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
24 PAGE
Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Notes

11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.682 13.412 14.192 15.026 15.917 16.70 14.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.598 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.023 21.878 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.824 12.657 25.372 27.888 30.324 33.003 35.949
17 18.430 20.012 21.761 23.697 25.840 28.213 30.840 33.750 36.793 40.544
18 19.614 21.412 23.414 25.645 28.132 30.905 33.999 37.540 41.301 45.599
19 20.811 22.84 25.117 27.671 30.539 33.760 37.379 41.446 460.18 51.158
20 22.019 24.297 26.870 29.778 33.066 36.785 40.995 45.762 51.169 57.274
21 23.239 25.783 28.676 31.969 35.719 39.992 44.865 50.422 56.764 64.022
22 24.471 27.299 30.536 34.248 38.505 43.392 49.005 55.456 62.872 71.402
23 25.716 28.845 32.452 36.618 41.430 46.995 43.435 60.893 69.531 79.542
24 26.973 30.421 34.426 39.082 44.501 50.815 258.176 66.764 76.789 88.496
25 28.243 32.030 36.459 41.645 47.726 54.864 63.248 73.105 84.699 98.346
30 34.786 40.568 47.575 56.084 66.438 79.057 94.459 113.282 136.305 164.491
Present Value: Present Value or Discounting Technique

The concept of the present value is the exact opposite of that of compound
value. While in the latter approach money invested now appreciates in
value because compound interest is added, in the former approach (present
value approach) money is received at some future date and will be worth
less because the corresponding interest is lost during the period. In other
words, the present value of a rupee that will be received in the future
will be less than the value of a rupee in hand today. Thus, in contrast
to the compounding approach where we convert present sums into future
sums, in present value approach future sums are converted into present
sums. Given a positive rate of interest, the present value of future rupees
will always be lower. It is for this reason therefore, that the procedure
of finding present values is commonly called discounting. It is concerned
with determining the present value of a future amount, assuming that the
decision maker has an opportunity to earn a certain return on his money.
This return is designated in financial literature as the discount rate, the
cost of capital or an opportunity cost. Since finding present value is
simply the reverse of compounding, the formula for compounding of the
sum can be readily transformed into a present value formula.
A  1 
P= = A n 
(1 + i )  (1 + i ) 
n
PAGE 25
Notes where P = the present value for the future sum to be received or spent
A = the sum to be received or spent in future
i = interest rate
n = the number of years.
In order to simplify the present value calculations, tables are readily
available for, various ranges of i and n.
This can be easily understood with this example.
Example: Mr. X has been given an opportunity to receive Rs. 1,060
one year from now. He knows that he can earn 6 per cent interest on
his investments. What amount will he be prepared to invest for this
opportunity?
A  1 
Solution: P= = A n 
(1 + i )  (1 + i ) 
n
A = 1060
i = 6%
n = 1 year
1060
P=
(1 + .06 )
1060
P= = Rs. 1000
1.06
Example: Mr. X wants to find the present value of Rs. 2,000 to be
received 5 years from now, assuming 10 per cent rate of interest.
A  1 
Solution: P= = A n 
(1 + i )  (1 + i ) 
n
Or P = A (PVIF)
PVIF = Present value interest factor
PVIF as per Table for 5 years at 10% is 0.621.
Therefore, Present value = Rs. 2,000 (0.621)
= Rs. 1.242
26 PAGE
Present Value of Re. 1 Notes

Years 5% 6% 8% 10% 12% 14% 15% 16% 18% 20% 22% 24% 25% 28% 30%
1 0.952 0.943 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833 0.820 0.806 0.800 0.781 0.769
2 0.907 0.890 0.857 0.826 0.797 0.769 0.756 0.743 0.718 0.694 0.672 0.650 0.640 0.610 0.592
3 0.864 0.840 0.794 0.751 0.712 0.75 0.658 0.641 0.609 0.579 0.551 0.524 0.512 0.477 0.455
4 0.823 0.792 0.735 0.683 0.636 0.592 0.572 0.552 0.516 0.482 0.451 0.423 0.410 0.373 0.450
5 0.784 0.747 0.681 0.621 0.567 0.519 0.497 0.476 0.327 0.402 0.370 0341 0.328 0.291 0.269
6 0.746 0.705 0.630 0.564 0.507 0.456 0.432 0.410 0.370 0.335 0.303 0.275 0.262 0.227 0.207
7 0.711 0.662 0.583 0.513 0.452 0.400 0.376 0.354 0.314 0.279 0.249 0.222 0.210 0.178 0.159
8 0.647 0.627 0.570 0.467 0.404 0.351 0.327 0.305 0.266 0.233 0.204 0.179 0.168 0.139 0.123
9 0.645 0.592 0.500 0.424 0.361 0.308 0.284 0.263 0.225 0.193 0.167 0.144 0.134 0.108 0.094
10 0.614 0.558 0.463 0.386 0.322 0.270 0.247 0.227 0.191 0.162 0.137 0.116 0.107 0.085 0.073
11 0.585 0.527 0.429 0.350 0.287 0.237 0.215 0.195 0.162 0.135 0.112 0.094 0.087 0.066 0.056
12 0.557 0.497 0.397 0.319 0.257 0.208 0.187 0.168 0.137 0.112 0.092 0.076 0.069 0.052 0.043
13 0.530 0.469 0.368 0.290 0.229 0.182 0.163 0.145 0.116 0.093 0.075 0.061 0.055 0.040 0.033
14 0.505 0.442 0.340 0.263 0.205 0.160 0.141 0.125 0.099 0.078 0.062 0.049 0.044 0.032 0.025
15 0.481 0.417 0.315 0.239 0.183 0.140 0.123 0.108 0.084 0.065 0.051 0.040 0.035 0.025 0.020
16 0.458 0.394 0.292 0.218 0.163 0.123 0.107 0.093 0.071 0.054 0.042 0.032 0.028 0.019 0.015
17 0.436 0.371 0.270 0.198 0.147 0.108 0.093 0.080 0.060 0.045 0.034 0.026 0.023 0.015 0.012
18 0.416 0.350 0.250 0.180 0.130 0.095 0.081 0.069 0.051 0.038 0.028 0.021 0.018 0.012 0.009
19 0.396 0.331 0.232 0.164 0.1161 0.083 0.070 0.060 0.043 0.031 0.023 0.017 0.014 0.009 0.007
20 0.377 0.312 0.215 0.149 0.104 0.073 0.061 0.051 0.037 0.026 0.019 0.014 0.012 0.007 0.005
Present Value of a Series of Cash Flows

In a business situation, it is natural that returns received by a firm are
spread over a number of years. An investment made now may fetch
returns for a period after some time. Any businessman would like to
know whether it is beneficial to invest or forego a certain sum now, in
anticipation of returns he will earn over a number of year(s). In order to
take this decision he will need to equate the total anticipated future returns
to the present sum he is going to sacrifice. To estimate the resent value
of future series of returns, the present value of each expected inflows
will be calculated. (In case of compounding, the expected future value
of series of cash flows was calculated).
The present value of series of cash flows can be represented by the
following formula:
P=Sum of individual present values of each cash flow
A1, A2, A3, Cash flows after period 1, 2, 3, etc.
i = Discounting rate.
Example: Find out the present value of future cash inflows given the
time value money as 10% that will be received over next four years.
PAGE 27
Notes Year Cash Flows (Rs.)

1 1000
2 2000
3 3000
4 4000
Solution:
Year Cash flows (Rs.) Present Value Present
Factor Value
1 1000 .909 909
2 2000 .826 1652
3 3000 .751 2251
4 4000 .683 2732
Present Value of series of cash flows Rs. 7546
Present Value of an Annuity
In the above case there was a mixed stream of cash inflows. Annuity
can be defined as a series of equal cash flows of an amount each time.
Due to this nature of an annuity, a short cut is possible.
A1 A2 An  n 1 
PVA n = + + ....... = ∑ 
(1 + i ) (1 + i ) (1 + i )  i =1 (1 + t ) 
1 2 n n
where PVA = Present value of an annuity

A = Value single instalment
i = Rate of interest
However, as stated earlier a more practical method of computing the
present value would be to the annual instalment with the present value
factor. The formula would then be as follows:
PVA = A × ADF
where ADF denotes Annuity Discount Factor.
Example: Mr. X wishes to determine the present value of the annuity
consisting of cash inflows of Rs 1,000 per year for 5 years. The rate of
interest he can earn from his investment is 10 per cent.
28 PAGE
Solution: Notes
Present Value of an Annuity of Rs. 1000
Year end (1) Cash flows (2) PVF (3) Present Value (4) (2) × (3)
1 1000 .909 909
2 1000 .826 826
3 1000 .751 751
4 1000 .683 683
5 1000 .621 621
3790
The Present Value of an Annuity of Rs. 1000 for 5 years is 3790.
However, calculations become easier because the present value factor
for each year is to be multiplied by the annual amount of Rs. 1,000.
This method of calculating the present value of the annuity can also be
expressed as an equation:
P = Rs. 1,000 (0.909) + Rs. 1,000 (0.826) + Rs. 1,000 (OTS1) + Rs.
1,000 (0.683) + Rs. 1,000 (0.621) = Rs 3.790.
Simplifying the equation by taking out 1,000 as common factor outside
the equation.
P = Rs. 1,000 (0.909 +0.826+0.751+0.683 +0.621) = Rs. 1 (........790)
= Rs 3.790
Thus, the present value of an annuity can be found by multiplying the
annuity amount by the sum of the present value factors for each year of
the life of the annuity. Such ready-made calculations are available in Table.
Present Value of Re. 1 Received Annually For Years
Years 5% 6% 8% 10% 12% 14% 15% 16% 18% 20% 22% 24% 25% 28% 30%
1 0.952 0.943 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833 0.820 0.806 0.800 0.781 0.769
2 1.859 1.833 1.783 1.736 1.690 1.647 1.626 1.605 1.566 1.528 1.492 1.457 1.440 1.392 1.361
3 2.773 2.676 2.577 2.847 2.402 2.322 2.283 2.246 2.174 20.16 2.042 1.981 1.952 1.868 1.816
4 3.546 3.465 3.312 3.170 3.037 2.914 2.855 2.798 2.690 2.589 2.494 2.404 2.362 2.241 2.166
5 4.330 4.212 3.993 3.791 3.605 3.433 3.352 3.274 3.127 2.991 2.864 2.745 2.689 2.532 2.346
6 5.076 4.917 4.623 4.335 4.11 3.889 3.784 3.685 3.498 3.326 3.167 3.020 2.951 2.759 2.643
7 5.786 5.582 5.206 4.868 4.564 4.288 4.160 4.039 3.812 3.605 3.416 3.242 3.161 2.937 2.802
8 6.463 6.210 5.747 5.335 4.968 4.639 4.487 4.344 4.078 3.837 3.619 3.421 3.329 3.076 2.925
9 7.109 6.802 6.247 5.759 5.328 4.946 4.772 4.607 4.303 4.031 3.786 3.566 3.463 3.184 3.019
10 7.722 7.360 6.710 6.145 5.650 5.216 5.019 0.833 4.494 4.192 3.923 3.682 3.571 3.269 3.092
11 8.306 7.787 7.139 6.495 5.937 5.453 5.234 5.029 4.656 4.237 4.35 3.776 3.656 3.335 3.147
12 8.863 8.384 7.536 6.814 6.194 5.660 5.421 5.197 4.793 4.439 4.127 3.851 3.725 3.387 3.190
PAGE 29
Notes Years 5% 6% 8% 10% 12% 14% 15% 16% 18% 20% 22% 24% 25% 28% 30%
13 3.394 8.853 7.904 7.106 6.424 5.842 5.583 4.342 4.910 4.533 4.203 3.912 3.780 3.427 3.223
14 9.899 9.295 8.244 7.367 6.628 6.002 5.724 5.468 5.008 4.611 4.265 3.962 3.824 3.459 3.249
15 10.380 9.712 8.559 7.606 6.811 6.142 5.847 5.575 5.092 4.675 4.315 4.001 3.859 3.483 3.0268
16 10.383 10.106 8.851 7.824 6.974 6.265 5.954 5.669 5.162 4.730 4.357 4.033 3.887 3.503 3.283
17 11.274 10.477 9.122 8.022 7.120 6.373 6.047 5.749 5.222 4.775 4.391 4.059 3.910 3.518 3.295
18 11.690 10.828 9.372 8.201 7.250 6.467 6.128 5.818 5.273 4.812 4.419 4.080 3.928 3.529 3.304
19 12.082 11.158 9.614 8.365 7.366 6.550 6.188 5.877 5.316 4.844 4.442 4.097 3.942 3.539 3.311
20 12.462 11.470 9.818 5.514 7.469 6.623 6.25 5.929 5.355 4.870 4.460 4.110 3.954 3.546 3.316
Thus, table presents the sum of present values for an Annuity Discount
Factor (ADF) of Rs 1 for wide ranges of interest rates, i, and number of
years, n. From Table the sum ADF for five years at the rate of 10 per
cent is found to be 3.791. Multiplying this factor by annuity amount (A)
of Rs 1,000 in this example gives Rs 3,791. This answer is the same as
the one obtained from the long method.
IN-TEXT QUESTIONS
6. The Risk - Return trade off implies higher return for a lower
risk. (True/False)
7. In _______ concept, the interest earned on the initial principal
becomes a part of principal at the end of the compounding
period.
8. In _________ concept, the present value of a rupee that will be
received in the future will be less than the value of a rupee in
hand today.
1.8 Concept of Risk and Return

While making the decisions regarding investment and financing, the finance
manager needs to achieve the right balance between risk and return, in
order to optimize the value of the firm. Return and risk go together in
investments. Everything an investor (be it the firm or the investors in
the firm) does is tied directly or indirectly to return and risk. Let us now
examine these concepts of risk and return in descriptive form.
Return
The objective of any investor is to maximize expected returns from
the investments, subject to various constraints, primarily risk. Return is
the motivating force, inspiring the investor in the form of rewards, for
30 PAGE
undertaking the investment. The importance of returns in any investment Notes

decision can be traced to the following factors:
u It enables investors to compare alternative investments in terms of
what they have to offer the investor.
u Measurement of historical (past) return enables the investors to assess
how well they have done.
u Measurement of historical returns also helps in estimation of future
returns.
The reveals that there are two types of return-Realized or Historical
Return and Expected Return.
Realized Return
This is ex-post (after the fact) return, or return that could have been
earned. For example, a deposit of Rs.1,000 in a bank on January 1, it
stated annual interest rate of 10% will be worth Rs. l,100 exactly a year
later. The historical or realized return in this case is 10%.
Expected Return
This is the return from an asset that investors anticipate or expect to earn
over some future period. The expected return is subject to uncertainty,
or risk, and may or may not occur. The investor compensates for the
uncertainty in returns and the timing of those returns by requiring an
expected return that is sufficiently high to offset the risk or uncertainty.
The Components of Return
What constitutes the return on any investment? Return is basically made
up of two components:
u The periodic cash receipts or income on the investment in the form
of interest, dividends etc. The term yield is often used in connection
with this component of return. Yield refers to the income derived
from a security in relation to its price, usually its purchase price.
For example, the yield on a 10% bond at a purchase price of
Rs. 900 is 11.11%.
u The appreciation (depreciation) in the price of the asset be referred
to as capital gain (loss). This is the difference between the purchase
price and the price at which the asset can be sold.
PAGE 31
Notes Many investors have capital gains as their primary objective and expect
this component to be larger than the income component.
Measuring the Rate of Return
The rate of return is the total return the investor receives during the
holding period (the period when the security is owned or held by the
investor) stated as a percentage of the purchase price of the investment
at the beginning of the holding period. In other words, it is the income
from the security in the cash flows and the difference in price of the
security between the beginning and end of the holding period expressed
as a percentage of the purchase price of the security at the beginning of
the holding period.
The general equation for calculating the rate of return is shown below:
D + ( Pt − Pt −1 )
k= t
Pi =1
where k = Rate of return
rice of the security at time ‘t’ i.e., at the end of the holding
Pt = P
period.
rice of the security at time ‘t – 1’ i.e., at the beginning of
Pt −1 = P
the holding period or purchase price.
Dt = Income or cash flows receivable from the security at time
‘t’.
m are usually stated at an annual percentage rate to allow comparison
of returns between securities. Let us first look at the calculation of the
rates of return of an equity stock and then a bond.
A Stock’s Rate of Return
What are the two components of return from shares? The first component
‘Dt’ is the income in cash from dividends and the second component is
the price change (appreciation and depreciation).
Example: If a share of C Ltd. is purchased for Rs. 3,580 on February
8 of last year, and sold for Rs. 3,800 on February 9 of this year and
the company paid a dividend of Rs. 35 for the year, calculate the rate
of return?
32 PAGE
D1 + ( Pt − Pt −1 ) 35 + (3,800 − 3,580) Notes

Solution: k= = = 7.12%
Pt =1 3,580
Rate of Return of a Bond (Debenture)

In the case of bonds, instead of dividends, the investor is entitled to
payments of interest annually or semi-annually, based on the coupon
rate. The investor also benefits if there is an appreciation in the price
of the bond.
Example: If a 14% Rs. 1,000 ICICI debentures was purchased for Rs.
1,350 and the price of this security rises to Rs. 1,500 by the end of a
year. Find the Rate of return for debenture.
14 + (1,500 − 1,350)
Solution: k= = 2148%
1,350
Risk
Risk and return go hand in hand in investments and finance. One cannot
talk about returns without talking about risk, because investment decisions
always involve a trade-off between risk and return. Risk can be defined
as the chance that the actual outcome from an investment will differ from
the expected outcome. This means that, the more variable the possible
outcomes that can occur (i.e., the broader the range of possible outcome),
the greater the risk.
Sources of Risk
Following are the some of the general sources of risk.
u Interest Rate Risk: Interest rate risk is the variability in a security’s
return resulting from changes in the level of interest rates. Other
things being equal, security prices move inversely to interest rates.
This risk affects bondholders more directly than equity investors.
u Market Risk: Market risk refers to the variability of returns due
to fluctuations in the securities market. All securities are exposed
to market risk but equity shares get the most affected. This risk
included a wide range of factors exogenous to securities themselves
like depressions, wars, politics, etc.
u Inflation Risk: With rise in inflation there is reduction of purchasing
power, hence this is also referred to as purchasing power risk and
PAGE 33
Notes affects all securities. This risk is also directly related to interest
rate risk, as interest rates go up with inflation.
u Business Risk: This refers to the risk of doing business in a particular
industry or environment and it gets transferred to the investors who
invest in the business or company.
u Financial Risk: Financial risk arises when companies resort to financial
leverage or the use of debt financing. The more the company resorts
to debt financing, the greater is the financial risk.
u Liquidity Risk: This risk is associated with the secondary market
in which the particular security is traded. A security which can
be bought or sold quickly without significant price concession is
considered liquid. The greater the uncertainty about the time element
and the price concession, the greater the liquidity risk. Securities
which have ready markets like treasury bills have lesser liquidity
risk.
Measurement of Risk
Risk is associated with the dispersion in the likely outcomes. Dispersion
refers to variability. If an asset’s return has no variability, it has no risk.
An investor analyzing a series of returns on an investment over a period
of years needs to know something about the variability of its returns or
in other words the asset’s total risk. There are different ways to measure
variability of returns. The range of the returns, i.e. the difference between
the highest possible rate of return and the lowest possible rate of return
is one measure, but the range is based on only two, extreme values.
The variance of an asset’s rate of return can be found as the sum of the
squared deviation of each possible rate of return from the expected rate
of return multiplied by the probability that the rate of return occurs.
n
VAR(k ) = ∑ Pi (ki − K ) 2
i =1
where VAR(k) = Variance of returns

Pi = Probability associated with the 1 possible outcome
ki = Rate of return from the possible outcome
k = Expected rate of return
n = Number of years.
34 PAGE
A third and most popular way of measuring variability of returns is Notes

standard deviation. The standard deviation denoted by is simply the square
root of the variance of the rates of return explained above.
1/2
 n 
σ = VAR(k ) =  ∑ Pi (ki − K ) 2 
 i =1 
The standard deviation and variance are conceptually equivalent quantitative
measures of total risk. Standard deviation is preferred to range because
of the following advantages:
u Unlike the range, standard deviation considers every possible event
and assigns each event a weight equal to its probability.
u Standard deviation is a very familiar concept and many calculators
and computers are programmed to calculate it.
u Standard deviation is a measure of dispersion around the expected
(or average) value. This is in absolute consensus with the definition
of risk as “variability of returns”.
u Standard deviation is obtained as the square root of the sum of
squared differences multiplied by their probabilities. This facilities
comparison of risk as measured by standard deviation and expected
returns as both are measured in the same costs. This is why standard
deviation is preferred to variance as a measure of risk.
IN-TEXT QUESTIONS
9. ______________________ return that was or could have been
earned.
10. _______ is the return from an asset that investors anticipate or
expect to earn over some future period.
11. Which of the following is not a source of risk.
(a) Market
(b) Inflation
(c) Liquidity
(d) Profitability
12. If an asset’s return has no variability, it has no risk.
(True/False)
PAGE 35
Notes 1.9 Summary

The current chapter introduces the concept of financial management to the
students. The chapter deals with the various approaches and views towards
financial management and helps the students to know the importance of
financial management in business. The lesson also talks about the time
value of money and the techniques of valuation. The concept of risk and
return has also been discussed in the chapter. There are various sources
of risk namely Interest Rate Risk, Market Risk, Inflation Risk, Business
Risk, Financial Risk and Liquidity Risk. The risk can be calculate using
the dispersion value of the likely outcomes.
1. Funds requirements
2. Broadens
3. True
4. True
5. True
6. False
7. Compounded interest
8. Present Value
9. Realised
10. Expected
11. (d) Profitability
12. True

1. What is Financial Management?
2. Discuss the Objectives of Financial Management?
3. Critically evaluate various approaches of Financial Management?
4. Explain the importance of Financial Management?
36 PAGE
5. What is Time value of Money? How it can be valued using various Notes
techniques.
6. What is Risk - Return Trade off ?

u J.C. Van Horne, Financial Management and Policy, Prentice Hall of
India.
u H. Levy and M. Sarnat, Principles of financial Management, Engelwood
Cliffs, Prentice Hall of India.
u I.M. Pandey, Financial Management, Vikas Publishing House Pvt.
Ltd.
u Shrutika Kesar, Financial Management, Sumit Enterprises.
u Eugene F. Brigham and Michael C Ehrhardt, Financial Management,
Thomson.
u Keown, Martin, Petty, Scott, Jr. Financial Management Principles
and Applications, Prentice Hall of India.
u M.Y. Khan and P.K. Jain, Financial Management, Text and Problems,
Tata McGraw Hill, New Delhi.
u R.P. Rastogi, Fundamentals of Financial Management, Galgotia,
Publications, New Delhi.
u V.K. Bhalla, Financial Management & Policy, Anmol Publications,
Delhi.
u Prasanna Chandra, Financial Management- Theory and Practice, Tata
McGraw Hill.
PAGE 37
UNIT - II
PAGE 39
L E S S O N
1
Capital Budgeting
Manju Gupta
STRUCTURE
1.2 Introduction
1.3 Significance of Capital Budgeting Decisions
1.4 Capital Budgeting Process
1.5 Capital Budgeting Techniques
1.6 The Payback Period
1.7 Acceptance Rule
1.8 Discounted Cash Flow Techniques (DCF)
1.9 Summary

After studying this chapter students may be able to understand:—
u The meaning of Capital Budgeting.
u The relevance of investing in long-term projects.
u Techniques of capital budgeting.
u Various types of discounted cash flow techniques.
1.2 Introduction
Every financial manager has to take three important decisions i.e. financing decision,
investment decision and dividend decision. Investment decision is basically concerned with
PAGE 41
Notes financing of current and fixed assets of the firm. Financing of current
asset is known as working capital management decision while investment
in fixed assets is known as capital budgeting decision.
The capital budgeting decisions are related to the allocation of investible
funds to different long-term projects. Broadly speaking, the capital
budgeting decision denotes a decision where the lump sum funds are
invested in the initial stages of a projects and the return are expected
over a long period of time (i.e., more than a year). Capital budgeting
decisions are important for almost all types of organizations and involves
a huge commitment of funds.
In any growing concern, capital budgeting is more or less a continuous
process carried out by different functional areas of management such as
production, marketing etc. All the relevant functional departments play a
crucial role in the capital budgeting decision process of any organization.
The role of a finance manager in the capital budgeting basically lies in
the process of critical and in-depth analysis and evaluation of various
alternative proposals and then to select one out of these. As already
stated, the basic objective of financial management is to maximize the
wealth of the shareholders, therefore the objective of capital budgeting is
to select those long term investment projects that are expected to make
maximum contribution to the wealth of the shareholders in a long run.
Features of Capital Budgeting:
u The exchange of current funds for future benefits.
u The funds are invested in the long-term assets.
u The future benefits will occur to the firm over a series of years.
u Capital budgeting decisions are irreversible which means once taken,
cannot be change.
u It involves commitment of huge amount of funds and therefore, are
risky.
Capital budgeting decisions are compulsorily to be made in following
cases:
(i) Replacements: Replacements of fixed assets may become necessary
either on account of their being worn out or becoming outdated on
account of new technology.
42 PAGE
(ii) Expansion: A firm may have to expand its production capacity on Notes
account of high demand for its products and inadequate production
capacity which will require additional capital investment. In such
event, investment in fixed assets is necessary.
(iii) Diversification: A business may like to reduce its risk by operating
in several markets rather than in a single market. In such an event
capital investment may become necessary for purchase of new
machinery and facilities to handle the new products.
(iv) Research and Development: Large sums of money may have to be
expended for research and development in case of those industries
where technology is rapidly changing. In case large sums of money
are needed for equipment, these proposals will normally be included
in the capital budget.
(v) Miscellaneous: A firm may have to invest money in projects which
do not directly help in achieving profit oriented goals. For example,
installation of pollution control equipment may by necessary account
of legal requirements. Thus, funds will be required for such purposes
also.
1.3 Significance of Capital Budgeting Decisions

The capital budgeting decisions are often said to be the most important part
of financial management. Any decision that requires the use of financial
resources in capital projects is a capital budgeting decision. The capital
budgeting decisions affect the profitability of a firm for a long period;
therefore, the importance of these decisions is obvious. Even a single
wrong decision by a firm may endanger the existence of the firm for
example a profitable firm decision to diversify into a new product line if
not taken correctly, may convert that firm into a loss making firm. There
are several factors and considerations which make the capital budgeting
decisions as the most important decisions of a finance manager. The
relevance of capital budgeting may be stated as follows:
(a) Long Term decisions: Capital budgeting decisions have long term
effects on the risk and return composition of the firm. Since these
decisions have long term implications and consequences, thus it
PAGE 43
Notes affect the future position of the firm to a considerable extent.

By taking a capital budgeting decision, a finance manager in fact
makes a commitment into the future, both by committing to the
future needs of funds of the project and by committing to its future
implications.
(b) Heavy investment Outlays: The capital budgeting decisions generally
involve large commitment of funds and as a result substantial portion
of capital funds are blocked in the capital budgeting decisions.
In relative terms therefore, more attention is required for capital
budgeting decisions, otherwise the firm may suffer from the heavy
capital losses in time to come. It is possible that the return from
a project may not be sufficient enough to justify capital budgeting
decisions.
(c) Irreversible in nature: Most of the capital budgeting decisions are
irreversible decisions. Once decided firm may not be in a position
to revert back unless it is ready to absorb heavy losses which
may result due to abandoning a project in midway. Therefore, the
capital budgeting decisions should be taken only after considering
and evaluating each and every detail of the project, otherwise the
financial consequences may be far reaching.
(d) Complex decisions: Capital budgeting decisions are among the firm’s
most difficult decision as it involves future assessment of cash flows
which are difficult to predict it is really a complex problem to
correctly estimate the future cash flows of an investment. Because of
the prevalence of uncertainty associated with economic environment
forces.
1.4 Capital Budgeting Process

The process of capital budgeting involves a number of steps that follow
capital budgeting.
Identification of Organizational Long-term Goals: In the very beginning,
the finance manager has to find out whether strategic or tactical investment
will be more suitable for the firm from the viewpoint of its long-term
44 PAGE
goals. Entering a new product market involves strategic investment. Such Notes
proposals cannot be evaluated solely in terms of their impact on the cash
flow. Intangible benefits that are in conformity with the firm’s long-term
goals should also be considered. On the contrary, tactical investments are
those which primarily influence the firm’s cash flow but do not necessarily
change the character of the firm. Establishment of new facilities in an
existing market for the purpose of manufacturing products related to the
current product may be an example of a tactical investment proposal. Such
investment proposals carry less risk as compared to the risk inherent in
strategic proposals.
Screening of Proposals: When the manager is satisfied that the proposal
conforms to the long-term goals of the firm, he or she proceeds on to
the second phase, that of screening the proposal. The second phase is
one in which the manager determines the impact of the proposal on the
firm. In large firms, it is the project analysis division that looks for new
ideas and qualitatively evaluates their potential impact on the firm’s
revenues and cost. It examines whether the proposal would reduce cost
and or increase revenue.
Estimation of Costs and Benefits of a Proposal: The most important
step required in the capital budgeting decision is to estimate the cost and
benefit associated with all the proposals being considered. The cost of a
proposal is generally the capital expenditure required to install a project
or to implement a decision. However, the benefits of a proposal may be
in the form of increased output, increased sales, reduction in labour cost,
reduction in wastages etc. Every proposal is to be examined in the light
of its cost and benefits.
Estimation of the Required Rate of Return: The rate of return expected
from a proposal is to be estimated in order to (i) adjust the future cost
and benefit of a proposal for time value of money, and (ii) thereafter,
determining the profitability of the proposal. This required rate return is
also known as Cost of Capital.
Using the capital budgeting decision criterion: A proper capital budgeting
technique is to be applied to select the best alternative. So, in the first
PAGE 45
Notes instance the technique itself is to be selected and then is to be applied

for a better decision making.
Project Implementation: In this phase, the firm makes the required
arrangements to take up the new project. This includes arrangement of
capital, training of personnel and other relevant works.
Control: After the project is implemented, the firm monitors whether
costs are incurred in accordance with the set standards. Minor deviations
are managed, however, if deviations are very large, the project may be
abandoned.
Project Audit: When the project is complete, the extent of success or
failure and the reasons thereof are carefully studied. In this way the audit
phase provides valuable information to the firm.
IN-TEXT QUESTIONS
1. The capital budgeting decisions are related to the allocation of
investible funds to different ________ assets.
(a) Long-term
(b) Short-term
(c) Both (a) and (b)
(d) None of the above
2. Any decision that requires the use of ___________ resources
is a capital budgeting decision.
3. Which of the following is not true about Capital Budgeting?
(a) Capital Budgeting decisions have an influence on the future
stability of an organisation
(b) Capital Budgeting decisions include investments to expand
the business
(c) Capital Budgeting decisions are of an irreversible nature
(d) Sunk cost is a part of Capital Budgeting
4. Which of the following would be the best example of a capital
budgeting decision?
(a) Purchasing new machinery to replace an existing one
46 PAGE
4. Which
(b) of the following
Transferring moneywould be thecreditor’s
to your best example of a capital budgeting
account Notes
decision?
(c) Payment of electricity bill for your factory
(a) Purchasing new machinery to replace an existing one
(b) Transferring money to your creditor’s account
1.5 (c)Capital Budgeting

Payment of electricity Techniques
bill for your factory
The main objective of capital fund investment is to obtain sufficient
1.5 Capital Budgeting Techniques
future economic return to deserve the original outlay i.e., sufficient cash
receipts over
The main theoflife
objective of the
capital fundproject
investmentto isjustify thesufficient
to obtain investment
future made.
economicThere
return to
deserve the original outlay i.e., sufficient cash receipts over the
are different techniques available for or non-discounted and time adjustedlife of the project to justify
the investment made. There are different techniques available for or non-discounted and time
or discounted
adjusted cash cash
or discounted flows.
flows.
Evaluation Criteria
Evaluation Criteria
Non-Discounting Methods Discounting Methods
Payback Period Accounting rate Net present Internal rate Profitability

of return value of return Index
IMAGE MATTER
1.6 The Payback

Non-Discounting Methods Period
Discounting Methods
The payback period measures the length of time required to recover the
Paybackoutlay
initial Period in the project.
Accounting rate of return Initial Investment
Payment Period =
Net present value Annual Cash Inflows
Internal rate of
Example: If return
a project with a life of 5 years involves an initial outlay
of Rs. 20 lakh
Profitability and is expected to generate a constant annual inflow of
Index Method
Rs. 8 lakh. Find the payback period of the project.
Solution: The payback period of the project is:
1.6 The Payback Period
Initial Investment
Payment
The payback periodPeriod = the length of time required to recover the initial outlay in the
measures
project. Annual Cash Inflows
Initial Investment
Payment Period =
Annual Cash Inflows
PAGE 47
Notes 20
PB = = 2.5 years.
8
In case the cash flows are different: If the project is expected to generate
different annual inflows of say Rs. 4 lakh, Rs. 6 lakh, Rs. 8 lakh. Rs.
10 lakh and Rs. 14 lakh over the 5 years period the payback period will
be find out by cumulating the cash flows.
Year Cash flows (lakhs) Cumulative cash inflows
1 4 4
2 6 10
3 8 18
4 10 28
5 14 42
Pay Back Period = 3 years + (20000 – 18,000) / (28,000 – 18,000) =

3.2 years
In order to use the payback period as a decision rule for accepting or
rejecting the projects, the firm has to decide upon an appropriate cut-off
period.*
*The cut-off point refers to the point below which a project would not
be accepted. For Example, if 10% is the desired rate of return, the cut-
off rate is 10%. The cut-off point may also be in terms of period. For
example, if the management desires that the investment in the project
should be recouped in three years, the period of three years would be
taken as the cut-off period. A project, incapable of generating necessary
cash to pay for the initial investment in the project within three years,
will not be accepted. Projects with payback periods less than or equal to
the cut-off period will be accepted and others will be rejected.
The payback period is a widely used investment appraisal criterion for
the following reasons:
u It is simple in both concept and application.
u It helps in weeding out risky projects by favoring only those projects
which generate substantial inflows in earlier years.
48 PAGE
u The emphasis in payback is on the early recovery of investment. Notes

Thus, it gives insight into liquidity of the project. The funds so
released can be put to other uses.
u Payback period method also deals with risk. The project with a shorter
payback period will be less risky as compared to projects with a
longer payback period, as the cash inflow which arises further will
be less certain.
The payback period criterion however, suffers from the following
shortcomings:
u It fails to consider the concept of time value of money.
u The payback period method ignores many of cash inflows which
occur after the payback period.
u The cut-off period is chosen rather arbitrarily and applied uniformly
for evaluating projects regardless of their life spans. Consequently,
the firm may accept too many short-lived projects and only too few
long-lived ones.
u Since the application of the payback criterion leads to discrimination
against projects which generate substantial cash inflows in later years,
the criterion cannot be considered as a measure of profitability.
Suitability of Payback Method: The use of payback period as a technique
of evaluating capital budgeting proposals is suitable in following cases:
u During instability, the firm may have a primary consideration of
recovering the initial cost at the earliest opportunity.
u When the firm has limited funds available and has no ability or
willingness to raise additional funds. In such as case, the firm
may wish to undertake those projects which ensure early liquidity/
recovery.
Accounting Rate of Return or Average Rate of Return (ARR): The ARR
is based upon the accounting concept of return on investment or rate of
return. The ARR may be defined as the annualized net income earned
on the average funds invested in a project. In other words, the annual
returns of a project are expressed as a percentage of the net investment
in the project.
PAGE 49
Notes Average Annual Profit (after tax)

ARR =
Average investment in the project
This clearly shows that the ARR is a measure based on the accounting
profits rather than the cash flows. It is very similar to the measure of
rate of return on capital employed, which is generally used to measure
the overall profitability of the firm.
In case the expected profits (after tax) generated by a project are equal
for all the years than the annual profit itself is the average profit. So,
this annual profit will be compared with the average investment.
Annual Profit (after tax)
ARR =
If the project is expected to generate unequal profits or uneven stream of
profits over different years, then the ARR may be calculated by finding
out the average annual profits.
Average Annual Pr ofit (after tax)
ARR =
The average investment refers to the average quantum of funds that

remains invested or blocked in the proposal over its economic life.
Example: A project will cost Rs. 40000. Its stream of Earnings Before
Depreciation, Interest and Taxes (EBDIT) during first year through five
years is expected to be Rs. 10,000, Rs. 12,000, Rs. 14,000, Rs. 16,000
and Rs. 20,000. Assume a 50 per cent tax rate and depreciation on
straight-line basis.
Year EBDIT EBT PAT (50% tax)
1 10000 2000 1000
2 12000 4000 2000
3 14000 6000 3000
4 16000 8000 4000
Initial Investment
Depreciation =
Life of Pr oject
40000
Depreciation = = 8000
5
50 PAGE
Total profit after tax is 16000 Notes

Average profit after tax = 16000/5=3200
Average Annual Pr ofit (after tax)
ARR =
3200
ARR = × 1000 = 16%
20000
To use it as an appraisal criterion, the ARR of a project is compared with
the ARR of the firm as a whole or against some external yard-stick like
the average rate of return for the industry as a whole. To illustrate the
computation of ARR consider a project with the following data:
Ins (Amount in Rs.)
Year 0 1 2 3
Investment (90000)
Sales Revenue 120000 100000 80000
Operating expenses 60000 50000 40000
Depreciation 30000 30000 30000
Annual Income 30000 20000 10000
30, 000 + 20, 000 + 10, 000
Average annual income = = 20, 000
3
90, 000 + 0
Average net book value of investment = = 45, 000
2
20, 000
Account rate of return = ×100 = 44 per cent
45, 000
The firm will accept the project if its target average rate of return is
lower than 44 per cent.
1.7 Acceptance Rule

As an accept-or-reject criterion, this method will accept all those projects
whose ARR is higher than the minimum rate established by the management
and reject those projects which have ARR less than the minimum rate.
This method would rank a project as number one if it has highest ARR
and lowest rank would be assigned to the project having lowest ARR.
PAGE 51
Notes As an investment appraisal criterion, ARR has the following merits:

u Like payback criterion, ARR is simple both in concept and application.
It appeals to businessmen who find the concept of rate of return
familiar and easy to work with rather than absolute quantities.
u It considers the returns over the entire life of the project and therefore,
serves as a measure of profitability (unlike the payback period which
is only a measure of capital recovery).
u The ARR can be readily calculated from the accounting data; unlike
in the NPV and IRR methods, no adjustments are required to arrive
at cash flow of the project.
This criterion, however, suffers from several serious defects:
First, this criterion ignores the time value of money. Put differently, it
gives no allowance for the fact that immediate receipts are more valuable
than the distant flows and results giving too much weight to the more
distant flows.
Second, the ARR depends on accounting income and not on the cash
flows. Since cash flows and accounting income are often different and
investment appraisal emphasizes cash flows, a profitability measure based
on accounting income cannot be used as a reliable investment appraisal
criterion.
Finally, the firm using ARR as an appraisal criterion must decide on a
yard-stick for judging a project and this decision is often arbitrary Often
firms use their current book-return as the yard-stick for comparison. In
such cases if the current book return of a firm tends to be unusually high
or low, then the firm can end up rejecting good projects or accepting
bad projects.
To conclude, the traditional methods of appraising capital investment
decisions, the major draw-backs are (1) they do not consider the total
benefits in terms of the magnitude and (2) the timing of cash flows. The
time adjusted techniques satisfy these requirements.
1.8 Discounted Cash Flow Techniques (DCF)

The distinguishing characteristic of the DCF capital budgeting techniques is
that they take into consideration the time value of money while evaluating
52 PAGE
the costs and benefits of a project. In one form or another, all these Notes
methods require cash flows to be discounted at a certain rate, that is,
the cost of capital. The cost of capital (k) is the minimum discount rate
earned on a project that leaves the market value unchanged. The second
commendable feature of these techniques is that they take into account
all benefits and the costs occurring during the entire life of the project.
The first method under this technique is NPV.
Net Present Value: The net present value is equal to the present value of
future cash flows and any immediate cash outflow. In case of a project
the immediate cash flow will be investment (cash outflow) and then net
present value will be defined as the sum of the present values of cash
inflows less initial investment.
CF1 CF2 CF3 CFn
NPV = 1
+ 2
+ 3
+ − C0
(1 + k ) (1 + k ) (1 + k ) (1 + k ) n
Example: A company is considering a new project with initial outlays of

Rs. 12500. Forecasted annual income before charging depreciation but,
after all other charges are as follows:
1st year 5100
2nd year 5100
3rd year 5100
4th year 7100
Calculate NPV at 12%.
Solution:
The net cash flows of the project and their present values are as follows:
Year 1 2 3 4
Net cash flow (Rs.) 5100 5100 5100 7100
PVIF @ k = 12% 0.893 0.797 0.712 0.636
Present value (Rs.) 4554 4065 363 4516
Net Present Value = (4,554 +4,065 +3,631 +4,516) - (12,500)
= Rs. (16766-12500) = Rs. 4,266
The decision rule based on the NPV criterion is obvious. A project will
be accepted if its NPV is positive and rejected if its NPV is negative.
Rarely in real life situations, we encounter a project with NPV exactly
PAGE 53
Notes equal to zero. If it happens, theoretically speaking, the decision-maker is

supposed to be either indifferent in accepting or rejecting the project. But
in practice, NPV in the neighbourhood of zero calls for a close review
of the projections made in respect of such parameters that are critical
to the viability of the project because even minor adverse variations can
affect the viability of viable projects.
As an investment appraisal criterion, NPV has the following merits:
u The NPV is a conceptually sound criterion of investment appraisal
because it takes into account the time value of money.
u NPV considers the cash flow stream in its entirety. In other words,
it considers the total benefits arising out of the proposal over its
lifetime.
u Since net present value represents the contribution to the wealth of
the shareholders, maximization NPV is congruent with the objective
of investment decision making viz., maximization of shareholders’
wealth.
u A changing discount rate can be built into the NPV calculations
by altering the denominator. This feature becomes important as this
rate normally changes because the longer the time span, the lower
is the value of money and the higher is the discount rate.
u This method is particularly useful for the selection of mutually
exclusive projects.
This criterion, however, suffers from several serious defects:
The first problem in applying this criterion appears to be the difficulty
in comprehending the concept per se. Most non-financial executives and
businessmen find ‘Return on Capital Employed’ or ‘Average Rate of
Return’ easy to interpret compared to absolute values like NPV.
The second, and a more serious problem associated with the present value
method, involves the calculation of the required rate of return to discount
the cash flows. The discount rate is the most important element used in
the calculation of the present values because different discount rates will
give different present values. The relative desirability of a proposal will
change with a change in the discount rate.
54 PAGE
Another shortcoming of the NPV is that it is an absolute measure. Prima Notes

facie between two projects, this method will favour the project which has
highest present value. But it is likely that this project may also involve a
larger initial outlay. Thus, in case of projects involving different outlays,
the present value method may not give dependable results.
Finally, the present value method may also not give satisfactory results
in the case of two projects having different effective lives. In general,
the project with a shorter economic life would be preferable, other things
being equal. A project which has a higher present value may also have
larger economic life so that the funds will remain invested for a longer
period, while the alternative proposal may have shorter life but smaller
present value. In such situations, the present value method may not reflect
the true worth of the alternative proposals.
Internal Rate of Return (IRR): The second Discounted Cash Flow (DCF)
or time-adjusted method for appraising capital investment decisions is
the Internal Rate of Return (IRR) method. This technique is also known
as yield on investment, marginal efficiency of capital. Like the present
value method the IRR method also considers the time value of money by
discounting the cash streams. The basis of the discount factor, however,
is different in both cases. In the case of the net present value method, the
discount rate is the required rate of return and being a predetermined rate,
usually the cost of capital; its determinants are external to the proposal
under consideration. The IRR, on other hand, is based on facts which are
internal to the proposal. In other words, while arriving at the required
rate of return for finding out present values the cash flows-inflows as
well as outflows are not considered. But, the IRR depends entirely on
the initial outlay and the cash proceeds of the project which is being
evaluated for acceptance or rejection. It is, therefore appropriately referred
to as internal rate of return.
The internal rate of return is usually the rate of return that a project
earns. It is defined as the discount rate(r) which equates the aggregate
present value of the net cash inflows with the aggregate present value
of cash outflows of a project. In other words, it is that rate which gives
the project NPV of zero.
PAGE 55
Notes IRR can be determined by solving the following equation for r:

CF1 CF2 CF3 CFn
C0 = + + +
(1 + r ) (1 + r ) (1 + r ) (1 + r ) n
1 2 3
where r = Internal rate of return

CF = Cash inflows at different time periods
= Cash outflow at 0 time period
SV = Salvage value
WC = Working capital adjustments
Example: A firm is evaluating a proposal costing Rs. 100000 and having
annual cash inflow of Rs. 25000 occurring at the end of each of next six
years. There is no salvage value. Compute IRR for the project.
Solution: The annual cash inflow is uniform at Rs. 25000 for the six years.
Hence, the pay back is 4 years for the project. The IRR is calculated:
1
F=
C
where F = Factor to be located
I = Initial investment
C = Cash inflow per year
1,00,000
F = Rs. =4
25,000
This factor 4 should be located in present value annuity in the lines of

6 years. The discount percentage will be somewhere between 12% and
13%. This means that the IRR is more than 12% but less than 13%.
In order to find out the exact IRR, the NPV of the project for both these
rates are calculated.
At 12% NPV = (Rs. 25000 PVAF*) – 100000
= (Rs. 25000 × 4.111) - 100000
= (Rs. 102775-100000) = 2775
*The present annuity value of Rs. 1 at 12% for 6 years is 4.111.
56 PAGE
At 13% NPV = (Rs. 25000 PVAF) - 100000 Notes

= (Rs. 25000 3.998*)-100000
= (Rs. 99950-100000)=-50
*The present annuity value of Rs. 1 at 13% for 6 years is 3.998.
Difference in calculated present Value and required net cash outlays
× Difference in Rate
Difference in calculated Values
1, 02, 775 − 1, 00, 000

IRR = 12% + × 1% = 12.98%
1, 02, 775 − 99,950
Accept-Reject Decision: The use of the IRR, as a criterion to accept

capital investment decision, involves a comparison of the actual IRR
with the required rate of return also known as the cut off rate or hurdle
rate. The project would quantify to be accepted if the IRR (r) exceeds
the cut off rate (k). If the IRR and the required rate of return are equal,
the firm is indifferent as to whether accept or reject the project.
IRR is a popular method of investment appraisal and has a number of
merits like:
u It takes into account the time value of money.
u It considers the cash flow stream over the entire investment horizon.
u Like ARR, it makes sense to businessmen who prefer to think in
terms of rate of return on capital employed.
This criterion however suffers from the following limitation:
u It involves tedious calculations. It generally involves complicated
computation problems.
u Secondly it produces multiple rates which can be confusing.
u Thirdly in evaluating mutually exclusive proposals, the project with
the highest IRR would be picked up to the exclusion of all others.
However, in practice it may not turn out to be the one hotel which
is the most profitable and consistent with the objectives of the firm,
that is, maximization of the shareholders’ wealth.
u Finally, under the IRR method, it is assumed that all intermediate
cash flows are reinvested at the IRR.
PAGE 57
Notes Profitability Index: Another time-adjusted method of evaluating the

investment proposals is the Benefit-Cost (BC) ratio or Profitability
Index (PI). Profitability index is the ratio of the present value of cash
inflows, at the required rate of return, to the initial cash outflow of the
investment. The formula for calculating benefit-cost or profitability index
is as follows:
PI = Present value of cash inflows/Present value of cash outflows
Example: The initial cash outlay of a project is Rs. 1,00,000 and it can
generate cash inflow of Rs. 40,000, Rs. 30,000, Rs. 50,000 and Rs. 20,000
in year 1 through 4. Assume a 10 per cent rate of discount. Calculate
PI for the project.
Solution: The PV of cash inflows at 10 per cent discount rate is:
PV = R
s. 40,000 (PVF) + Rs. 30,000 (PVF) + Rs. 50,000 (PVF) + Rs.
20,000 (PVF)
= R
s. 40,000 × 0.909 + Rs. 30,000 × 0.826 + Rs. 50,000 × 0.751
+ Rs. 20,000 × 0.68
NPV = R
s. 1,12,350- Rs. 1,00,000 = Rs. 12,350
PV of cash flows = Rs. 1,12,350
Rs. 1,12,350
C1 = = 1.1235.
Rs. 1, 00, 000
The project will be accepted as the PI>1.

Acceptance Rule:
The following are the PI acceptance rules:
u Accept the project when PI is greater than i.e., PI > 1.
u Reject the project when PI is less than i.e., PI < 1.
u May accept the project when PI is equal to i.e., PI = 1.
The project with positive NPV will have PI greater than 1. PI less than
one means that the project’s NPV is negative.
Evaluation of PI Method: Like the NPV and IRR rules, PI is a conceptually
sound method of appraising investment projects. It is a variation of the
NPV method, and requires the same computations as the NPV method.
58 PAGE
u It recognizes the concept of time value of money. Notes

u It is consistent with the shareholders value maximization principle.
u In the PI method, since the present value of cash inflows is divided
by the initial cash outflows, hence it is a relative measure of a
project’s profitability.
But there are two serious limitations inhibiting the use of this criterion.
First, it provides no means for aggregating several smaller projects into
a package that can be compared with a large project.
Second, when the investment outlay is spread over more than one period,
this criterion cannot be used.
Thirdly like NPV method PI also need calculation of cash flows and
estimation of discount rate. In practice, the estimation of cash flows and
discount rate is difficult to compute.
IN-TEXT QUESTIONS
5. Which of the following is a Non-Discounting Technique of
Capital Budgeting?
(a) Payback period
(b) IRR
(c) NPV
(d) PI
6. The __________ period measures the length of time required
to recover the initial outlay in the project.
7. The net present value is equal to the present value of future
cash flows and any immediate cash outflow.(True/False)
8. Profitability Index is also known as yield on investment, marginal
efficiency of capital.(True/False)
9. _________ is the ratio of the present value of cash inflows, at
the required rate of return, to the initial cash outflow of the
investment.
10. Which of the following is true?
(a) Accept the project when PI is greater than one PI > 1
PAGE 59
Notes (b) Accept the project when PI is less than one PI < 1
(c) Accept the project when PI is less than one PI =1
1.9 Summary
The chapter explain the concept and significance of capital budgeting
projects as well as the techniques for the evaluation of such projects.
The techniques involved in the capital budgeting are Payback Period
Method, Discounted Payback Period Method, Accounting Rate of Return,
Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability
Index. The lesson discusses all the techniques along with its advantages
and limitations followed by a numerical illustration.
1. (a) Long-term
2. Financial
3. (d) Sunk Cost is a part of Capital Budgeting
4. (a) Purchasing new machinery to replace an existing one
5. (a) Payback Period
6. Payback
7. True
8. False
9. Profitability Index
10. (a) Accept the project when PI is Greater than one PI > 1

1. What are the various types of capital budgeting.
2. What is the difference between Non-discounting and discounting
methods of capital budgeting.
60 PAGE
1.12 Suggested Readings Notes
u J.C.Van Horne, Financial Management and Policy, Prentice Hall of

India.
u I.M. Pandey, Financial Management, Vikas Publishing House Pvt.
Ltd.
u Shrutika Kesar, Financial Management, Sumit Enterprises.
u Keown, Martin, Petty, Scott, Jr. Financial Management Principles
and Applications, Prentice Hall of India.
u M.Y. Khan and P.K. Jain, Financial Management, Text and Problems,
Tata McGraw Hill, New Delhi.
u R.P. Rastogi, Fundamentals of Financial Management, Galgotia,
Publications, New Delhi.
u V. K. Bhalla, Financial Management & Policy, Anmol Publications,
Delhi.
u Prasanna Chandra, Financial Management - Theory and Practice, Tata
McGraw Hill.
PAGE 61
UNIT - III
PAGE 63
L E S S O N
1
Cost of Capital-I
Smriti Chawla
STRUCTURE
1.2 Introduction
1.3 Understand the Meaning, Concept and Significance of Cost of Capital
1.4 Classification of Cost
1.5 Problems in Determining the Cost of Capital
1.6 Computation of Specific Source of Finance
1.7 Summary

After studying this chapter students may be able to understand:
u The concept of cost of capital.
u The problems faced in determining the cost of capital.
u Various methods used to find out the cost of capital.
1.2 Introduction
The cost of capital of a firm is the minimum rate of return expected by its investors. It is
the weighted average cost of various sources of finance used by a firm. The capital used
by a firm may be in the form of debt, preference capital, retained earnings and equity
shares. The concept of cost of capital is very important in the financial management. A
decision to invest in a particular project depends upon the cost of capital of the firm or
the cut off rate which is the minimum rate of return expected by the investors. In case
PAGE 65
Notes a firm is not able to achieve even the cut off rate, the market value of
its shares will fall. In fact cost of capital is the minimum rate of return
expected by its investors which will maintain the market value of shares at
its present level. Hence to achieve the objective of wealth maximisation,
a firm must earn a rate of return more than its cost of capital.
1.3 Understand the Meaning, Concept and Significance

of Cost of Capital
The cost of capital of a firm or the minimum rate of return expected
by its investors has a direct relation with the risk involved in the firm.
Generally, higher the risk involved in a firm, higher is the cost of capital.
According to Solomon Ezra Cost of capital is the minimum required rate
of earnings or the cut-off rate of capital expenditures. Thus, we can say
that cost of capital is that minimum rate of return which a firm, and, is
expected to earn on its investments so as to maintain the market value
of its shares. From the definitions given above we can conclude three
basic aspects of the concept of cost of capital:
According to Solomon Ezra Cost of capital is the minimum required rate
of earnings or the cut-off rate of capital expenditures.
Thus, we can say that cost of capital is that minimum rate of return which
a firm, and, is expected to earn on its investments so as to maintain the
market value of its shares. From the definitions given above we can
conclude three basic aspects of the concept of cost of capital:
(i) Cost of capital is not a cost as such. In fact, it is the rate of return
that a firm requires to earn from its projects.
(ii) It is the minimum rate of return. Cost of capital of a firm is that
minimum rate of return which will at least maintain the market
value of the shares.
(iii) It comprises of three components. As there is always some business
and financial risk in investing funds in a firm, cost of capital
comprises of three components:
(a) The expected normal rate of return at zero risk level, say the
rate of interest allowed by banks;
66 PAGE
(b) The premium for business risk; and Notes

(c) The premium for financial risk on account of pattern of capital
structure.
Symbolically cost of capital may be represented as:
where, K = r0+b+f
K = Cost of capital
r0 = Normal rate of return at zero risk level
b = Premium for business risk
f = Premium for financial risk
Significance of the Cost of Capital
The concept of cost of capital is very important in the financial management.
It plays a crucial role in both capital budgeting as well as decisions
relating to planning of capital structure. Cost of capital concept can also
be used as a basis for evaluating the performance of a firm and it further
helps management in taking so many other financial decisions.
1. As an Acceptance Criterion in Capital Budgeting: Capital budgeting
decisions can be made by considering the cost of capital. According
to the present value method of capital budgeting, if the present
value of expected returns from investment is greater than or equal
to the cost of investment, the project may be accepted; otherwise
the project may be rejected. The present value of expected return
is calculated by discounting the expected cash inflows at cut-off
rate (which is the cost of capital). Hence, the concept of cost of
capital is very useful in capital budgeting decision.
2. As a Determinant of Capital Mix in Capital Structure Decisions:
Financing the firm’s assets is a very crucial problem in every
business and as a general rule there should be a proper mix of debt
and equity capital in financing a firm’s assets. While designing an
optimal capital structure, the management has to keep in mind the
objective or maximising the value of the firm and minimising the
cost of capital. Measurement of cost of capital from various sources
is very essential in planning the capital structure of any firm.
PAGE 67
Notes 3. As a basis for evaluating the Financial Performance: The concept of

cost of capital can be used to ‘evaluate the financial performance of
top management’. The actual profitability of the project is compared
to the projected overall cost of capital and the actual cost of capital
of funds raised to finance the project. If the actual profitability of
the project is more than the projected and the actual cost of capital,
the performance may be said to be satisfactory.
4. As a Basis for taking other Financial Decisions: The cost of capital
is also used in making other financial decisions such as dividend
policy, capitalisation of profits, making the rights issue and working
capital.
1.4 Classification of Cost

1. Historical Cost and Future Cost: Historical cost are book cost
which are related to the past. Future costs are estimated costs for
the future. In financial decisions future costs are more relevant than
the historical costs. However, historical costs act as guide for the
estimation of future costs.
2. Specific Cost and Composite Cost: Specific cost refers to the cost
of a specific source of capital while composite cost is combined
cost of various sources of capital. It is the weighted average cost
of capital. In case more than one form of capital is used in the
business, it is the composite cost which should be considered for
decision-making and not the specific cost. But where only one type
of capital is employed the specific cost of that type of capital may
be considered.
3. Explicit Cost and Implicit Cost: An explicit cost is the discount rate
which equates the present value of cash inflows with the present
of cash outflows. In other words it is the internal rate of return.
O1 O2 On n
Ot
I0 = +
(1 + k ) (1 + k )
+ .............. + = ∑
(1 + k ) t −1 (1 + k )
2 n t
where, Io, is the net cash inflow at zero point of time,

Ot is the outflow of cash in period 1, 2 ........... and n.
k is the explicit cost of capital.
68 PAGE
Implicit cost also known as the opportunity cost is the cost of the Notes
opportunity foregone is order to take up a particular project.
4. Average Cost and Marginal Cost: An average cost refers to the
combined cost of various sources of capital such as debentures,
preference shares and equity shares. It is the weighted average cost
of the costs of various sources of finance. Marginal cost of capital
refers to the average cost of capital which has to be incurred to
obtain additional funds required by a firm. In investment decisions,
it is the marginal cost which should be taken into consideration.
IN-TEXT QUESTIONS
1. The cost of capital of a firm is the _________rate of return
expected by its investors.
(a) Minimum
(b) Average
(c) Maximum
(d) None
2. An __________ cost refers to the combined cost of various
sources of capital such as debentures, preference shares and
equity shares.
3. __________ cost refers to the cost of a specific source of capital
while composite cost is combined cost of various sources of
capital.
4. An _________ cost is the discount rate which equates the present
value of cash inflows with the present of cash outflows.
1.5 Problems in Determining the Cost of Capital

It has already been stated that the cost of capital plays a crucial role in
the decisions relating to financial management. However, the determination
of the cost of capital of a firm is not an easy task because of conceptual
problems as well as uncertainties of proposed investments and the pattern
of financing. The major problems concerning the determination of cost of
capital are discussed as below: Problems in determining Cost of Capital
PAGE 69
Notes 1. Conceptual controversies regarding the relationship between the

cost of capital and the capital structure: Different theories have
been propounded by different authors explaining the relationship
between capital structure, cost of capital and the value of the firm.
This has resulted into various conceptual difficulties. According to
the Net Income Approach and the Traditional Approach both the cost
of capital as well the value of the firm have a direct relationship
with the method and level of financing. In their opinion, a firm
can minimise the weighted average cost of capital and increase the
value of the firm by using debt financing. On the other hand, Net
Operating Income and Modigliani and Miller Approach prove that
the cost of capital is not affected by changes in the capital structure
or say that debt equity mix is irrelevant in determination of cost
of capital structure determination of cost of capital and the value
of a firm. However, the M and M approach is based upon certain
unrealistic assumptions such as, there is a perfect market or the
expected earnings of all the firms have identical risk characteristic,
etc.
2. Problems in computation of cost of equity: The computation of
cost of equity capital depends upon the expected rate of return by
its investors. But the quantification of the expectations of equity
shareholders is a very difficult task because there are many factors
which influence their valuation about a firm.
3. Problems in computation of cost of retained earnings: It is sometimes
argued that retained earnings do not involve any cost but in reality,
it is the opportunity cost of dividends foregone by its shareholders.
Since different shareholders may have different opportunities for
investing their dividends, it becomes very difficult to compute the
cost of retained earnings.
4. Problems in assigning weights: For determining the weighted average
cost of capital, weights have to be assigned to the specific cost of
individual source of finance. The choice of using the book value of
the source or the market value of the source poses another problem
in the determination of capital.
70 PAGE
1.6 Computation of Specific Source of Finance Notes
Computation of each specific source of finance, viz., debt, preference share

capital equity share capital and retained earnings is discussed as below:
1.6.1 Cost of Debit

The cost of debt is the rate of interest payable on debt. For example, a
company issues Rs. 1,00,000 debentures at par; the before tax cost of
this debt issue will also be 10%. By way of formula, before-tax-cost of
debt may be calculated as:
I
(i) Kdb =
P
where, Kdb = Before tax cost of debt
I = Interest and
P = Principal
In case the debt is raised at premium or discount, we should consider
P as the amount of the net proceeds received from the issue and
not the face value of securities. The formula may be changed to
I
(ii) Kdb = (where, NP proceeds).
NP
Further, when debt is used as a source of finance, the firm saves a
considerable amount in payment of tax as the interest is allowed as
a deductable expense in computation tax. Hence, the effective cost
of debt is reduced. The after tax cost of debt may be calculated
with the help of following formula;
I
(iii) Kdb = Kdb (1-t) = (I-t).
NP
Where, Kdb = After tax cost of debt
t = Rate of tax
Cost of Redeemable Debt
Usually, the debt is issued to be redeemed after a certain period
during lifetime of a firm. Such a debt issue is known as Redeemable
debt. The cost of redeemable debt capital is computed as:
PAGE 71
Notes (iv) Before-tax cost of debt

1
1+ ( P − NP )
K db = n
1
( P + NP )
2
Where, I = Interest
N = Number of years in which debt is to be redeemed
P = Proceeds at par
NP = Net Proceeds
(v) After tax cost of debt, Kda = Kdb (1-t)
1
1+ ( P − NP )
Where, K db = n
1
( P + NP )
2
Illustration 1: A Company issues shares of Rs.10,00,000, 10% redeemable
debentures at a discount of 5%. The cost of floatation amount to Rs. 30,000.
The debentures are redeemable after 5 years. Calculate before tax and
after tax cost of debt assuming tax rate of 50%.
Solution:
Cost of Debt Redeemable at Premium

Sometimes debentures are to be redeemed at a premium; i.e. at more than
the face value after the expiry of a certain period. The cost of such debt
redeemable at premium can be computed as below:
72 PAGE
(i) Before tax cost of debt, Notes

1
1+ ( RV − NP )
K db = n
1
( RV + NP )
2
Where, I = Interest
n = Number of years in which debt is to be redeemed
RV = Redeemable value of debt
NP = Net Proceeds
(ii) After-tax cost of debt,
Kda= Kdb (1-t)
Illustration 2: A 5-year Rs.100 debenture of a firm can be sold for a net
price of Rs. 96.50. The coupon rate of interest is 14% per annum and
debenture will be redeemed at 5% premium on maturity. The firm tax
rate is 40%. Compute the after tax cost of debentures.
Solution:
Cost of Debt Redeemable in Instalments

Financial institutions generally require principal to be amortised in
instalments. A company may also issue a bond or debenture to be
redeemed periodically. In such a case, principal amount is repaid each
period instead of a lumpsum at maturity and hence cash period include
interest and principal. The amount of interest goes on decreasing each
period as it is calculated on decreasing each period as it is calculated
PAGE 73
Notes on the outstanding amount of debt. The before-tax cost of such a debt
can be calculated as below:
n = Number of years to maturity

Kd = Cost of debt or required rate of return
Cost of Existing Debt
If a firm wants to compute the current cost of its existing debt, the current
market yield of the debt should be taken into consideration. Suppose a
firm has 10% debentures of Rs. 100 each outstanding on January 1, 1994
to be redeemed on December 31, 2000 and the new debentures could be
issued at a net realisable price of Rs. 90 in the beginning of 1996, the
current cost of existing debt will be computed as:
Cost of Zero Coupon Bonds

Sometimes companies issue bonds or debentures at a discount from their
eventual maturity value and having zero interest rate. No interest is
payable on such debentures before their redemption and at the time of
redemption the maturity value of the bond is to be paid to the investors.
The cost of such debt can be calculated by finding the present values of
cash flows as below:
74 PAGE
(i) Prepare the cash flow table using an arbitrary assumed discount rate Notes
to discount the cash flows to the present value.
(ii) Find out the net present value by deducting the present value of the
outflows from the present value of the inflows.
(iii) If the net present value is positive apply higher rate of discount.
(iv) If the higher discount rate still gives a positive net present value
increase the discount rate further until the NPV becomes negative.
(v) If the NPV is negative at this higher rate the cost of debt must be
between these two rates.
Illustration 3: X Ltd. has issued redeemable zero coupon bonds of Rs.
100 each at a discount rate of Rs. 60 repayable at the end of fourth year.
Calculate the cost of debt.
Floating or Variable Rate Debt

The interest on floating rate debt changes depending upon the market
rate of interest payable on gilt edged securities or the prime lending rate
of the bank. For example, suppose a company raises debt from external
sources on the terms of prime lending rate of the bank plus four per cent.
If the prime lending rate of the bank is 8% p.a. the company will have
to pay interest at the rate of 12% p.a. Further, if the prime lending rate
falls to 6% p.a. the company shall pay interest at only 10% p.a.
Illustration 4: ABC Ltd. raised a debt of Rs. 50 lakhs on the terms that
interest shall be payable at prime lending rate of bank plus three per cent.
The prime lending rate of the bank is 7 per cent. Calculate the cost of
debt assuming that the corporate rate of tax is 35%.
PAGE 75
Notes Solution:
Real or Inflation Adjusted Cost of Debt

In the days of inflation, the real cost of debt is much less than the nominal
cost as the fixed amount is payable irrespective of the fall in the value
of money because of price level changes. The real cost of debt can be
calculated as below:
1.6.2 Cost of Preference Capital

A fixed rate of dividend is payable on preference shares. Though dividend
is payable at the discretion of the Board of directors and there is no legal
binding to pay dividend, yet it does not mean that preference capital is
cost free. The cost of preference capital is a function of dividend expected
by its investors i.e. its stated dividend. In case dividends are not paid
to preference shareholders, it will affect the fund raising capacity of the
firm. Hence, dividends are usually 48 paid regularly on preference shares
except when there are no profits to pay dividends. The cost of preference
capital which is perpetual can be calculated as:
D
KP =
P
Where KP = Cost of Preference Capital
D = Annual Preference Dividend
P = Preference Share Capital (Proceeds)
D
KP =
NP
It may be noted that as dividend are not allowed to be deducted in
computation of tax, no adjustment is required for taxes.
76 PAGE
Sometimes Redeemable Preference Shares are issued which can be redeemed Notes
or cancelled on maturity date. The cost of redeemable preference share
capital can be calculated as:
MV − NP
D+
K pr = n
1
( MV + NP )
2
Where, Kpr = Cost of Redeemable Preference Shares
D = Annual Preference dividend
MV = Maturity Value of Preference Shares
NP = Net proceeds of Preference Shares
Illustration 5: A company issues 10,000 shares 10% Preference Shares
of Rs. 100 each. Cost of issue is Rs. 2 per share. Calculate cost of
preference capital if these shares are issued (a) at par, (b) at a premium
of 10% and (c) at a discount of 5%.
Solution :
1.6.3 Cost of Equity Share Capital

The cost of equity is the maximum rate of return that the company must
earn on equity financed portion of its investments in order to leave
unchanged the market price of its stock. The cost of equity capital is
function of the expected return by its investors. The cost of equity is not
the out-of-pocket cost of using equity capital as the equity shareholders
are not paid dividend at a fixed rate every year. Moreover, payment of
dividend is not a legal binding. It may or may not be paid. But it does
PAGE 77
Notes not mean that equity share capital is a cost free capital. The cost of
equity can be computed in following ways:
(a) Dividend Yield Method or Dividend/Price Ratio Method: According
to this method, the cost of equity capital is the ‘discount rate that
equates the present value of expected future dividends per share with
the net proceeds (or current market price) or a share’. Symbolically.
D D
Ke = or NP
NP NP
Where Ke = Cost of Equity Capital
D = Expected dividend per share
NP = Net proceeds per share
MP = Market Price per share.
Illustration 6: A company issues 1000 equity shares of Rs. 100 each at a
premium of 10%. The company has been paying 20% dividend to equity
shareholders for the past five years and expects to maintain the same
in the future also. Compute the cost of equity capital: Will it make any
difference if the market price of equity share is Rs. 160?
Solution :
(b) Dividend yield plus growth in dividend method: When the dividends
of the firm are expected to grow at a constant rate and the dividend
payout ratio is constant this method may be used to compute the cost
of equity capital. According to this method the cost of equity capital is
based on the dividends and the growth rate.
78 PAGE
where, Ke = Cost of equity capital Notes

D1 = Expected Dividend per share at the end of the year
NP = Net proceeds per share
G = Rate of growth in dividends
Do = Previous year’s dividend
Further, in case cost of existing equity share capital is to be calculated,
the NP should be changed with MP (market price per share) in the above
equation.
D1
Ke = +G
MP
Illustration 7: (a) A company plans to issue 1000 new shares of Rs.
100 each at par. The floatation costs are expected to be 5% of the share
price. The company pays a dividend of Rs. 10 per share initially and
the growth in dividends is expected to be 5%. Compute the cost of new
issue of equity shares.
(b) If the current market price of an equity share is Rs. 150, calculate
the cost of existing equity share capital.
Solution :
(c) Earning Yield Method: According to this method, the cost of equity
capital is the discount rate that equates the present values of expected
future earnings per share with the net proceeds (or, current market price)
of a share. Symbolically:
Ke = Earnings per share
Net proceeds
PAGE 79
Notes where, the cost of existing capital is to be calculated:

Ke = Earnings per share
Market Price per share
=
(d) Realised Yield Method: One of the serious limitations of using dividend
yield method or earnings yield method is the problem of estimating the
expectations of the investors regarding future dividends and earnings. It is
not possible to estimate future dividends and earnings correctly; both of
these depend upon so many uncertain factors. To remove this drawback,
realised yield method which takes into account the actual average rate of
return realised in the past may be applied to compute the cost of equity
share capital. To calculate the average rate of return realised, dividend
received in the past along with the gain realised at the time of sale of
shares should be considered. The cost of equity capital is said to be the
realised rate of return by the shareholders. This method of computing
cost of equity share capital is based upon the following assumptions:
(a) The firm will remain in the same risk class over the period.
(b) The shareholders expectations are based upon the past realised yield.
(c) The investors get the same rate of return as the realised yield even
if they invest elsewhere;
(d) The market price of shares does not change significantly.
1.6.4 Cost of Retained Earning

It is sometimes argued that retained earnings do not involve any cost
because a firm is not required to pay dividends on retained earnings.
However, the shareholders expect a return on retained profits. Retained
earnings accrue to a firm only because of some sacrifice made by the
shareholders in not receiving the dividends out of the available profits.
The cost of retained earnings may be considered as the rate of return which
the existing shareholders can obtain by investing the after tax dividends
in alternative opportunity of equal qualities. It is, thus, the opportunity
cost of dividends foregone by the shareholders. Cost of retained earnings
can be computed with the help of following formula:
80 PAGE
D Notes
Kr = +G
NP
Where, Kr = Cost of retained earnings
D = Expected dividend
NP = Not proceeds of share issue
G = Rate of growth
IN-TEXT QUESTIONS
5. The cost of debt is the _____________ payable on debt.
6. The cost of equity share or debt is known as __________.
(a) The specific cost of capital
(b) The related cost of capital
(c) The burden on the shareholder
7. Which of the following methods involves computing the cost of
capital by dividing the dividend by market price/net proceeds
per share?
(a) Adjusted price method
(b) Price earning method
(c) Dividend yield method
(d) Adjusted dividend method
8. Earning Yield Method involves _____________ and __________
to reach out to cost of capital.
9. The _______________________ may be considered as the
rate of return which the existing shareholders can obtain by
investing the after tax dividends in alternative opportunity of
equal qualities.
1.7 Summary
u The cost of capital is the minimum required rate of return which
firm must earn on its funds in order to satisfy the expectation of
its supplier of funds. If the return from capital budgeting proposals
PAGE 81
Notes is more than cost of capital then difference will be added to wealth
of shareholders.
u The concept of cost of capital has a role to play in capital budgeting
as well as in finalizing the capital structure for the firm. The cost
of capital depends upon the risk free interest rate and risk premium,
which depends upon the risk of investment and risk of firm.
u The cost of capital may be defined in terms of (1) explicit cost,
which the firm pays to supplier, and (2) implicit cost. i.e. opportunity
cost of funds to firm. The cost of capital is calculated in after tax
terms.
u Different sources of funds available to firm may be grouped into
Debt, Pref. share capital, Equity share capital and retained earning
and these sources have their specific cost of capital. However the
overall cost of capital of the firm may be ascertained as the weighted
average of these specific costs of capital.
u The cost of retained earnings is lower than cost of equity as former
does not have any floatation cost.
u The Weighted average cost of capital WACC may be ascertained by
applying book value weights or market value weights of different
sources of funds. The WACC is denoted as Kw.
1. (a) Minimum
2. Average Cost
3. Specific Cost
4. Explicit Cost
5. Rate of Interest
6. (a) The Specific Cost of Capital
7. (c) Dividend Yield Method
8. Earning per share and Net Proceeds
9. Cost of Retained Earnings
82 PAGE
1.9 Self-Assessment Questions Notes
1. What is the relevance and significance of cost of capital in capital

budgeting? How does the cost of capital enter the capital budgeting
process?
2. Define the concept of cost of capital? State how you would determine
the weighted average cost of capital of a firm?
3. How is cost of equity capital determined under CAPM?
4. Write short notes on (a) Marginal cost of capital (b) Cost of retained
earnings.
5. The cost of preference capital is generally lower than cost of equity.
State the reasons?
6. What are the problems in determining the cost of capital?
7. How is the cost of zero coupon bonds determined?

u Brealey, R.A., Myers S.C., Allen F., & Mohanty P. (2020), Principles
of Corporate Finance, McGraw Hills Education.
u Khan, M.Y. & Jain, P.K. (2011), Financial Management: Text, Problems
and Cases, New Delhi: Tata McGraw Hills.
u Kothari, R. (2016), Financial Management: A Contemporary Approach,
New Delhi: Sage Publications Pvt. Ltd.
u Maheshwari, S. N. (2019), Elements of Financial Management, Delhi:
Sultan Chand & Sons.
u Maheshwari, S. N. (2019), Financial Management – Principles &
Practice, Delhi: Sultan Chand & Sons.
u Pandey, I. M. (2022), Essentials of Financial Management, Pearson.
u Rustagi, R.P. (2022), Fundamentals of Financial Management, New
Delhi: Taxmann, New Delhi, 6EC (1264)-03.02.2023
u Sharma, S.K. & Sareen, R. (2019), Fundamentals of Financial
Management, New Delhi: Sultan Chand & Sons (P) Ltd.
PAGE 83
Notes u Singh, J.K. (2016), Financial Management: Theory and Practice, New
Delhi: Galgotia Publishing House.
u Singh, S. and Kaur, R. (2020), Fundamentals of Financial Management,
New Delhi: Scholar Tech Press.
u Tulsian, P.C. & Tulsian, B. (2017), Financial Management, New
Delhi: S. Chand.
84 PAGE
L E S S O N
2
Cost of Capital-II
Smriti Chawla
STRUCTURE

2.2 Introduction
2.3 Computation of Weighted Average Cost of Capital
2.4 Marginal Cost of Capital
2.5 Cost of Equity Using Capital Asset Pricing Model (CAPM)
2.6 Summary

u The concept of cost of capital.
u The problems faced in determining the cost of capital.
u Various methods used to find out the cost of capital.
2.2 Introduction
A firms’s weighted average cost of capital is the combined cost of capital across all the
sources such as equity, preferred shares and debt. During the calculation of weighted
average cost, the cost of capital of each source is taken as the percentage of total capital
and then they are added to reach WACC.
The WACC involves the cost of capital by other sources which largely depends on how
the firm finances its operations. The weighted average cost of capital take cues from the
PAGE 85
Notes capital structure of the firm and then compares the equity and debt to
their respective proportions to the capital structure. The following section
deals with the calculation of WACC.
2.3 Computation of Weighted Average Cost of Capital

Weighted average cost of capital is the average cost of the costs of
various source of financing. Weighted average cost of capital is also
known as composite cost of capital, overall cost of capital or average
cost of capital. Once the specific cost of individual sources of finance
is determined, we can compute the weighted average cost of capital by
putting weights to the specific costs of capital in proportion of various
sources of funds to total. The weights may be given either by using the
book value of source or market value of source. If there is a difference
between Market value and Book value weights, the weights, the weighted
average cost of capital would also differ. The Market value weighted
average cost would be overstated if market value of the share is higher
than book value and vice versa. The market value weights are sometimes
preferred to the book value weights because the market value represents
the true value of investors. However, the market value weights suffer
from the following limitations:
(i) It is very difficult to determine the market values because of frequent
fluctuations.
(ii) With the use of market value weights, equity capital gets greater
importance.
For the above limitations, it is better to use book value which is readily
available. Weighted average cost of capital can be computed as follows:
ΣXW
Kw =
ΣW
Kw = Weighted average cost of capital
X = Cost of specific source of finance
W = Weight, proportion of specific source of finance
86 PAGE
Illustration 1: A firm has the following capital structure and after-tax Notes
costs for the different sources of funds used:
Source of Funds Amount Proportion After-tax cost
Rs. % %
Debt 15,00,000 25 5
Preference Shares 12,00,000 20 10
Equity Shares 18,00,000 30 12
Retained Earnings 15,00,000 25 11
Total 60,00,000 100
You are required to compute the weighted average cost of capital.

Solution:
Computation of Weighted Average Cost of Capital
Source of Funds Proportion Cost % Weighted Cost %
(W) (X) Proportion × Cost (XW)
%
Debt 25 5 1.25
Preference shares 20 10 2.00
Equity Shares 30 12 3.60
Retained Earnings 25 11 2.75
Weighted Average Cost of Capital 9.60%
Illustration 2: Continuing illustration 1, the firm has 18,000 equity shares
of Rs. 100 each outstanding and the current market price is Rs. 300 per
calculate the market, value weighted average cost of capital assuming
that the market values and book values of the debt and preference capital
are same.
Solution:
Source of Funds Amount Proportion % Cost% Weighted Cost % Pro-
(Rs.) (X) X portion × Cost (XW)
Debt 15,00,000 18.52 5 0.93
Preference shares 12,00,000 14.81 10 1.48
Equity Shares
Retained 54,00,000 66.67 12 8.00
Earnings 81,00,000 100
Weighted Average Cost of Capital 10.41%
PAGE 87
Notes 2.4 Marginal Cost of Capital

The marginal cost of capital is the weighted average cost of new capital
calculated by using the marginal weights. The marginal weights represent
the proportion of various sources of funds to be employed in raising
additional funds. In case, a firm employs the existing proportion of
capital structure and the component costs remain the same the marginal
cost of capital shall be equal to the weighted average cost of capital. But
in practice, the proportion and /or the component costs may change for
additional funds to be raised. Under this situation the marginal cost of
capital shall not be equal to weighted average cost of capital. However,
the marginal cost of capital concept ignores the long-term implications of
the new financing plans, and thus, weighted average cost of capital should
be preferred for maximisation of shareholder’s wealth in the long-run
Illustration 3: A firm has the following capital structure and after-tax
costs for the different sources of funds used:
Source of Funds Amount (Rs.) Proportion (%) After-tax Cost (%)
Debt 4,50,000 30 7
Preference Shares 3,75,000 25 10
Equity Shares 6,75,000 45 15
15,00,000 100
(a) Calculate the weighted average cost of capital using book-value
weights.
(b) The firm wishes to raise further Rs. 6,00,000 for the expansion of
the project as below.
Debt Rs. 3,00,000
Preference Capital Rs. 1,50,000
Equity Capital Rs. 1,50,000
Assuming that specific costs do not change, compute the weighted
marginal cost of capital.
Solution:
Computation of Weighted Average Cost of Capital (WACC)
Source of Funds Proportion (%) After tax Cost Weighted Cost %
(W) % (XW) %
Debt 50 7 3.50
88 PAGE
Source of Funds Proportion (%) After tax Cost Weighted Cost % Notes
(W) % (XW) %
Weighted Marginal Cost of Capital (WMCC) 11.35%
Computation of Weighted Average Cost of Capital (WACC)
Source of Funds Marginal Weight After tax Weighted Marginal
Proportion (%) (W) Cost % Cost %
Debt 50 7 3.50
Weighted Marginal Cost of Capital (WMCC) 9.75%
IN-TEXT QUESTIONS
1. Suppose a firm has 30% debts and 70% equity in its capital
structure. The cost of debts and cost of equity is assumed to be
10% and 15% respectively, what is the overall cost of capital?
(a) 11%
(b) 13.5%
(c) 14%
(d) 15%
2. During the planning period, a marginal cost for raising a new
debt is classified as
(a) Debt cost
(b) Relevant cost
(c) Borrowing cost
(d) Embedded cost
3. In weighted average cost of capital, a company can affect its
capital cost through
(a) Policy of capital structure
(b) Policy of Investment
(c) Policy of dividends
(d) All of the above
PAGE 89
Notes 2.5 Cost of Equity Using Capital Asset Pricing Model

(CAPM)
The value of an equity share is a function of cash inflows expected by
the investors and risk associated with cash inflows. It is calculated by
discounting the future stream of dividends at required rate of return
called capitalization rate. The required rate of return depends upon the
element of risk associated with investment in share. It will be equal to
the risk free rate of interest plus the premium for risk. Thus required
rate of return Ke for the share is,
Ke = Risk – Free rate of interest + Premium for risk
According to CAPM, the premium for risk is the difference between
market return from diversified portfolio and risk free rate of return. It
is indicated of beta coefficient (β):
Risk – premium = (Market return of a diversified portfolio – Risk free
return) × β I =β I (Rm - Rf ). Thus, cost of equity, according to CAPM
can be calculated as below:
Ke = Rf + β I
(Rm - Rf )
where, Ke = Cost of equity capital
Rf = Risk free rate of return
Rm = Market return of a diversified portfolio
βI = Beta coefficient of the firm’s portfolio
Illustration 4: You are given the following facts about a firm:
1. Risk free rate of return is 11%.
2. Beta co-efficient βI of the firm is 1.25.
Compute the cost of equity capital using Capital Asset Pricing Model
(CAPM) assuming a market return of 15 per cent next year. What would
be the cost of equity if βI rises to 1.75.
Solution:
Ke = Rf + β I (Rm - Rf )
when βI = 1.25
Ke = 11% +1.25(15%-11%)
= 11%+5% =16%
90 PAGE
when βI = 1.75 Ke= 11%+1.75(15%-11%) Notes

= 11%+7%
= 18%
Illustration 5: The following is an extract from the financial statement
of KPN Ltd.
Rs. Lakhs (Operating)
Profit 105
Less : Interest on debentures 33
72
Less: Income – tax (50%) 36
Net Profit 36
Equity Share capital (shares 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 Rs. 12 and per debenture Rs. 93.75.
1. What is the earning per share?
2. What is the percentage cost of capital to the company for the
debenture funds and the equity?
Solution:
1. Calculation of Earnings per Share:
Earnings Per Share (EPS) = Profit After Tax/No. of Equity Shares
= 36,00,000/20,00,000=Rs. 1.80
2. Computation of Percentage Cost of Capital.
(a) Cost of Equity Capital:
Cost of Equity (Ke) = D/MP
or Ke (%) = 1.80/12 *100= 15%
where D = expected earnings per share
and MP= Market price per share.
PAGE 91
Notes (b) Cost of Debenture Funds:

At Book value At Market Value
(Rs. Lakhs) (Rs. Lakhs)
Value of 15% debenture 220.00 206.25
Interest cost for the year 33.00 33.00
Less: Tax at 50% 16.50 16.50
Interest cost after tax 16.50 16.50
Cost of Debenture Fund (%) 16.50/220x100 16.50/206.25x100
= 7.5% = 8%
Illustration 6: Given below is the summary of the balance sheet of a

company as at 31st December, 1999:
Liabilities Rs. Assets Rs.
Equity share capital
20,000 shares of Rs. 100 each 2,00,000 Fixed Assets 4,00,000
Reserves and surplus 1,30,000 Investments 50,000
8% debentures 1,70,000 Current assets 2,00,000
Current Liabilities
Short term loans 1,00,000
Trade creditors 50,000
6,50,000 6,50,000
You are required to calculate the company’s weighed average cost of
capital using balance sheet valuations: The following additional information
is also available:
1. 8% Debentures were issued at par.
2. All interest’s payments are up to date and equity dividends is
currently 12%.
3. Short term loan carries interest at 18% p.a
4. The shares and debentures of the company are all quoted on the
Stock Exchange and current Market prices are as follows:

Equity Shares Rs.14 each
8% Debentures Rs. 98 each.
5. The rate of tax for the company may be taken at 50%.
92 PAGE
Solution: Notes
Calculation of the Cost of Equity: Rs
Equity Share 2,00,000
Reserves and Surplus 1,30,000
Equity (Shareholder’s Fund 3,30,000
Book Value Per Share = 3,30,000/20,000 =Rs. 16.50.
Equity Dividend Per Share = 12/100*10 =Rs. 1.20
Therefore, Cost of Equity (%)= 1.20/16.50*100= 7.273 %
Computation of Weighted Average Cost of Capital:
Capital Structure or Amount (Rs.) Before Tax After Tax Weighted
Type of Capital Cost Cost % Cost % Average
Equity Funds 3,30,000 7.273% 7.273% 24,000
Debentures 1,70,000 8% 4% 6,800
Total 5,00,000 30,800
Weighted Average Cost of Capital = 30,800/5,00,000*100 =6.16 %
Summary of Formulae
S.No. Purpose Formula
I
1. Before tax cost of debt K db =
NP
I
2. After cost of debt K db = K db (1 − t ) = (1 − t )
NP
1
1 + ( P − NP)
3. Before tax cost of redeemable debt K db = n
1
( P + NP)
2
4. After tax cost of redeemable debt K db = K db (1 − t )
c
1
1 + ( RV − NP)
5. Cost of debt redeemable at premium K db = n
1
( RV + NP)
2
n
I t + Pt
6. Cost of debt redeemable in instalments Vd = ∑
t −1 ( I + K d )t
PAGE 93
Notes S.No. Purpose Formula

Cost of irredeemable preference share D
7. Kp =
capital NP
MV − NP
D+
8. Cost of redeemable preference share capital K pr = n
1
( MV + NP)
2
D D
9. Cost of equity-dividend yield approach Ke = or
NP MP
Cost of equity-dividend yield plus constant D D (1 + g )
10. Ke = 1 + G = 0 +G
growth NP NP
D
11. Cost of retained earnings Kr = +G
NP
ΣXW
12. Weighted average cost of capital Kw =
ΣW
13. Cost of equity - CAPM approach K e = R f + β I ( Rm − R f )
IN-TEXT QUESTIONS
4. According to CAPM, the premium for risk is the difference
between ____________ from diversified portfolio and risk free
rate of return.
5. Cost of debt is always calculated after the payment of tax.
(True/False)
2.6 Summary
u The cost of capital is the minimum required rate of return which
firm must earn on its funds in order to satisfy the expectation of
its supplier of funds. If the return from capital budgeting proposals
is more than cost of capital then difference will be added to wealth
of shareholders.
u The concept of cost of capital has a role to play in capital budgeting
as well as in finalizing the capital structure for the firm. The cost
94 PAGE
of capital depends upon the risk free interest rate and risk premium, Notes
which depends upon the risk of investment and risk of firm.
u The cost of capital may be defined in terms of (1) explicit cost,
which the firm pays to supplier, and (2) implicit cost. i.e. opportunity
cost of funds to firm. The cost of capital is calculated in after tax
terms.
u Different sources of funds available to firm may be grouped into
Debt, Pref. share capital, Equity share capital and retained earning
and these sources have their specific cost of capital. However the
overall cost of capital of the firm may be ascertained as the weighted
average of these specific costs of capital.
u The cost of retained earnings is lower than cost of equity as former
does not have any floatation cost.
u The Weighted average cost of capital WACC may be ascertained by
applying book value weights or market value weights of different
sources of funds. The WACC is denoted as Kw.
1. (b) 13.5%
2. (b) Relevant cost
3. (d) All of the above
4. Market Return
5. False

1. What is the relevance and significance of cost of capital in capital
budgeting? How does the cost of capital enter the capital budgeting
process?
2. Define the concept of cost of capital? State how you would determine
the weighted average cost of capital of a firm?
3. How cost of equity capital is determined under CAPM?
PAGE 95
Notes 4. Write short notes on (a) Marginal cost of capital (b) Cost of retained
earnings
5. The cost of preference capital is generally lower than cost of equity.
State the reasons?
6. What are the problems in determining the cost of capital?
7. How is the cost of zero coupon bonds determined?

Delhi: Taxmann, New Delhi, 6EC(1264)-03.02.2023
Management, New Delhi: Sultan Chand & Sons (P.) Ltd.
u Singh, J.K. (2016), Financial Management: Theory and Practice, New
Delhi: S. Chand.
96 PAGE
L E S S O N
3
Capital Structure
Theories
Smriti Chawla
STRUCTURE
3.2 Introduction
3.3 Concept of Capital Structure
3.4 Optimal Capital Structure
3.5 Objects of Appropriate Capital Structure
3.6 Importance of Capital Structure
3.7 Theories of Capital Structure
3.8 Summary

u The meaning of Capital Structure.
u The relevance of optimum capital structure.
u The various approaches to capital structure.
3.2 Introduction
Capital Structure refers to the proportionate amount that makes up capitalisation. The
capital structure decision can influence the value of the firm through the cost of capital
PAGE 97
Notes and trading on equity or leverage. The optimum capital structure may
be defined as “that capital structure or combination of debt and equity
that leads to the maximum value of the firm” optimal capital structure
‘maximum’ the value of the company and hence the wealth of its owners
and minimizes the company’s cost of capital’ (Solomon, Ezra, the Theory
of Financial Management). Thus every firm should aim at achieving the
optimal capital structure and then to maintain it.
3.3 Concept of Capital Structure

Some authors include retained earnings and capital surplus for the purpose
of capital structure; in that case capital structure shall be:
Rs. Proportion/Mix
Equity Share Capita 10,00,000 42.55%
Preference Share Capita 5,00,000 21.28%
Long-Term loans and Debentures 2,00,000 8.51%
Retained Earnings 6,00,000 25.53%
23,50,000 100%
Hence, the term capital structure refers to the firm’s permanent or long
term financing consisting of equity share capital, retained earnings,
preference share capital, debentures and long-term debts.
3.4 Optimal Capital Structure

The following considerations should be kept in mind while maximizing
the value of the firm in achieving the goal of optimum capital structure:
(i) If the return on investment is higher than the fixed cost of funds,
the company should prefer to raise funds having a fixed cost, such
as debentures, loans and preference share capital. It will increase
earnings per share and market value of the firm. Thus, a company
should, make maximum possible use of leverage.
(ii) When debt is used as source of finance, the firm saves a considerable
amount in payment of tax as interest is allowed a deductible expense
in computation of tax. Hence, the effective cost of debt is reduced
98 PAGE
called tax leverage. A company should, therefore, take advantage Notes

of tax leverage.
(iii) The firm should undue financial risk attached with the use of
increased debt financing. It the shareholders perceive high risk in
using further debt-capital, it will reduce the market price of shares.
(iv) The capital structure should be flexible.
3.5 Objects of Appropriate Capital Structure

The objects of an appropriate capital structure have been summarized by
Soloman Ezra in the following words:
“The advantage of having an appropriate financial structure, if such an
optimum does exist, are twofold, it maximizes value of the company
and hence the wealth of its owner; it minimizes the company’s cost of
capital which in turn increases its ability to find new wealth creating
investment opportunities. Also by increasing the firm’s opportunities to
engage in future wealth creating investment, it increases the economy’s
rate of investment and growth.”
More specifically, the objects may be classified as follows:
u Minimisation of Cost of Capital
u Minimisation of Risk
u Maximisation of Return
u Preservation of Control
IN-TEXT QUESTIONS
1. The capital structure decision can influence the value of the firm
through the ………………. and trading on equity or leverage.
Cost of Capital
2. Capital structure refers to the firm’s short-term financing consisting
of equity share capital, retained earnings, preference share
capital, debentures and long-term debts. (True/False)
PAGE 99
Notes 3. If the return on investment is higher than the fixed cost of funds,
the company should prefer to raise funds having a fixed cost,
such as debentures, loans and preference share capital.
(True/False)
4. When debt is used as source of finance, the firm saves a
considerable amount in payment of tax as interest is allowed
a deductible expense in computation of tax. (True/False)
5. Which of the following is not an objective of the capital structure
optimization.
(a) Minimisation of Cost of Capital
(b) Minimisation of Risk
(c) Maximisation of Return
3.6 Importance of Capital Structure

The term ‘Capital structure’ refers to the relationship between the various
long-term forms of financing such as debenture, preference share capital
and equity share capital. Financing the firm’s assets is a very crucial
problem in every business and as a general rule there should be a proper
mix of debt and equity capital in financing the firm’s assets. The use of
long-term fixed interest-bearing debt and preference share capital along
with equity shares is called Financial leverage or Trading on equity.
The long-term fixed interest-bearing debt is employed by a firm to earn
more from the use of these sources than their cost so as to increase the
return on owner’s equity. It is true the capital structure cannot affect the
total earnings of a firm but it can affect the share of earnings available
for equity shareholders. Say, for example a company has an equity capital
of 1000 shares of Rs. 100 each fully paid and earns an average profits
of Rs. 30,000. Now the company wants to make an expansion and needs
another of Rs. 1,00,000. The options with the company are-either to
issue new shares or raise loans @ 10% p.a. Assuming that the company
would earn the same rate of profits. It is advisable to raise loans a by
doing so earnings per share will magnify. The company shall pay only
Rs. 10,000 as interest and profit expected shall be Rs. 60,000 (before
100 PAGE
payment of interest). After the payment of interest the profits left for Notes
equity shareholders shall be Rs. 50,000 (ignoring tax). It is 50% return
on the equity capital against 30% return otherwise. However, leverage
can operate adversely also if the rate the interest on long-terms loans is
more than the expected rate of earnings of the firm.
The impact of leverage on Earnings Per Share (EPS) can be understood
with the help of following illustration.
Illustration 1: ABC Company has currently an all equity capital structure
consisting of 15,000 equity shares of Rs. 100 each. The management is
planning to raise another Rs. 25 lakhs to finance a major programme
of expansion and is considering three alternative methods of financing:
(i) To issue 25,000 equity shares of Rs. 100 each.
(ii) To issue 25,000, 8% debentures of Rs. 100 each.
(iii) To issue 25,000, 8% Preference shares of Rs. 100 each.
The company’s expected earnings before interest and taxes will be Rs. 8
lakhs. Assuming a corporate tax rate of 50 per cent, determine the Earnings
Per Share (EPS) in each alternative and comment which alternative is
best and why?
Solution:
Alternative Alternative II Alternative
I Equity Preference Debt III Shares
Financing Financing Financing
Earnings Before Interest and 8.00 8.00 8.00
Tax (EBIT)
Less Interest - 2.00 -
But before Tax 8.00 6.00 8.00
Less Tax @ 50% 4.00 3.00 4.00
Earnings after Tax 4.00 3.00 4.00
Less Preference Dividend - - -
Earnings Available to Equity 4.00 3.00 2.00
Shareholders
Number of Equity shares 40,000 15,000 15,000
4,00,000 3,00,000 2,00,000
Earnings Per Share (EPS) Rs. 10 Rs. 20 Rs. 13.33
PAGE 101
Notes Comments: As the earnings per share highest in alternative II, i.e. debt
financing, the company should issue 25,000 8% debentures of Rs. 100
each. It will double the earnings of the equity shareholders without loss
of any control over the company.
3.7 Theories of Capital Structure

Different theories have been propounded by different authors to explain
the relationship between capital structure, cost of capital and value of the
firm. The main contributors to the theories are Durand, Ezra, Solomon,
Modigliani and Miller. The important theories are discussed below:
1. Net Income Approach.
2. Net Operating Income Approach.
3. The Traditional Approach.
4. Modigliani and Miller Approach.
Assumptions: For clear understanding of the theories of capital structure
and relationship between capital structure, cost of capital and the value
of firm, following assumptions are made:
u The firm uses only two sources of funds i.e debt and equity.
u The firm’s total assets are given and its investment decisions do
not change.
u The firm’s total financing remains unchanged but degree of leverage
can be changed for replacing debt for equity or equity for debt.
u The firm’s dividend payout ratio is 100% and it does not a all retain
the earnings.
u The EBIT is not expected to grow.
u Business risk of the firm is constant and it is assumed to be independent
of capital structure and financial risk.
u Investor’s subjective probability distribution of the future expected
operating earnings of the firm is the same.
102 PAGE
3.7.1 Net Income Approach Notes
According to this approach, a firm can minimise the weighted average

cost of capital and increase the value of the firm as well as market price
of equity shares by using debt financing to the maximum possible extent.
The theory propounds that a company can increase its value and reduce
the overall cost of capital by increasing the proportion of debt in its
capital structure. This approach is based upon the following assumptions:
(i) The cost of debt is less than the cost of equity.
(ii) There are no taxes.
(iii) The risk perception of inventors is not changed by the use of debt.
The line of argument in favour of net income approach is that as
proportion of debt financing in capital structure increase¸ the proportion
of and cheaper source of funds increases. This result in the decrease in
overall (weighted average) cost of capital leading to an increase in the
value of the firm. The reasons for assuming cost of debt to be less than
the cost of equity are that interest rates are usually lower than dividend
rates due to element of risk and the benefit of tax as the interest is a
deductible expense.
The figure shows that kd and IMAGEke areMATTER

constant for all levels of leverages
i.e. for all levels of debt financing. As the debt proportion of the financial
Cost Capital % increases, the WACC, k , decreases as the k is less than k . This
leverage o d e
result
Leverage (degree)in the increase in value of the firm. It may be noted that k o
will
approach kd as the debt proportion is increased. However, ko will never
The figure shows
touch kd as kd and
thatthere ke arebeconstant
cannot a 100%for all firm.
debt levelsSome elementi.e.
of leverages of for all levels of
equity
debt financing.
must beAsthere.
the debt proportion
However, if theoffirm
the is
financial leverage
100% equity increases,
firm, then the thek WACC,
is ko,
o
decreases as the kd is less than ke. This result in the increase in value of the firm. It may be
noted that ko will approach kd as the debt proportion is increased. However, ko will never PAGE 103
touch kd as there © cannot be a 100% debt firm. Some element of equity must
Department of Distance & Continuing Education, Campus of Open Learning, be there.
However, if the firm is 100% equity firm,ofthen
School Openthe ko is equal
Learning, to ke. The
University rate of decline in ko
of Delhi
depends upon the relative position of kd and ke. Net Income Approach suggests that higher
the degree of leverage, better it is, as the value of the firm would be higher.
Illustration 2: (a) A company expects a net income of Rs. 80,000. It has Rs. 2,00,000, 8%
Debentures. The equity capitalization rate of the company is 10%. Calculate the value of the
Notes equal to ke. The rate of decline in ko depends upon the relative position
of kd and ke. Net Income Approach suggests that higher the degree of
leverage, better it is, as the value of the firm would be higher.
Illustration 2: (a) A company expects a net income of Rs. 80,000. It
has Rs. 2,00,000, 8% Debentures. The equity capitalization rate of the
company is 10%. Calculate the value of the firm and overall capitalisation
rate according to the Net Income Approach (ignoring income-tax).
(b) If the debenture debt is increased to Rs. 3,00,000, what shall be the
value of the firm and the overall capitalisation rate?
Solution:
(a) Calculation of the Value of the Firm
Market Value of Equity
= 64, 000×
= Rs. 6,40,000
Market Value of Debentures = Rs. 2,00,000
Value of the Firm = Rs.8,40,000
Calculation of Overall Capitalisation Rate

(b) Calculation of Value of the Firm if Debenture Debt Raised to Rs.
3,00,000
Rs.
Net Income 80,000
Less: Interest on 8% Debentures of Rs. 3,00,000 24.000
Earnings available to equity shareholders 56,000
Equity Capitalisation Rate 10% 10%
Market Value of Equity = 56, 000 × 100/10
= Rs. 5,60,000
Market Value of Debentures = Rs. 3,00,000
Value of the Firm = Rs. 8,60,000
Overall Capitalisation Rate 80,000
= × 100 = 9.30%
8,60,000
104 PAGE
Thus, it is evident that with the increase in debt financing the value of Notes
the firm has increased and the overall cost of capital has decreased.
3.7.2 Net Operating Income Approach

This theory as suggested Durand is another extreme of the effect of
leverage on the value of the firm. It is diametrically opposite to the
net income approach. According to this approach, change in the capital
structure of a company does not affect the market value of the firm and
the overall cost of capital remains constant irrespective of the method of
financing. It implies that the overall of capital remains the same whether
the debt-equity mix is 50:50 or 20:80 or 0:100. Thus, there is nothing as
an optimal capital structure and every capital structure is the optimum
capital structure. This theory presumes that:
(i) the market capitalizes the value of the firm as a whole;
(ii) the business risk remains constant at every level of debt equity mix.
The reasons propounded for such assumptions are that the increased use
of debt increase the financial risk of the equity shareholders and hence
the cost of equity increases. On the other hand, the cost of debt remains
constant with the increasing proportion of debt as the financial risk of the
lenders is not affected. Thus, the advantage of using the cheaper source
of funds, i.e.; debt is exactly offset by the increased cost of equity.
The figure shows that the cost of debt, k , and the overall cost of capital,
The figure shows that the cost of debt, kd, and thed overall cost of capital, ko, are constant for
k , are constant for all levels of leverage. As the debt proportion or the
all levels ofo leverage. As the debt proportion or the financial leverage increases, the risk of
financial leverage increases, the risk of the shareholders also increases and
the shareholders also increases and thus the cost of equity capital, ke also increases. However,
thus
the increase in the
ke, iscost ofthat
such equity capital, value
the overall ke also
of increases. However,
the firm remains theItincrease
same. may be noted that
for an all equity firm, the ke is just equal to ko. As the debt proportion is increased, the ke also
increases. However, the overall cost of capital remains constant because increase in ke is PAGE just 105
sufficient to offset the benefits of cheaper debt financing.
Illustration 3 (a): A company expected a net operating income of Rs. 1,00,000. It has Rs.
5,00,000, 6% Debentures. The overall capitalisation rate is 10%. Calculate the value of the
firm and the equity capitalisation rate (cost of equity) according to the Net Operating Income
Approach.
Notes in ke, is such that the overall value of the firm remains same. It may be
noted that for an all equity firm, the ke is just equal to ko. As the debt
proportion is increased, the ke also increases. However, the overall cost
of capital remains constant because increase in ke is just sufficient to
offset the benefits of cheaper debt financing.
Illustration 3: (a) A company expected a net operating income of
Rs. 1,00,000. It has Rs. 5,00,000, 6% Debentures. The overall capitalisation
rate is 10%. Calculate the value of the firm and the equity capitalisation
rate (cost of equity) according to the Net Operating Income Approach.
(b) If the debenture debt is increased to Rs. 7,50,000. What will be the
effect on the value of the firm and the equity capitalisation rate?
Solution:
(a) Net Operating Income = Rs. 1,00,000
Overall Cost of Capital = 10%
Market Value of the first (V) Net Operating Income  EBIT 
=
Overall Cost of Capital  K O 
= 1,00,000× 100
10
= Rs. 10,00,000
Market Value of Firm Rs. 10,00,000
Less: Market Value of Debentures Rs. 5,00,000
Total Market Value of Equity Rs. 5,00,000
Equity Capitalisation Rate or Cost of equity (Ke)
Earnings available to equity shareholders
= or EBIT − I / V − B
Total market value of equity shares
(where, EBIT means Earnings before Interest and Tax)

V is Value of the firm
B is Value of debt capital
I is interest on debt
= 1,00,000 – 30,000/10,00,000 – 5,00,000 × 100
70, 000
= ×100 = 14%
5, 00, 000
106 PAGE
(b) If the debenture debt is increased to Rs. 7,50,000, the value of the Notes
firm shall remain unchanged at Rs. 10,00,000. The equity capitalisation
rate will increase as follows:
Equity Capitalization Rate (ke)
= EBIT – I/V – B
= 1,00,000 – 45,000/10,00,000 – 7,50,000×100
55, 000
= 2,50, 000 × 100 = 22%
3.7.3 Traditional Approach

The traditional approach, also known as Intermediate approach, is a
compromise between the two extremes of net income approach and net
operating income approach. According to this theory, the value of the firm
can be increased initially or the cost of capital can be decreased by using
more debt as the debt is a cheaper source of funds than equity. Thus,
optimum capital structure can be reached by a proper debt-equity mix.
Beyond a particular point, the cost of equity increases because increase
debt increases the financial risk of the equity shareholders. The advantage
of cheaper debt at this point of capital structure is offset by increased
cost of equity after this there comes a stage, when the increased cost of
equity cannot be offset by the advantage of low-cost debt. Thus, overall
cost of capital, according to this theory, decreases upto a certain point,
remains more or less unchanged for moderate increase in debt thereafter:
and increase or rises beyond a certain point. Even the cost of debt may
increase at this state due to increased financial risk.
Cost ke Cost ke
of ko of ko
Capital kd Capital kd
% %
Leverage Leverage
O O
(degree) Range of Optimal (degree)
Optimal Capital
Capital Structure
Structure
(Part B)
(Part A)
Traditional View point on the relationship between Leverage, cost of

capital and value of the firm.
PAGE 107
Notes The figure shows that there can either be a particular financial leverage
(as in Part A) or a range of financial leverage (as in Part B) when the
overall cost of capital, Ko is minimum. The figure in Part A shows that
at the financial leverage level O, the firm has the lowest ko and therefore,
the capital structure at that financial leverage is optimal. The Part B of
the figure shows that there is not one optimal capital structure, rather
there is a range of optimal capital structure from leverage level O to
level P. Every capital structure over this range of financial leverage is
an optimal capital structure. Thus, as per the traditional approach, a firm
can be benefited from a moderate level of leverage when the advantages
using debt (having lower cost) outweigh the disadvantages of increasing
Ke (as a result of higher financial risk). The overall cost of capital, Ko,
therefore is a function of the financial leverage. The value of the firm
can be affected therefore, by the judicious use of debt and equity in the
capital structure.
Illustration 4: Compute the market value of the firm, value of shares
and the average cost of capital from the following information:
Rs.
Net Operating Income 2,00,000
Total Investment 10,00,000
Equity Capitalisation Rate:
(a) If the firm uses no debt 10%
(b) If the firm uses Rs. 4,00,000 debentures 11%
(c) If the firm uses Rs. 6,00,000 debentures 13%
Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest
whereas Rs. 6,00,000 debentures can be raised at 6% rate of interest.
Solution:
Computation of Market Value of Firm, Value of Shares & the Average
Cost of Capital
(a) No debt (b) Rs. 4,00,000 (c) Rs. 6,00,000
5% Debentures 6% Debentures
Net Operating Income Rs. 2,00,000 Rs. 2,00,000 Rs. 2,00,000
Less: Interest i.e., Cost of debt: 20,000 36,000
Earnings available to Equity Rs. 2,00,000 Rs. 1,80,000 Rs. 1,64,000
Shareholders
Equity Capitalisation Rate 10% 11% 13%
108 PAGE
(a) No debt (b) Rs. 4,00,000 (c) Rs. 6,00,000 Notes

5% Debentures 6% Debentures
Market Value of shares 100 100 100
2,00,000 × 1,80,000 × 1,64,000 ×
10 11 13
Rs. 20,00,000 Rs. 16,36,363 Rs. 12,61,538
Market value of debt (debentures) 20,00,000 4,00,000 6,00,000
Average Cost of Capital 2,00,000 2,00,000 2,00,000
× 100 × 100 × 100
20,00,000 20,36,363 18,61,538
Earnings EBIT
or = 10% = 9.8% = 10.7%
Value of the firm V
Comments: It is clear from the above that if debt of Rs. 4,00,000 is used
the value of the firm increases and the overall cost of capital decreases.
But, if more debt is used to finance in place of equity, i.e., Rs. 6,00,000
debentures, the value of the firm decreases and the overall cost of capital
increases.
3.7.4 Modigliani and Miller Approach

M&M hypothesis is identical with the Net Operating Income approach if
taxes are ignored. However, when corporate taxes are assumed to exist,
their hypothesis is similar to the Net Income Approach.
(a) In the absence of taxes: The theory proves that the cost of capital
is not affected by changes in the capital structure or say that the
debt-equity mix is irrelevant in the determination of the total value
of a firm. The reason argued is that though debt is cheaper to equity,
with increased use of debt as a source of finance, the cost of equity
increases. This increase in cost of equity offsets the advantages
of low cost of debt. Thus, although the financial leverage affects
the cost of equity, the overall cost of capital remains constant.
The theory emphasizes the fact that firm’s operating income is a
determinant of its total value. The theory further propounds that
beyond a certain limit of debt, the cost of debt increases (due to
increased financial risk) but the cost of equity falls thereby again
balancing the two costs. In the opinion of Modigliani & Miller, two
identical firms in all respects except their capital structure cannot
have different market values or cost of capital because of arbitrage
PAGE 109
Notes process. In case two identical firms except for their capital structure
have different market values or cost of capital arbitrage will take
place and the investors will engage in ‘personal leverage’ (i.e. they
will buy equity of the other company in preference to the company
having lesser value) as against the corporate leverage’: and this will
again render the two firms to have the same total value.

The M&M approach is based upon the following assumptions:
(i) There are no corporate taxes.
(ii) There is a perfect market.
(iii) Investors act rationally.
(iv) The expected earnings of all the firms have identical risk
characteristics.
(v) The cut-off point of investment in a firm is capitalization rate.
(vi) Risk to investors depends upon the random fluctuations of
expected earnings and the possibility that the actual value of
the variables may turn out to be different from best estimates.
(vii) All earnings are distributed to the shareholders.
(b) When the corporate taxes are assumed to exist: Modigliani and
Miller, in their Article of 1963 have recognized that the value of
the firm will increase or the cost of capital will decrease with the
use of debt on account of deductibility of interest charges for tax
purpose. Thus, the optimum capital structure can be achieved by
maximizing the debt mix in the equity of a firm.

According to the M&M approach, the value of a firm unlevered
can be calculated as.
Value of unlevered firm (Vu)
= Earnings before interest and tax/Overall cost of capital
= EBIT/ko (1 – t)
and, the value of levered firms is:
VL=Vu+tD
where, Vu is value of unlevered firm
110 PAGE
and, tD is the discounted present value of the tax savings resulting Notes
from the tax deductibility of the interest charges, t is the rate of
tax and D the quantum of debt used in the mix.
Illustration 5: A company has earnings before interest and taxes of
Rs. 1,00,000. It expects a return on its investment at a rate of 12.5%.
You are required to find out the total value of the firm according to the
Miller-Modigliani theory.
Solution: According to the M and M theory, total value of the firm
remains constant. It does not change with the change in capital structure.
Earnings Before Interest & Tax
Total value of firm =
Overall cos t of capital
EBIT
V=
K0
1, 00, 000
= / 100
12.5
1, 00, 000
=
12.5
= Rs. 8,00,000
Illustration 6: There are two firms X and Y which are exactly identical
except that X does not use any debt in its financing, while Y has
Rs. 1,00,000 5% Debentures in its financings. Both the firms have earnings
before interest and tax of Rs. 25,000 and the equity capitalization rate is
10%. Assuming the corporation tax of 50% calculate the value of the firm.
Solution: The Market value of firm X which does not use any debt
EBIT
V0 −
K0
100
= 25, 000 × = 2,50, 000
10
The market value of firm Y which uses debt financing of Rs. 1,00,000
Vt = Uu + td
= Rs. 2,50,000 +.5×1,00,000
= Rs. 2,50,000 + 50,000 => Rs. 3,00,000
PAGE 111
Notes How does the Arbitrage Process Work?

We have noticed in illustration that the market value of firm Y, which uses
debt content in its capital structure, is higher than the market value of
firm X which does not use debt content in its capital structure. According
to M & M theory, this situation cannot remain for a long period because
of the arbitrage process. As the investors in company Y can earn a higher
rate of return on their investment with lower financial risk, they will sell
their holding of shares in company X and invest the same in company
Y. Further, as company Y does not use any debt in its capital structure
the financial risk to the investors will be less, thus, they will engage
in personal leverage by borrowing additional funds equivalent to their
proportionate share in firm X’s debt at the same rate of interest and invest
the borrowed funds also in company Y. The arbitrage process will continue
till the prices of shares of company X fall and that of company Y rise
so as to make the market value of the two funds identical. However, in
the arbitrage process, such investors who switch their holdings will gain.
Illustration, given below, illustrates the working of arbitrage process.
Illustration 7: The following is the data regarding two companies ‘A’
and ‘B’ belonging to the same equivalent risk class:
Company A Company B
Number of ordinary shares 1,00,000 1,50,000
8% Debentures 50,000 -
Market Price per share Rs. 1.30 Rs. 1.00
Profit before interest Rs. 20,000 Rs, 20,000
All profits after paying debenture interest are distributed as dividends.
You are required to explain how under Modigliani and Miller approach,
an investor holding 10% of shares in company ‘A’ will be better off in
switching his holding to company ‘B’
Solution: In the opinion of Modigliani & Miller, two identical firms in
all respects except their capital structure cannot have different market
values because of arbitrage process. In case two identical firms except
for their capital structure have different market values, arbitrage will take
place and the investors will engage in ‘personal leverage’ as against the
corporate leverage. In the given problem, the arbitrage will work out as
below:
112 PAGE
1. The investor will sell in the market 10% of shares in company ‘A’ Notes
 110 
for Rs. 13,000  × 1, 00, 000 × 1.30
100 
 10 
2. He will raise a loan of Rs. 5000  × 50, 000 to take advantage
100 
of personal leverage as against the corporate leverage as company
‘B’ does not use debt content in its capital structure.
3. He will buy 18,000 shares in company ‘B’ with the total amount
realised from 1 and 2, i.e., Rs. 13,000 plus Rs. 5000, Thus he will
have 12% of shares in company ‘B’.
The investor will gain by switching his holding as below:
Present income of the investor in company ‘A’:
Profit before interest of the company = Rs. 20,000
Less Interest on debentures (8%) = Rs. 4,000
Profit after Interest 16,000
Share of the investor = 10% of Rs. 16,000
i.e. Rs. 1600
Income of the investor after switching holding to company
‘B’
Profit before interest for company ‘B’ = Rs. 20,000
Less Interest = Nil
Profit after interest 20,000
18, 000
Share of the investor (= 20,000 × ) = Rs. 2400
1,50, 000
Less: Interest paid on loan taken 8% of Rs. 5000 = 400
Net Income of the investor 2000
As the net income of the investor in company ‘B’ is higher than the loss
of income from company ‘A’ due to switching the holding, the investor
will gain in switching his holding to company ‘B’.
IN-TEXT QUESTIONS
6. Which of the following is not an assumption to understand the
concept of capital structure.
(a) The firm uses only two sources of funds i.e. debt and
equity.
PAGE 113
Notes (b) The firm’s total assets are given and its investment
decisions do not change.
(c) The firm’s dividend Payout ratio is 100% and it does not
at all retain the earnings.
(d) The EBIT is expected to grow.
7. According to Net Income approach, a firm can __________
the weighted average cost of capital and increase the value of
the firm as well as market price of equity shares by using debt
financing to the maximum possible extent.
8. The Net Income approach assumes that the cost of debt is more
than the cost of equity. (True/False)
9. According to traditional approach, the value of the firm can be
increased initially or the cost of capital can be decreased by
using more equity as the equity is a cheaper source of funds
than debt. (True/False)
10. M & M hypothesis is identical with the Net Operating Income
approach if taxes are ignored. (True/False)
3.8 Summary
The capital structure of the firm talks about the best combination of the
debt and equity so that the value of the firm can be maximised. The
chapter talks about the different approaches which can help a firm to
decide upon its capital structure. A firm has to make the decision regarding
the various sources of finance as they are required to keep the interest of
its shareholders. The Net income approach advocates the debt financing
while the net operating income approach says that the capital structure
does not affect the value of the firm. The traditional approach favours
debt as they can initially help the firm to reduce the cost of capital. The
MM approach takes many assumptions and then help in the analysis of
capital structure.
114 PAGE
3.9 Answers to In-Text Questions Notes
1. Cost of Capital
2. False
3. True
4. True
6. (d) The EBIT is expected to grow
7. Minimize
8. False
9. False
10. True

1. What is the meaning of Capital Structure.?
2. What is the role of debt in Capital Structure?
3. What is the role of equity in the Capital Structure?
4. Distinguish between the Net Income Approach and Net Operating
Income Approach?

u Brealey, R.A., Myers S.C., Allen F. & Mohanty P. (2020), Principles
PAGE 115
Notes u Rustagi, R.P. (2022), Fundamentals of Financial Management, New

Delhi: Taxmann, New Delhi: 6EC (1264)-03-02-2023
Delhi: S. Chand.
116 PAGE
L E S S O N
4
Capital Structure:
Planning and Designing
Smriti Chawla
STRUCTURE
4.2 Capital Structure Management or Planning the Capital Structure
4.3 Essential Features of a Sound Capital Mix
4.4 Factors Determining the Capital Structure
4.5 Profitability and Capital Structure: EBIT-EPS Analysis
4.6 Liquidity and Capital Structure: Cash Flow Analysis
4.7 Illustration
4.8 Summary

u How to make a good capital mix.
u Factors affecting the capital structure of the firms.
u The concept of profitability and liquidity.
u The cash flow analysis.
4.2 Capital Structure Management or Planning the Capital Structure

Estimation of capital requirements for current and future needs is important for a firm.
Equally important is the determining of capital mix. Equity and debt are the two principle
PAGE 117
Notes sources of finance of a business. But, what should be the proportion

between debt and equity in the capital structure of a firm now much
financial leverage should a firm employ? This is a very difficult question.
To answer this question, the relationship between the financial leverage
and the value of the firm or cost of capital has to be studied. Capital
structure planning, which aims at the maximisation of profits and the
wealth of the shareholders, ensures the maximum value of a firm or the
minimum cost of the shareholders. It is very important for the financial
manager to determine the proper mix of debt and equity for his firm.
In principle every firm aims at achieving the optimal capital structure
but in practice it is very difficult to design the optimal capital structure.
The management of a firm should try to reach as near as possible of the
optimum point of debt and equity mix.
4.3 Essential Features of a Sound Capital Mix

A sound or an appropriate capital structure should have the following
essential features:
(i) Maximum possible use of leverage.
(ii) The capital structure should be flexible.
(iii) To avoid undue financial/business risk with the increase of debt.
(iv) The use of debt should be within the capacity of a firm. The firm
should be in a position to meet its obligation in paying the loan
and interest charges as and when due.
(v) It should involve minimum possible risk of loss of control.
(vi) It must avoid undue restrictions in agreement of debt.
(vii) The capital structure should be conservative. It should be composed
of high grade securities and debt capacity of the company should
never be exceeded.
(viii) The capital structure should be simple in the sense that can be
easily managed and also easily understood by the investors.
(ix) The debt should be used to the extent that it does not threaten the
solvency of the firm.
118 PAGE
4.4 Factors Determining the Capital Structure Notes
The capital structure of a concern depends upon a large number of factors

such as leverage or trading on equity, growth of the company, nature
and size of business, the idea of retaining control, flexibility of capital
structure, requirements of investors costs of floatation of new securities,
timing of issue, corporate tax rate and the legal requirements. It is not
possible to rank them because all such factors are of different importance
and the influence of individual factors of a firm changes over a period
of time. Every time the funds are needed. The financial manager has to
advantageous capital structure. The factors influencing the capital structure
are discussed as follows:
1. Financial Leverage of Trading on Equity: The use of long term
fixed interest bearing debt and preference share capital along with
equity share capital is called financial leverage or trading on equity.
The use of long-term debt increases, magnifies the earnings per
share if the firm yields a return higher than the cost of debt. The
earnings per share also increase with the use of preference share
capital but due to the fact that interest is allowed to be deducted
while computing tax, the leverage impact of debt is much more.
However, leverage can operate adversely also if the rate of interest
on long-term loan is more than the expected rate of earnings of the
firm. Therefore, it needs caution to plan the capital structure of a
firm.
2. Growth and Stability of Sales: The capital structure of a firm is
highly influenced by the growth and stability of its sale. If the
sales of a firm are expected to remain fairly stable, it can raise a
higher level of debt. Stability of sales ensures that the firm will
not face any difficulty in meeting its fixed commitments of interest
repayments of debt. Similarly, the rate of the growth in sales also
affects the capital structure decision. Usually greater the rate of
growth of sales, greater can be the use of debt in the financing of
firm. On the other hand, if the sales of a firm are highly fluctuating
or declining, it should not employ, as far as possible, debt financing
in its capital structure.
PAGE 119
Notes 3. Cost of Capital: Every rupee invested in a firm has a cost. Cost of
capital refers to the minimum return expected by its suppliers. The
capital structure should provide for the minimum cost of capital.
The main sources of finance for a firm are equity, preference share
capital and debt capital. The return expected by the suppliers of
capital depends upon the risk they have to undertake. Usually, debt
is a cheaper source of finance compared to preference and equity
capital due to (i) fixed rate of interest on debt: (ii) legal obligation
to pay interest: (iii) repayment of loan and priority in payment at the
time of winding up of the company. On the other hand, the rate of
dividend is not fixed on equity capital. It is not a legal obligation
to pay dividend and the equity shareholders undertake the highest
risk and they cannot be paid back except at the winding up of the
company and that too after paying all other obligations. Preference
capital is also cheaper than equity because of lesser risk involved
and a fixed rate of dividend payable to preference shareholders.
But debt is still a cheaper source of finance than even preference
capital because of tax advantage due to deductibility of interest.
While formulating a capital structure, an effort must be made to
minimize the overall cost of capital.
4. Minimisation of Risk: A firm’s capital structure must be developed
with an eye towards risk because it has a direct link with the
value. Risk may be factored for two considerations: (a) the capital
structure must be consistent with the business risk, and (b) the
capital structure results in certain level of financial risk. Business
risk may be defined as the relationship between the firm’s sales
and its Earnings Before Interest and Taxes (EBIT). In general, the
greater the firm’s operating leverage – the use of fixed operating
cost – the higher its business risk. Although operating leverage is
an important factor affecting business risk, two other factors also
affect it – revenue stability and cost stability. Revenue stability refers
to the relative variability of the firm’s sales revenue. Firms with
highly volatile product demand and price have unstable revenues
that result in high levels of business risk. Cost stability is concerned
with the relative predictability of input price. The more predictable
120 PAGE
and stable these inputs prices are, the lower is the business risk, Notes
and vice versa. The firm’s capital structure directly affects its
financial risk, which may be described as the risk resulting from
the use of financial leverage. Financial leverage is concerned with
the relationship between Earnings Before Interest and Taxes (EBIT)
and Earnings Per Share (EPS). The more fixed-cost financing i.e.,
debt (including financial leases) and preferred stock, a firm has in
capital structure, the greater its financial risk.
5. Control: The determination of capital structure is also governed by
the management desire to retain controlling hands in the company.
The issue of equity share involves the risk of losing control. Thus
in case the company is interested in – retaining control, it should
prefer the use of debt and preference share capital to equity share
capital. However, excessive use of debt and preference capital may
lead to loss of control and other bad consequences.
6. Flexibility: The term flexibility refers to the firm’s ability to adjust
its capital structure to the requirements of changing conditions.
A firm having flexible capital structure would face no difficulty
in changing its capitalization or source of fund. The degree of
flexibility in capitals structure depends mainly on (i) firm’s unused
debt capacity, (ii) terms of redemption, (iii) flexibility in fixed
charges, and (iv) restrictive stipulation in loan agreements.

If a company has some unused debt capacity, it can raise funds to
meet the sudden requirements of finances. Moreover, when the firm
has a right to redeem debt and preference capital at its discretion it
will able to substitute the source of finance for another, whenever
justified. In essence, a balanced mix of debt and equity needs to
be obtained, keeping in view the consideration of burden of fixed
charges as well as the benefits of leverages simultaneously.
7. Profitability: A capital structure should be the most profitable from
the point of view of equity shareholders. Therefore, within the
given constraints, maximum debt financing (which is generally
cheaper) should be opted to increase the returns available to the
equity shareholder.
PAGE 121
Notes 8. Cash Flow Ability: The EBIT – EPS analysis, growth of earnings
and coverage ratio are very useful indicator of a firm’s ability to
meet its fixed obligations at various levels of EBIT. Therefore, an
important feature of a sound capital structure is the firm’s ability to
generate cash flow to service fixed charges. At the time of planning
the capital structure, the ratio of net cash inflows to fixed charges
should be examined. The ratio depicts the number of times the fixed
charges commitments are covered by net cash inflows. Greater is
this coverage, greater is this capacity of a firm to use debts and
other sources of funds carrying fixed rate of interest and dividend.
9. Characteristics of the Company: The peculiar characteristics of a
company in regards to its size, nature, credit standing etc. play
a pivotal role in ascertaining its capital structure. A small size
company will not be able to raise long-term debts at reasonable
rate of interest on convenient terms. Therefore, such companies rely
to a significant extent on the equity share capital and reserves and
surplus for their long-term financial requirements.
In case of large companies the funds can be obtained on easy terms and
reasonable cost by selling equity shares and debentures as well. Moreover
the risk of loss of control is also less in case of large companies, because
their shares can be distributed in a wider range. When company is widely
held, the dissident shareholders will not be able to organize themselves
against the existing management, hence, no risk of loss of loss of control.
Thus, size of a company has a vital role to play in determining the
capital structure.
The various elements concerning variation in sales, competition with
other firms and life cycle of industry also affect the form and size of
capitals structure. If company’s sales are subject to wide fluctuations, it
should rely less on debt capital and opt for conservative capitals structure.
A company facing keen competition with other companies will run the
excessive risk of not being able to meet payments on borrowed funds.
Such companies should place much emphasis on the use of equity than
debt: similarly, if a company is in infancy stage of its life cycle, it will
run a high risk of mortality. Therefore, companies in their infancy should
122 PAGE
rely more on equity than debt. As a company grows mature, it can make Notes
use of senior securities (bonds and debentures).
Capital Structure of a New Firm: The capital structure a new firm
is designed in the initial stages of the firm and the financial manager
has to take care of many considerations. He is required to assess and
evaluate not only the present requirement of capital funds but also the
future requirements. The present capital structure should be designed
in the light of a future target capital structure. Future expansion plans,
growth and diversifications strategies should be considered and factored
in the analysis.
Capital Structure of an Existing Firm: An existing firm may require
additional capital funds for meeting the requirements of growth, expansion,
and diversification or even sometimes for working capital requirements.
Every time the additional funds are required, the firm has to evaluate
various available sources of funds vis-à-vis the existing capital structure.
The decision for a particular source of funds is to be taken in the totality
of capital structure i.e., in the light of the resultant capital structure after
the proposed issue of capital or debt.
Evaluation of Proposed Capital Structure: A financial manager has to
critically evaluate various costs and benefits, implications and the after-
effects of a capital structure before deciding the capital mix. Moreover,
the prevailing market conditions are also to be analyzed. For example, the
present capital structure may provide a scope for debt financing but either
the capital market conditions may not be conducive or the investors may
not be willing to take up the debt instrument. Thus, a capital structure
before being finally decided must be considered in the light of the firm’s
internal factors as well as the investor’s perceptions.
IN-TEXT QUESTIONS
1. ________and _______are the two principal sources of finance
of a business.
2. Which of the following does not help in sound capital mix:
(a) Minimum use of Leverage
(b) Flexibility
PAGE 123
Notes (c) Risk avoidance

(d) Use of debt within the capacity of the firm
3. The use of long term fixed interest bearing debt and preference
share capital along with equity share capital is called ___________
leverage or trading on equity.
4. The purpose of optimum capital structure is to _________ the
overall cost of capital.
5. A small size company will not be able to raise ________ at
reasonable rate of interest on convenient terms.
4.5 Profitability and Capital Structure: EBIT–EPS Analysis

The financial leverage affects the pattern of distribution of operating
profit among various types of investors and increases the variability of
the EPS of the firm. Therefore, in search for an appropriate capitals
structure for a firm, the financial manager must analysis the effects of
various alternative financial leverages on the EPS. Given a level of EBIT,
EPS will be different under different financing mix depending upon the
extent of debt financing. The effect of leverage on the EPS emerges
because of the existence of fixed financial charge i.e., interest on debt
financial fixed dividend on preference share capital. The effect of fixed
financial charge on the EPS depends upon the relationship between the
rate of return on assets and the rate of fixed charge. If the rate of return
on assets is higher than the cost of financing, then the increasing use of
fixed charge financing (i.e., debt and preference share capital) will result
in increase in the EPS. This situation is also known favourable financial
leverage or Trading on Equity. On the other hand, if the rate of return on
assets is less than the cost of financing, then the effect may be negative
and therefore, the increasing use of debt and preference share capital
may reduce the EPS of the firm.
The fixed financial charge financing may further be analyzed with reference
to the choice between the debt financing and the issue of preference
shares. Theoretically, the choice is tilted in favour of debt financing
because of two reasons: (i) the explicit cost of debt financing i.e., the
124 PAGE
rate of interest payable on debt instruments or loans is generally lower Notes

than the rate of fixed dividend payable on preference shares, and (ii)
interest on debt financing is tax-deductible and therefore the real costs
(after-tax) is lower than the cost of preference share capital.
Thus, the analysis of the different capital structure and the effect of
leverage on the expected EPS will provide a useful guide to select a
particular level of debt financing. The EBIT-EPS analysis is of significant
importance and if undertaken properly, can be an effective tool in the
hands of a financial manager to get an insight into the planning and
designing the capital structure of the firm.
Limitations of EBIT-EPS Analysis: If maximisation of the EPS is the
only criterion for selecting the particular debt-equity mix, then that capital
structure which is expected to result in the highest EPS will always be
selected by all the firms. However, achieving the highest EPS need not
be the only goal of the firm. The main shortcomings of the EBIT-EPS
analysis may be noted as follows:
(i) The EPS Criterion Ignore the Risk Dimension: The EBIT-EPS
analysis ignores as to what is the effect of leverage on the overall
risk of the firm. With every increase in financial leverage, the risk
of the firm and therefore that of investors also increase. The EBIT-
EPS analysis fails to deal with the variability of EPS and the risk
return trade-off.
(ii) EPS is more of a Performance Measure: The EPS basically, depends
upon the operating profit which in turn, depends upon the operating
efficiency of the firm. It is a resultant figure and it is more a
measure of performance rather than a measure of decision-making.
These shortcomings of the EBIT-EPS analysis do not, in any way, affect
its value in capital structure decisions. Rather the following dimensions
may be added to the EBIT-EPS analysis to make it more meaningful.
The Risk Considerations: The risk attached with the leverage may be
incorporated in the EBIT-EPS analysis. The financial manager may start
by finding out the indifference level of EBIT (i.e., the level of EBIT at
which the EPS will be same for more than one capital structure). The
expected value of EBIT may then be compared with this indifference level
of EBIT. If the expected value of EBIT is more than the indifference
PAGE 125
Notes level of EBIT, than the debt financing is advantageous to the firm. The
more is the difference between the expected EBIT and the indifference
level of EBIT, greater is the benefit of debt financing, and so stronger
is the case for debt financing.
In case, the expected EBIT is less than the indifference level of EBIT, then
the probability of such occurrence is to be assessed. If the probability is
high, i.e., there are more chances that the expected EBIT may fall below
the indifference level of EBIT, then the debt financing is considered to be
risky. If, however, the probability is negligible, then the debt financing
may be opted.
Debt Capacity: Whenever a firm goes for debt financing (howsoever big
or small), it inherently opts for taking two burdens, i.e., the burden of
interest payment and the burden of repayment of the principal amount.
Both these burdens are to be analyzed (i) from the point of view of
liquidity required to meet the obligations, and (ii) from the point of view
of debt capacity.
The profits of the firm’s vis-à-vis the burden of debt financing should
also be analyzed. The debt capacity or ability of the firm to service the
debt can be analyzed in terms of the coverage ratio, which shows the
relationship between the EBIT and the fixed financial charge. The higher
the EBIT in relation to fixed financial charge, the better it is. For this
purpose, Interest coverage ratio may be calculated as follows:
Interest Coverage Ratio = EBIT/Fixed Interest Charge
4.6 Liquidity and Capital Structure: Cash Flow Analysis

A finance manager, while evaluating different capital structure, should
also find out the liquidity required for (i) interest on debt, (ii) repayment
of debt, (iii) dividend on preference share capital, and (iv) redemption
of preference share capital. The requirement of liquidity should then be
compared with the cash availability from operations of the firm as follows:
1. Debt Service-Coverage Ratio: In the Debt Service Coverage Ratio
(DSCR), the cash profits generated by the operations are compared
with the total cash required for the service of the debt and the
preference share capital i.e.
126 PAGE
PAT + Depreciation + Interest − Non − cash expenses Notes

DSCR =
Pref . Dividend + Interest + repayment Obligation
2. Projected Cash Flow Analysis: The firm may also undertake the cash
flow analysis for the period under consideration. This will enable
the financial manager to assess the liquidity capacity of the firm
to meet the obligations of interest payments and the repayment of
principal obligations. A projected cash budget may be prepared to
find out the expected cash inflows and cash outflows (including
interest and repayments). If the inflows are comfortably higher than
the outflow, then the firm can proceed with the debt financing.
EBIT-EPS Analysis versus Cash Flow Analysis (i.e., Profitability
versus Liquidity): In the EBIT-EPS analysis, it has been pointed out that
a financial manager should evaluate a capital structure from the point of
view of the profitability of equity shareholders. A capital structure which
is expected to result in maximisation of EPS should be selected. Financial
leverages at different levels are considered so as to find out their effect
on the EPS. On the other hand, in the cash flow analysis, the liquidity
side of the leverage is stressed. A capital structure should be evaluated
in the light of available liquidity. The firm need not face any liquidity
problem in debt servicing. Under these two analyses, the different aspects
of the capital structure are evaluated. The EBIT-EPS analysis stresses
the profitability of the proposed financing mix and analyses it from the
point of view of equity shareholders. The cash flow analysis looks upon
a financing mix and stresses the need for liquidity requirement of debt
financing and thus, it emphasizes the debt investor.
Financial Distress
An increase in debt thus increases the probability of financial distress. The
financial distress is a situation when a firm finds it difficult to honour
its commitment to the creditors/debt investors. With reference to capital
structure, the financial distress refers to the situation when the firm
faces difficulties in paying interest and principal repayments to the debt
investors. Financial distress arises when the fixed financial obligations
of the firm affect the firm’s normal operations. There are many degrees
of financial distress. One extreme degree of financial distress is the
bankruptcy, a condition in which the firm is unable to meet its financial
obligation and faces liquidation. The firm should try to achieve a trade-
PAGE 127
Notes off between the costs and benefits of debt financing. The cost being
the financial distress and the benefits being the interest tax-shield. The
financial manager must weigh the benefits of tax savings against the cost
of financial distress in the form of increasing risk. The cost of financial
distress is reflected in the market value of the firm and can be measured
therefore, through its effect on the value of the firm. Lower levels of
leverage will have little effects, but as the financial leverage increases,
the cost of financial distress increases and the market value of the debt
as well as the equity falls.
In view of the cost of financial distress, the market value of the firm may
not be as much as it could have been in absence of such costs. Thus,
the value of the firm is:
Value = Value (fall equity firm) + Present value of tax-shield – Present
value of cost of financial distress.
4.7 Illustration
Illustration 1: Alpha company is contemplating conversion of 500 14%
convertible bonds of Rs. 1,000 each. Market price of bond is Rs. 1,080.
Bond indenture provides that one bond will be exchanged for 10 share.
Price Earning ratio before redemption is 20:1 and anticipated price earning
ratio after redemption is 25:1. Number of shares outstanding prior to
redemption are 10,000. EBIT amounts to Rs. 2,00,000. The company is
in the 35% tax bracket. Should the company convert bonds into share?
Give reasons.
Solutions:
Present Position After Conversion
EBIT Rs. 2,00,000 Rs, 2,00,000
Less interest @ 14% 70,000 ----
1,30,000 2,00,000
Less tax @ 15% 45,500 70,000
Number of share 10,000 15,000
EPS Rs. 8.45 Rs. 8.67
P E Ratio 20 25
Expected market Price Rs. 169.00 Rs. 216.75
128 PAGE
The company may opt for conversion of bonds into equity shares as this Notes
will result in increase in market price of share from Rs. 169 of Rs. 216.75.
IN-TEXT QUESTIONS
6. Given a level of EBIT, EPS will be same under different financing
mix depending upon the extent of debt financing.(True/False)
7. The EBIT-EPS analysis ignores as to what is the effect of
leverage on the overall risk of the firm. (True/False)
8. In the Debt-equity ratio the cash profits generated by the operations
are compared with the total cash required for the service of the
debt and the preference share capital (True/False)
9. The financial distress is a situation when a firm finds it difficult
to honour its commitment to the equity shareholders.
(True/False)
10. Value = Value (fall equity firm) + Present value of tax-shield
+ Present value of cost of financial distress. (True/False)
4.8 Summary
u The relationship between capital structures, cost of capital and
value of firm has been one of the most debated areas of financial
management.
u Factors determine capital structure are control, flexibility, characteristic
of company, profitability, cash flow ability, cost of capital, minimization
of risk, trading leverage.
u Two basic techniques available to study the impact of a particular
capital structure are (i) EBIT–EPS Analysis which studies the
impact of financial leverage on the EPS of the firm and (ii) Cash
Flow Analysis which emphasizes the liquidity required in view of
particular capital structure.
u Different accounting ratios such as interest coverage ratio and debt
service coverage ratio may be ascertained to find out the debt
capacity of the firm and the cash profit generated by the firm which
may be used to service the debt.
PAGE 129
Notes u The financial manager should also take care of the financial distress
which refers to the situation when the firm is not able to meet its
interest/repayment liabilities and may even face a closure.
1. Debt and Equity

2. (a) Minimum use of Leverage
3. Financial
4. Minimize
5. Long-term debt
6. False
7. True
8. False
9. False
10. False

1. Explain the factors relevant in determining the capital structure?
2. Explain the feature of EBIT-EPS analysis, cash flow analysis and
valuation models approach to determination of capital structure?
3. What is financial distress? Examine the effects of financial distress
on the value of firm?
4. Explain theories of capital structure?
5. What is optimal capital structure?
6. Give critical appraisal of the traditional approach and the Modigliani
– Miller Approach to the problem of capital structure?

130 PAGE
u Khan, M.Y. & Jain, P.K. (2011), Financial Management: Text, Problems Notes
u Maheshwari, S.N. (2019), Elements of Financial Management, Delhi:
u Maheshwari, S.N. (2019), Financial Management – Principles &
u Pandey, I.M. (2022), Essentials of Financial Management, Pearson.
Delhi: Taxmann, New Delhi, 6EC (1264)-03.02.2023.
Delhi: S. Chand.
PAGE 131
L E S S O N
5
Financing Decision: EBIT–
EPS Analysis
Smriti Chawla
STRUCTURE
5.2 Introduction
5.3 Constant EBIT with Different Financing Patterns
5.4 Varying EBIT with Different Financing Patterns
5.5 Financial break-even level
5.6 Indifference Break-even Level
5.7 Shortfalls in EBIT-EPS Analysis
5.8 Summary

u The different patterns of financing.
u The optimization of break-even level.
u The factors affecting different financial plans.
132 PAGE
5.2 Introduction Notes
The analysis of the effect of different patterns of financing or the

financial leverage on the level of returns available to the shareholders,
under different assumptions of EBIT is known as EBIT-EPS analysis. A
firm has various options regarding the combinations of various sources
to finance its investment activities. The firms may opt to be an all-equity
firm (and having no borrowed funds) or equity-preference firm (having
no borrowed funds) or any of the numerous possibility of combinations
of equity, preference shares and borrowed funds. However, for all these
possibilities, the sales level and the level of EBIT are irrelevant as the
pattern of financing does not have any bearing on the sales or the EBIT
level. In fact, the sales and the EBIT level are affected by the investment
decisions.
Given a level of EBIT, a particular combination of different sources of
finance will result in a particular EPS and therefore, for different financing
patterns, there would be different levels of EPS.
5.3 Constant EBIT With Different Financing Patterns

Holding the EBIT constant while varying the financial leverage or
financing patterns, one can imagine the firm increasing its leverage by
issuing bonds and using the proceeds to redeem the capital, or doing the
opposite to reduce leverage.
Suppose, ABC Ltd. which is expecting the EBIT of Rs. 1,50,000 per
annum on an investment Rs. 5,00,000, is considering the finalization of
the capital structure or the financial plan. The company has access to raise
funds of varying amounts by issuing equity share capital, 12% preference
share and 10% debenture or any combination thereof. Suppose, it analyzes
the following four options to raise the required funds of Rs. 5,00,000.
1. By issuing equity share capital at par.
2. 50% funds by equity share capital and 50% funds by preference
shares.
3. 5% funds by equity share capital, 25% by preference shares and 25%
by issue of 10% debentures.
PAGE 133
Notes 4. 25% funds by equity share capital, 25% as preference share and 50%
by the issue of 10% debentures.
Assuming that ABC Ltd. belongs to 50% tax bracket, the EPS under the
above four options can be calculated as follows:
Option 1 Option 2 Option 3 Option 4
Equity share capital Rs. 5,00,000 Rs. 2,50,000 Rs. 2,50,000 Rs. 1,25,000
Preference share capital --- 2,50,000 1,25,000 1,25,000
10% Debentures --- --- 1,25,000 2,50,000
Total Funds 5,00,000 5,00,000 5,00,000 5,00,000
EBIT 1,50,000 1,50,000 1,50,000 1,50,000
- Interest --- --- 12,500 25,000
Profit before tax 1,50,000 1,50,000 1,37,500 1,25,000
- Tax @ 50% 75,000 75,000 68,750 62,500
Profit after Tax 75,000 75,000 68,750 62,500
- Preference Dividend --- 30,000 15,000 15,000
Profit for Equity shares 75,000 45,000 53,750 47,500
No. of Equity shares (of 5000 2500 2500 1250
Rs. 100 each)
EPS (Rs.) 15 18 21.5 38
In this case, the financial plan under option 4 seems to be the best as
it is giving the highest EPS of S.38. In this plan, the firm has applied
maximum financial leverage. The firm is expecting to earn an EBIT of
Rs. 1,50,000 on the total investment of Rs. 5,00,000 resulting in 30%
return. On an after-tax basis, this return comes to 15% i.e., 30% × (1-.5).
However, the after tax cost of 10% debentures is 5% i.e., 10% (1- .5)
and the after tax cost of preference shares is 12% only. In the option 4,
the firm has employed 50% debt, 25% preference shares and 25% equity
share capital, and the benefits of employing 50% debt (which has after tax
cost of 5% only) and 25% preference shares (having cost of 12% only)
are extended to the equity shareholders. Therefore the firm is expecting
an EPS of Rs. 38.
In case, the company opts for all-equity financing only, the EPS is Rs. 15
which is just equal to the after tax return on investment. However, in
option 2, where 5% funds are obtained by the issue of 12% preference
shares, the 3% extra is available to the equity shareholders resulting in
134 PAGE
increase in of EPS from Rs. 15 to Rs. 18. In plan 3, where 10% debt Notes
is also introduced, the extra benefit accruing to the equity shareholders
increases further (from preference shares as well as from debt) and the EPS
further increases to Rs. 21.50. The company is expecting this increase in
EPS when more and more preference share and debt financing is availed
because the after tax cost of preference shares and debentures are less
than the after tax return on total investment.
Hence, the financial leverage has a favourable impact on the EPS-only if
the ROI is more than the cost of debt. It will rather have an unfavourable
effect if the ROI is less than the cost of debt. That is why financial
leverage is also called the twin-edged sword.
5.4 Varying EBIT with Different Financing Patterns

Suppose, there are three firm X & Co., Y & Co. and Z & Co. These
firms are alike in all respect except the leverage. The financial position
of the three firms is presented as follows:
Capital Structure X & Co. Y & Co. Z & Co.
Share Capital (of Rs. 100 each) Rs. 2,00,000 Rs. 1,00,000 Rs. 50,000
6% Debenture --- 1,00,000 1,50,000
Total 2,00,000 2,00,000 2,00,000
These firms are expected to earn a ROI at different levels depending
upon the economic conditions. In normal conditions, the ROI is expected
to be 8% which may fluctuate by 3% on either side on the occurrence
of bad economic conditions or good economic conditions. How return is
available to the shareholders of the three firms is going to be affected by
the variations in the level of EBIT due to differing economic conditions?
The relevant presentations have been shown as follows:
Poor Eco. Cond. Normal Eco. Cond. Good Eco. Cond.
Total Assets Rs. 2,00,000 Rs. 2,00,000 Rs. 2,00,000
ROI 5% 8% 11%
EBIT Rs. 10,000 Rs. 16,000 Rs. 22,000
X & Co. (No Financial Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000
- Interest --- --- ---
PAGE 135
Notes Profit before Tax 10,000 16,000 22,000

- Tax @ 50% 5,000 8,000 11,000
Profit After Tax 5,000 8,000 11,000
Number of Shares 2,000 2,000 2,000
EPS (Rs.) 2.5 4 5.5
Y & Co. (50% Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000
- Interest 6,000 6,000 6,000
Profit before Tax 4,000 10,000 16,000
- Tax @ 50% 2,000 5,000 8,000
Profit After Tax 2,000 5,000 8,000
Number of Shares 1,000 1,000 1,000
EPS (Rs.) 2 5 8
Z & Co. (75% Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000
- Interest 9,000 9,000 9,000
- Tax @ 50% 500 3,500 6,500
Profit After Tax 500 3,500 6,500
Number of Shares 500 500 500
EPS (Rs.) 1 7 13
On the basis of the figures given above, it may be analyzed as to how
the financial leverage affects the returns available to the shareholders
under varying EBIT level. For this purpose, the normal rate of return i.e.
8% and EPS of different firms in normal economic conditions, both may
be taken at 100 and position of other figures of EBIT and EPS may be
shown on relative basis as follows:
Poor Eco. Normal Eco. Good Eco.
Cond. Cond. Cond.
EBIT 62.5 100 137.5
X & Co.
EPS 62.5 100 137.5
% change from normal -37.5% --- +37.5%
Y & Co.
EPS 40 100 160
136 PAGE
% change from normal -60 --- +60% Notes

Z & Co.
EPS 14.3 100 185.7
% change from normal -85.7% --- +85.7%
It is evident from the above figures that when economic conditions
change from normal to good conditions, the EBIT level increases by
37.5% (i.e. from 8% to 11%). The firm X & Co. having no leverage, is
not able to have the magnifying effect of its EBIT and therefore its EPS
increases only by 37.5%. On the other hand the firm Y & Co. (having
50% leverage) is able to have an increase in EPS (from Rs. 5 to Rs.
8). Similarly, the firm Z & Co. (having still higher leverage of 75%) is
able to have an increase of 85.7% in EPS (from Rs. 7 to Rs. 13). Thus,
higher the leverage, greater is the magnifying effect on the EPS in case
when economic condition improves.
On the other hand just reverse is the situation in case when economic
conditions worsen and the EBIT level is reduced by 37.5% (i.e. from
8% ROI to 5% ROI). In this case the EPS of X & Co. reduces only
by 37.5% (from Rs. 4 to Rs. 2.5) whereas the EPS of Y & Co. (50%
leverage) reduces by 60% (from Rs. 5 to Rs. 2). In case of Z & Co. the
decrease is more pronounced and EPS reduces by 85.7% (from Rs. 7 to
Rs. 13). Thus, higher the leverage, greater is the magnifying effect on
the EPS in case when the economic conditions improve.
On the other hand, just reverse is the situation in case when the economic
conditions worsen and the EBIT level reduced by 37.5%) i.e. from 8%
ROI to 5% ROI). In this case, the EPS of X & Co. reduces only by 37.5%
(from Rs. 4 to Rs. 2.5), whereas the EPS of Y & Co. (50% leverage)
reduces by 60% (from Rs. 5 to Rs. 2). In case of Z & Co. the decrease
is more pronounced and EPS reduces by 85.7% (from Rs. 7 to Re.1).
5.5 Financial Break-Even Level

In case the EBIT level of a firm is just sufficient to cover the fixed
financial charges then such level of EBIT is known as financial break-
even level. The financial break-even level of EBIT may be calculated
as follows:
PAGE 137
Notes If the firm has employed debt only (and no preference shares), the
financial break-even EBIT level is:
Financial break-even EBIT = Interest Charge
If the firm has employed debt as well as preference share capital, then
its financial breakeven EBIT will be determined not only by the interest
charge but also by the fixed preference dividend. It may be noted that
the preference dividend is payable only out of profit after tax, whereas
the financial break-even level is before tax. The financial break-even
level in such a case may be determined as follows:
Financial break-even EBIT = Interest Charge + Pref. Div./(1-t)
IN-TEXT QUESTIONS
1. The analysis of the effect of different patterns of financing or
the financial leverage on the level of returns available to the
shareholders, under different assumptions of EBIT is known
as___________.
2. A firm is expected to earn a same ROI even in the different
economic conditions if it has same EBIT.(True/False)
3. Where EBIT level of a firm is just sufficient to cover the
fixed financial charges then such level of EBIT is known as
_____________.
5.6 Indifference Break-Even Level

The indifference level of EBIT is one at which the EPS remains same
irrespective of the debt equity mix. While designing a capital structure,
a firm may evaluate the effect of different financial plans on the level of
EPS, for a given level of EBIT. Out of several available financial plans,
the firm may have two or more financial plans which result in the same
level of EPS for a given EBIT. Such a level of EBI at which the firm
has two or more financial plans resulting in same level of EPS, is known
as indifference level of EBIT.
The use of financial break-even level and the return from alternative
capital structures is called the indifference point analysis. The EBIT is
used as a dependent variable and the EPS from two alternative financial
plans is used as independent variable and the exercise is known as
138 PAGE
indifference point analysis. The indifference level of EBIT is a point at Notes

which the after tax cost of debt is just equal to the ROI. At this point
the firm would be indifferent whether the funds are raised by the issue
of debt securities or by the issue of share capital. The following example
will illustrate this point.
Suppose, PQR & Co. is expecting an EBIT of Rs. 55,00,000 after
implementing the expansion plan for Rs. 50,00,000. The funds requirements
needed to implement the plan can be raised either by the issue of further
equity share capital at an issue price of Rs. 5,000 each, or by the issue
of 10% debenture. Find out the EPS under these two alternative plans
if the existing capital structure of the firm stands at 10,000 shares. The
above situation can be analyzed as follows:
Financial Plan 1 Financial Plan 2
Number of existing shares 10,000 10,000
Number of new shares 1,000 ---
Total Number of shares 11,000 10,000
10% Debenture --- Rs. 50,00,000
EBIT (given) Rs. 55,00,000 Rs. 55,00,000
- Interest --- 5,00,000
Profit before Tax 55,00,000 50,00,000
Tax @ 50% 27,50,000 25,00,000
Profit after Tax 27,50,000 25,00,000
EPS (Rs.) 250 250
So, at the EBIT level of Rs. 55,00,000, the EPS is expected to be
Rs. 250 irrespective of the fact whether the additional funds are raised
by the issue of equity share capital or by the issue of 10% debt. This
EBIT level of Rs. 55,00,000 is known as the indifference level of EBIT.
However, in case the company is expecting EBIT of Rs. 50,00,000 or
Rs. 60,00,000, the EPS for both the financial plans has been calculated
in the following table.
Financial Plan 1 Financial Plan 2
EBIT Rs. 50,00,000 Rs. 60,00,000 Rs.50,00,000 Rs. 60,00,000
- Interest --- --- 5,00,000 5,00,000
Profit before Tax 50,00,000 60,00,000 45,00,000 55,00,000
Tax @ 50% 25,00,000 30,00,000 22,50,000 27,50,000
Profit after Tax 25,00,000 30,00,000 22,50,000 27,50,000
Number of Equity shares 11,000 11,0000 10,000 10,000
EPS (Rs.) 227 272 225 275
PAGE 139
Notes The above figures show that for an EBIT level below the indifference
level of Rs. 55,00,000, the EPS is lower at Rs. 225 in case of leveraged
option (i.e., debt financing) than the EPS of unleveraged option of
Rs. 227. However, if the EBIT is higher than the indifference level, then
the EPS is higher at Rs. 275 in case of levered option than the EPS of
Rs. 272 under unlevered option.
If the firm expects to generate exactly the same amount of EBIT at which
the EBIT-EPS lines intersect, ten from the point of view of the equity
shareholders, the firm would be indifferent as to choice of capital structure
because the same EPS would result from either of the alternatives.
IMAGE
Figure shows that if the firm MATTER
expects the EBIT at a level higher than the
indifference level, plan I is better and the EPS will be higher than EPS
EPS (Rs.) under plan II. However, if the expected level of EBIT is less than the
Plan I indifference level of EBIT, than plan II is better as the EPS under plan
II will be higher. It is only in such a situation when the expected EBIT
Plan II is just equal to the indifference level of EBIT that the EPS under both
the plans would be same.
EBIT (Rs.)
The EBIT-EPS line or a particular financial plan also shows the financial
Indifferencebreak
level even
of Ebit
level of EBIT. The intercepts on the horizontal axis OA (in
case of plan II) and OB (in case of plan I) are the financial break-even
level of EBIT under respective financial plans.
Figure shows that if the firm expects the EBIT at a level higher than the indifference level
plan I is better and the EPS will be higher than EPS under plan II. However, if the expected
level of EBIT is less than the indifference level of EBIT, than plan II is better as the EPS
140 PAGE
under plan II will be higher. It is only in such a situation when the expected EBIT is jus
equal to the indifference
Schoollevel of EBIT
of Open thatUniversity
Learning, the EPSofunder
Delhi both the plans would be same.
The EBIT-EPS line or a particular financial plan also shows the financial break even level o
EBIT. The intercepts on the horizontal axis OA (in case of plan II) and OB (in case of plan I
are the financial breakeven level of EBIT under respective financial plans.
5.7 Shortfalls in EBIT-EPS Analysis Notes
EBIT-EPS analysis helps in making a choice for a better financial plan.

However, it may have two complications namely:
If neither of the two mutually exclusive alternative financial plans involves
issue of new equity shares, then no EBIT indifference point will exist.
For example, a firm has a capital consisting of 1,00,000 equity shares
and wants to raise Rs. 10,00,000 additional funds for which the following
two plans are available: (i) to issue 10% bonds of Rs. 10,00,000, or (ii)
to issue 12% preference shares of Rs. 100 each. Assuming tax rate to be
50% the indifference level of EBIT for the two plans would be as follows:
(EBIT – 1,00,000) (1 - .5)/1,00,000 = EBIT (1 - .5) – 1,20,000
.5 EBIT – 50,000 = 5 EBIT – 1,20,000
= - 70,000
So, there is an inconsistent result and it indicates that there is no
indifference point of EBIT. If the EBIT-EPS lines of these two plans
are drawn graphically, these will be parallel and no intersection point
will emerge.
Sometimes, a given set of alternative financial plans may give negative
EPS to cause an indifference level of EBIT. For example, a firm having
1,00,000 equity shares already issued, requires additional funds of
Rs.10,00,000 for which the following two options are available: (i) to
issue 20,000 equity shares of Rs. 25 each and to raise to Rs. 5,00,000
by the issue of 9% bonds, or (ii) to issue 30,000 equity shares at Rs. 25
each and to issue 2,500 12% preference shares of Rs. 100 each. Assuming
the tax rate to be 50%, the indifference level of EBIT for the two plans
would be as follows:
(EBIT − 45, 000) (1 − 5) EBIT (1 − .5) − 30, 000
= = EBIT = Rs. − 1,35, 000
1, 20, 000 1,30, 000
So, the indifference point occurs at a negative value of EBIT, which is
imaginary.
IN-TEXT QUESTIONS
4. The indifference level of EBIT is one at which the___________
remains same irrespective of the debt equity mix.
PAGE 141
Notes 5. The use of financial break-even level and the return from
alternative capital structures is called the __________________.
5.8 Summary
u EBIT-EPS Analysis is another way of looking at the effects of
different types of capital structures. EBIT –EPS Analysis considers
the effect on EPS under different types of capital mix.
u Given a level of EBIT particular combination of different sources
will result in a particular level of EPS, and therefore for different
financing patterns, there would be different levels of EPS.
u Financial break-even level of EBIT is that level of EBIT at which
EPS of a firm is zero.
u Indifference level of EBIT is one at which the EPS remains same
under two different financial plans. At the difference level of EBIT,
the firm would be indifferent whether funds are raised by one capital
mix or other both will have same level of EPS.
1. EBIT-EPS analysis
2. False
3. Financial Break-even level.
4. EPS
5. Indifference point analysis

1. What is EBIT –EPS Analysis? How is it different from leverage
analysis?
2. Examine effects of change in EBIT of a firm on the EPS under (i)
same capital structure and (ii) different capital structure?
3. What are the shortcomings if any of the EBIT–EPS Analysis?
142 PAGE
Delhi: Taxmann, New Delhi, 6EC (1264)-03.02.2023
Delhi: S. Chand.
PAGE 143
L E S S O N
6
Financing Decision –
Leverage Analysis
Smriti Chawla
STRUCTURE

6.2 Introduction
6.3 Operating Leverage
6.4 Significance of Operating Leverage
6.5 Financial Leverage
6.6 Combined Leverage
6.7 Illustrations in Leverage Analysis
6.8 Summary

u The meaning of leverage.
u Different types of leverage.
u Calculation of the leverage.
144 PAGE
The term leverage, in general, refers to a relationship between two

interrelated variables. With reference to a business firm, these variables
may be costs, output, sales revenue, EBIT, Earnings Per Share (EPS) etc.
In financial analysis, the leverage reflects the responsiveness or influence
of one financial variable over some other financial variable.
The leverage may be defined as the % change in one variable divided
by the % change in some other variable or variables. Impliedly, the
numerator is the dependent variable, say X, and the denominator is the
independent variable, say Y. The leverage analysis thus, reflects as to how
responsiveness is the dependent variable to a change in the independent
variables. Algebraically, the leverage may be defined as:
% Change in dependent veriable
Leverage =
% Change in independent veriable
For example, a firm increased its sales promotion expenses from Rs. 5,000
to Rs. 6,000 i.e., an increase of 20%. This resulted in the increase in
number of unit sold from 200 to 300 i.e. an increase of 50%. The leverage
between the sales promotion expenses and the number of units sold may
be defined as:
% Change in units sold
Leverage =
% Change in Sales Promotion expenses
50
= 2.5
20
This means that % increase in number of unit sold is 2.5 times that of
% increase in sales promotion expenses. The operating profit of a firm
is a direct consequence of the sales revenue of the firm and in turn the
operating profit determines of profit available to the equity shareholders.
The functional relationship between the sales revenue and the EPS can
be established through operating profits (EBIT) as follows:
Sales Revenue EBIT Less Internet

Less Variable Profit before tax
costs Contribution Less Tax Profit
Less fixed Cost after tax
EBIT
PAGE 145
Notes The left hand side of the above presentation shows that the level of
EBIT depends upon the level of sales revenue and the right hand side
of the above presentation shows that the level of profit after tax or EPS
depends upon the level of EBIT. The relationship between sales revenue
and EBIT is defined as operating leverage and the relationship between
EBIT and EPS is defined as financial leverage. The direct relationship
between the sales revenue and the EPS can also be established by the
combining the operating leverage and financial leverage and is defined
as combined leverage.
6.3 Operating Leverage

The operating leverage measures the relationship between the sales revenue
and the EBIT. It measures the effect of change in sales revenue on the
level of EBIT. Hence, the operating leverage is calculated by dividing
the % change in EBIT by the % change in sales revenue.
% Change in EBIT
Operating Leverage =
% Change in Sales revenue

For example, ABC Ltd. sells 1000 unit @ Rs.10 per unit. The cost of
production is Rs. 7 per unit and the whole of the cost is variable in nature.
The profit of the firm is 1,000 × (Rs. 10 – Rs. 7) = Rs. 3,000. Suppose,
the firm is able to increase its sales level by 40% resulting in total sales
of 1400 units. The profit of the firm would now be 1400 × (Rs.10 – Rs.7)
= Rs. 4200. The operating leverage of the firm is
% Change in EBIT
Operating Leverage =
% Change in Sales revenue

= Increase in EBIT/EBIT/ Increase in Sales/ Sales
Rs.1200 ÷ Rs. 3000
Rs. 4000 ÷ Rs.10, 000 = 1
The Operating Leverage of 1 denotes that the EBIT level increases or

decreases in direct proportion to the increase or decrease in sales level.
This is due to fact that there are no fixed costs and total cost is variable
in nature.
Whenever, the % change in EBIT resulting from given % change in sales
is greater than the % change in sales, the OL exists and the relationship
146 PAGE
is known as the DOL (Degree of Operating Leverage). This means that Notes
as long as the DOL is greater than 1, there is an OL. The OL emerges as
result of existence of fixed element in the cost structure of the firm. The
OL, therefore, may be defined as firm’s position or ability to magnify the
effect of change in sales over the level of EBIT. The level of fixed costs,
which is instrumental in bringing this magnifying effect, also determines
the extent of this effect. Higher the level of fixed costs in relation to
variable costs, greater would be the DOL. The DOL may, at any particular
sales volume, also be calculated as a ratio of contribution to the EBIT.
Degree of Operating Leverage = Contribution/EBIT
Thus, on the basis of the above analysis, the OL may be interpreted as
follows:
1. The OL is the % change in EBIT as a result of 1% change in sales.
OL arises as a result of fixed cost in the cost structure. If there is
no fixed cost, there will be no OL and the % change in EBIT will
be same as % change in sales.
2. A positive DOL means that the firm is operating at a level higher
than the break-even level and both the EBIT and sales will vary
in the same direction.
3. A negative DOL means that the firm is operating at a level lower
than the break-even level; and the EBIT will be negative.
6.4 Significance of Operating Leverage

Operating Leverage explains the effect of change in sales on EBIT.
When there is high operating leverage, a small rise in sales will result
in a larger rise in EBIT. But if there is small drop in sales, EBIT will
fall dramatically or may even be wiped off. Thus, existence of high
operating leverage reflects high-risk situation. As the operating leverage
reaches its maximum near break even point, the firm can protect itself
from the dangers of operating leverage and the consequent operating risk
by operating sufficiently above the break even point.
PAGE 147
Notes 6.5 Financial Leverage

The Financial Leverage (FL) measures the relationship between the EBIT
and the EPS and it reflects the effect of change in EBIT on the level
of EPS. The FL measures the responsiveness of the EPS to a change in
EBIT and is defined as the % change in EPS divided by the % change
in EBIT. Symbolically,
% Change in EPS
Financial Leverage =
% Change in EBIT
= Increase in EPS ÷ EPS/Increase in EBIT ÷ EBIT

Hence, the FL may be defined as a % increase in EPS that is associated
with a given % increase in the level of EBIT. The increase in EPS of the
firm may be more than proportionate for increase in the level of EBIT. In
other words, the effect of increase or decrease in EBIT is magnified on
the level of EPS. The existence of fixed financing charge is instrumental
to bring this magnifying effect and also determines the extent of this
effect. Higher the level of fixed financial charge, greater would be the
FL. The FL may also be defined as:
EBIT EBIT
Financial Leverage = =
EBIT − Financial Charge PBT
On the basis of above analysis, the Financial Leverage can be interpreted

as:
(a) The Financial Leverage is a % change in EPS as result of 1%
change in EBIT. The FL emerges as a result of fixed financial cost
(in the form of interest and preference dividend). If there is no
fixed financial liability, there will be no FL. In such a case the %
change in EPS will be same as % change in EBIT.
(b) A positive FL means that the firm is operating at a level of EBIT
which is higher than the financial break-even level and both
the EBIT and EPS will vary in the same direction as the EBIT
changes.
(c) A negative FL means that the firm is operating at a level lower
than the financial breakeven level and the EPS will be negative.
148 PAGE
6.6 Combined Leverage Notes
The Combined Leverage (CL) is not a distinct type of leverage analysis:

rather it is a product of the OL and the FL. The CL may be defined as
the % change in EPS for a given % change in the sales level and may
be calculated as follows:
Combined Leverage = Operating Leverage x Financial Leverage
= % Change in EPS / % Change in sales
The Combined Leverage is interpreted as:
(a) The Combined Leverage is the % change in EPS resulting from a
1% change in sales level.
(b) A positive CL means that the leverage is being computed for a
sales level higher than the break even level and both the EPS and
sales will vary in the same direction.
(c) A negative CL means that the leverage is being calculated for a
sales level lower than the financial break even level and EPS will
be negative.
IN-TEXT QUESTIONS
1. The _________ reflects the responsiveness or influence of one
financial variable over some other financial variable.
2. The leverage may be defined as the % change in one variable
divided by the % change in some other variable or variables.
(True/False)
3. The relationship between sales revenue and EBIT is _____________.
4. The relationship between EBIT and EPS is ____________.
5. The direct relationship between the sales revenue and the EPS
is _____________.
6.7 Illustrations in Leverage Analysis

Illustration 1: Calculate the Degree of Operating Leverage (DOL), Degree
of Financial Leverage (DFL) and the Degree of Combined Leverage
(DCL) for the following firms and interpret the results.
PAGE 149
Notes Firm A Firm B Firm C

Output (units) 60,000 15,000 1,00,000
Fixed Cost (Rs.) 7,000 14,000 1,500
Variable cost per unit (Rs.) 0.20 1.50 0.02
Interest on borrowed funds 4,000 8,000 ---
Selling price per unit (Rs.) 0.60 5.00 0.10
Solution:
Firm A Firm B Firm C
Output (units) 60,000 15,000 1,00,000
Selling price per unit (Rs.) 0.60 5.00 0.10
Variable cost per unit (Rs.) 0.20 1.50 0.02
Contribution per unit 0.40 3.50 0.08
Total Contribution Rs. 24,000 Rs. 52,500 Rs. 8,000
Less fixed costs 7,000 14,000 1,500
EBIT 17,000 38,500 6,500
Less Interest 4,000 8,000 ---
Degree of Operating Leverage

Contribution/EBIT 24,000/17,000 52,500/38,500 8,000/6,500
= 1.41 =1.36 = 1.23
Degree of Financial Leverage
EBIT/PBT 17,000/13,000 38,500/30,500 6,500/6,500
= 1.31 = 1.26 = 1.00
Degree of Combined Leverage
Contribution/ EBT 24,000/13,000 52,500/30,500 8,000/6,500
= 1.85 = 1.72 = 1.23
Illustration 2: A firm has sales of Rs. 10,00,000, variable cost of Rs.
7,00,000 and fixed costs of Rs. 2,00,000 and debt of Rs. 5,00,000 at 10%
rate of interest. What are the operating, financial and combined leverages.
If the firm wants to double its Earnings Before Interest and Tax (EBIT),
how much of a rise in sales would be needed on a percentage basis?
150 PAGE
Solution: Notes
Statement of Existing Profit
Sales Rs. 10,00,000
Less Variable cost 7,00,000
Contribution 3,00,000
Less fixed cost 2,00,000
EBIT 1,00,000
Less Interest @ 10% on 5,00,000 50,000
Profit before Tax 50,000
Less Tax -
Profit after Tax 50,000
Operating leverage Contribution/EBIT = 3,00,000/1,00,000 = 3
Financial Leverage EBIT/PBT = 1,00,000/50,000 = 2
Combined Leverage = 3 × 2=6
Statement of sales needed to double EBIT
Operating Leverage is 3 times i.e. 33 – 1/3% increase in sales volume
causes a 100% increase in operating profit or EBIT. Thus, at the sales
of Rs. 13,33,333, operating profit or EBIT will become Rs. 2,00,000 i.e.
double existing one.
Verification:
Sales Rs. 13,33,333
Variable Cost (70%) 9,33,333
Fixed Cost 2,00,000
EBIT 2,00,000
Illustration 3: The balance sheet of well Established Company is as
follows:
Liabilities Amount Assets Amount
Equity share capital 60,000 Fixed Assets 1,50,000
Retained Earnings 20,000 Current Assets 50,000
10% long term debt 80,000
Current Liabilities 40,000 ------------
2,00,000 2,00,000
PAGE 151
Notes The company’s total assets turnover ratio is 3, its fixed operating costs
are Rs. 1,00,000 and its variable operating cost ratio is 40%. The income
tax rate is 50%. Calculate the different types of leverages given that the
face value of share is Rs. 10.
Solution: Total Assets Turnover Ratio = Sales / Total Assets
3 = Sales/2,00,000
Sales 6,00,000
Variable Operating Cost (40%) 2,40,000
Less Fixed Operating Cost 1,00,000
EBIT 2,60,000
Less interest (10% of 80,000) 8,000
PBT 2,52,000
Tax at 50% 1,26,000
PAT 1,26,000
Number of shares 6,000
EPS Rs. 21
Degree of Operating Leverage = Contribution/EBIT
= 3,60,000/2,60,000 = 1.38
Degree of Financial leverage = EBIT/PBT
= 2,60,000/2,52,000 = 1.03
Degree of Combined Leverage = 1.38 × 1.03 = 1.42
Illustration 4: The following information is available for ABC & Co.
EBIT Rs. 11,20,000
Profit before Tax 3,20,000
Fixed Costs 7,00,000
Calculate % change in EPS if the sales are expected to increase by 5%.
Solution: In order to find out the % change in EPS as a result of %
change in sales, the combined leverage should be calculated as follows:
Operating Leverage = Contribution/ EBIT
= Rs. 11,20,000 + Rs. 7,00,000/11,20,000
= 1.625
Financial Leverage = EBIT/Profit before Tax
= Rs. 11,20,000/3,20,000
= 3.5
152 PAGE
Combined Leverage = Contribution/ Profit before Tax = OL × FL Notes

= 1.625 × 3.5 = 5.69
The combined leverage of 5.69 implies that for 1% change in sales level,
the % change in EPS would be 5.69% so, if the sales are expected to
increase by 5%, then the % increase in EPS would be 5 x 5.69 = 28.45%.
Illustration 5: The data relating to two companies are as given below:
Company A Company B
Capital Rs. 6,00,000 Rs. 3,50,000
Debentures Rs. 4,00,000 6,50,000
Output (units) per annum 60,000 15,000
Selling price/unit Rs. 30 250
Fixed cost per annum 7,00,000 14,00,000
Variable cost per unit 10 75
You are required to calculate the Operating leverage, Financial leverage
and Combined Leverage of two companies.
Solution: Computation of Operating Leverage, Financial Leverage
and Combined Leverage
Company A Company B
Output (unit) per annum 60,000 15,000
Selling price/unit Rs. 30 250
Sales Revenue 18,00,000 37,50,000
Less variable cost
@ Rs. 10 and Rs.75 6,00,000 11,25,000
Contribution 12,00,000 26,25,000
Less fixed costs 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less Interest @ 12%
On debentures 48,000 78,000
PBT 4,52,000 11,47,000
DOL = Contribution/EBIT 12,00,000/5,00,000 26,25,000/12,25,000
= 2.4 = 2.14
DFL = EBIT/PBT 5,00,000/4,52,000 12,25,000/11,47,000
= 1.11 = 1.07
DCL = DOL x DFL 2.4 × 1.11 = 2.66 2.14 × 1.07 = 2.28
PAGE 153
Notes Illustration 6: X Corporation has estimated that for a new product its
break-even point is 2,000 units if the item is sold for Rs. 14 per unit, the
cost accounting department has currently identified variable cost of Rs.
9 per unit. Calculate the degree of operating leverage for sales volume
of 2,500 units and 3,000 units. What do you infer from the degree of
operating leverage at the sales volume of 2,500 units and 3,000 units
and their difference if any?
Solution:
Statement of Operating Leverage
Particulars 2500 units 3000 units
Sales @ Rs. 14 per unit 35,000 42,000
Variable cost 22,500 27,000
Contribution 12,500 15,000
Fixed Cost (2,000 x Rs. 14-9) 10,000 10,000
EBIT 2,500 5,000
Operating Leverage
= Contribution/ EBIT 12,500/2,500 15,000/5,000
= 5 = 3
Illustration 7: The following data is available for XYZ Ltd.
Sales Rs. 2,00,000
Less: Variable cost 60,000
Fixed Cost 1,00,000
EBIT 40,000
Less Interest 5,000
Profit before tax 35,000
Find out:
(a) Using concept of financial leverage, by what percentage will the
taxable income increase, if EBIT increases by 6%
(b) Using the concept of operating leverage, by what percentage will
EBIT increase if there is 10% increase in sales and,
(c) Using the concept of leverage, by what percentage will the taxable
income increase if the sales increase by 6%. Also verify the results
in view of the above figures.
154 PAGE
Solution: Notes
(i) Degree of Financial Leverage:

FL = EBIT/Profit before Tax = 40,000/35,000 = 1.15
If EBIT increases by 6%, the taxable income will increase by 1.15
x 6 = 6.9% and it may be verified as follows:
EBIT (after 6% increase) Rs. 42,400
Less Interest 5,000
Profit before Tax 37,400
Increase in taxable income is Rs. 2,400 i.e. 6.9% of Rs. 35,000

(ii) Degree of Operating Leverage:

OL = Contribution / EBIT = 1,40,000/40,000 = 3.50
If sale increases by 10%, the EBIT will increase by 3.50 × 10 =
35% and it may be verified as follows:
Sales (after 10% increase) Rs. 2,20,000
Less variable expenses @ 30% 66,000
Less Fixed cost 1,00,000
EBIT 54,000
Increase in EBIT is Rs. 14,000 i.e. 35% of Rs. 40,000

(iii) Degree of Combined leverage:

CL = Contribution/ Profit before tax = 1,40,000/35,000 = 4
If sales increases by 6%, the profit before tax will increase by 4×6=
24% and it may be verified as follows:
Sales (after 6% increase) Rs. 2,12,000
Less Variable expenses@ 30% 63,600
Less Fixed cost 1,00,000
EBIT 48,400
Less Interest 5,000
Profit before tax 43,400
Increase in Profit before tax is Rs. 8,400 i.e. 24% of Rs. 35,000
PAGE 155
Notes 6.8 Summary

u In Leverage analysis the relationship between two interrelated variables
is established. In financial management Operating leverage, Financial
leverage and Combined Leverage is calculated.
u The Operating relationship establishes the relationship between
Sales and EBIT. It measures the effect of change in sales revenue
on the level of EBIT. Operating leverage appears as a result of
fixed cost.
u The Financial leverage measures the responsiveness of the EPS for
given change in EBIT.
u The Financial leverage appears as a result of fixed financial charge
i.e. interest and preference dividend.
u Combined leverage may also be ascertained to measures the % change
in EPS for a % change in the sales.
1. Leverage
2. True
3. Operating Leverage
4. Financial Leverage
5. Combined Leverage

1. Distinguish between operating leverage and financial leverage. How
the two leverages can be measured?
2. Explain the concept of financial leverage. Examine the impact of
financial leverage on the EPS. Does the financial Leverage always
increases the EPS?
156 PAGE
Delhi: Taxmann, New Delhi: 6EC (1264)-03.02.2023
Delhi: S. Chand.
PAGE 157
UNIT - IV
PAGE 159
L E S S O N
1
Dividend Decision and
Valuation of the Firm
Smriti Chawla
STRUCTURE
1.2 Introduction
1.3 Concept and Significance
1.4 Dividend Decision and Valuation of Firms
1.5 Illustrations
1.6 Summary

u The concept of Dividend.
u Various concepts of dividend.
u Different approaches of dividend calculation.
1.2 Introduction
The term dividend refers to that profits of a company which is distributed by a company
amongst its shareholders. It is the reward given the shareholders for investments made by
them in the shares of the company. A company may have preference share capital as well
as equity share capital and dividends may be paid on both types of capital. The investors
are interested in earning the maximum return on their investments and to maximize their
PAGE 161
Notes wealth on the other hand, a company needs to provide funds to finance
its long-term growth. If a company pays out as dividend most of what it
earns, then for Business requirements and further expansion it will have
to depend upon external finance such as issue of debt or a new shares.
Dividend policy of a firm, thus affects both long-term financing and
wealth of shareholders.
1.3 Concept and Significance

The dividend decision is one of the three basic decisions which a financial
manager may be required to take, the other two being the investment
decisions and the financing decisions. In each period any earning that
remains after satisfying obligations to the creditors, the government and the
preference shareholders can either be retained or paid out as dividends or
bifurcated between retained earnings and dividends. The retained earnings
can then be invested in assets which will help the firm to increase or at
least maintain its present rate of growth.
In dividend decision, a financial manager is concerned to decide one or
more of the following:
- Should the profits be ploughed back to finance the investment
decisions?
- Whether any dividend be paid? If yes, how much dividend be paid?
- When these dividend be paid? Interim or final.
- In what form the dividend be paid? Cash dividend or Bonus shares.
All these decisions are inter-related and have bearing on the future growth
plans of a firm. If a firm pays dividend it affects the cash flow position
of the firm but earns the goodwill among investors who therefore may be
willing to provide additional funds for financing of investment plans of
firm. On the other hand, the profits which are not distributed as dividends
become an easily available source of funds at no explicit costs.
However, in case of ploughing back of profits, the firm may loose the
goodwill and confidence of the investors and may also defy the standards
set by other firms. Therefore, in taking dividend decision, the financial
manager has to consider and analyse various factors. Every aspects of
dividend decision is to be critically evaluated. The most important of
162 PAGE
these considerations is to decide as to what portion of profit should be Notes

distributed which is also known as dividend payout ratio.
1.4 Dividend Decision and Valuation of Firms

The value of the firm can be maximized if the shareholders wealth is
maximized. There are conflicting views regarding the impact of dividend
decision on valuation of the firm. According to one school of thought,
dividend decision does not affect shareholders wealth and hence the
valuation of firm. On other hand, according to other school of thought
dividend decision materially affects the shareholders wealth and also
valuation of the firm. We have discussed below the views of two schools
of thought under two groups:
1. The Relevance Concept of Dividend a Theory of Relevance.
2. The Irrelevance Concept of Dividend or Theory of Irrelevance.
1.4.1 The Relevance Concept of Dividend

This school of thought include Myron Gordon, James Walter and
Richardson. According to them dividends communicate information to
the investors about the firm’s profitability and hence dividend decision
becomes relevant. Those firms which pay higher dividends will have
greater value as compared to those which do not pay dividends or have
a lower dividend pay out ratio. It holds that dividend decisions affect
value of the firm.
We have examined below two theories representing this notion: (i) Walter’s
Approach and (ii) Gordon’s Approach.
u Walter’s Approach: Walter’s model is based upon the relationship
between the firms (a) return on investment i.e. r and (b) the cost
of capital or required rate of return i.e. k.
According to Prof. Walter, If r > k i.e. if the firm earns a higher rate
of return on its investment than the required rate of return, the firm
should retain the earnings. Such firms are termed as growth firm’s
and the optimum pay-out would be zero which would maximize
value of shares.
PAGE 163
Notes In case of declining firms which do not have profitable investments

i.e. where r < k, the shareholder would stand to gain if the firm
distributes it earnings. For such firms, the optimum payout would
be 100% and the firms should distribute the entire earnings as
dividend.
In case of normal firms where r-k the dividend policy will not affect
the market value of shares as the shareholders will get the same
return from the firm as expected by them. For such firms, there is
no optimum dividend payout and value of firm would not change
with the change in dividend rate.
Assumptions of Walter’s model

(i) Perpetual life of a firm.
(ii) Earnings and dividends do not change while determining the
value.
(iii) The Internal rate of return (r) and the cost of capital (k) of
the firm are given and assumed to be constant.
(iv) The investments of the firm are financed through retained
earnings only and the firm does not use external sources of
funds.
Walter’s formula for determining the value of share
D r ( E − D) / K e
P= +
K e Ke
Where P = Market price per share
D = Dividend per share
r = Internal rate of return
E = Earnings per share
ke = Cost of equity capital.
Criticism of Walter’s Model

Walter’s model has been criticised on account of various assumptions
made by Prof Walter in formulating his hypothesis.
(i) The basic assumption that investments are financed through
retained earnings only is seldom true in real world. Firms do
raise fund by external financing.
164 PAGE
(ii) The internal rate of return i.e. (r) also does not remain constant. Notes
As a matter of fact, with increased investment the rate of
return also changes.
(iii) The assumption that cost of capital (k) will remain constant
also does not hold good. As a firm’s risk pattern does not
remain constant, it is not proper to assume that (k) will always
remain constant.
u Gordon’s Approach: Another theory which contends that dividends
are relevant is Gordon’s model. This model which opinions that
dividend policy of a firm affects its value is based on following
assumptions:
1. The firm is an all equity firm. No external financing is used
and investment programmes are financed exclusively by
retained earnings.
2. r and ke are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the
growth rate, (g=br) is also constant.
5. ke > br
Gordon argues that the investors do have a preference for current
dividends and there is a direct relationship between the dividend policy
and the market value of share. His model is build upon the premise that
investors are basically risk averse and they evaluate the future dividend/
capital gains as a risky and uncertain proposition. Investors are certain
of receiving incomes from dividend than from future capital gains. The
incremental risk associated with capital gains implies a higher required
rate of return for discounting the capital gains than for discounting the
current dividends. In other words, an investor values current dividends
more highly than an expected future capital gain.
Hence, the “bird-in-hand” argument of this model suggests that dividend
policy is relevant, as investors prefer current dividends as against the future
uncertain capital gains. When investors are certain about their returns
they discount the firm’s earnings at lower rate and therefore placing a
higher value for share and that of firm. So, the investors require a higher
PAGE 165
Notes rate of return as retention rate increases and this would adversely affect
share price.
Symbolically:
E (1 − b)
P=
K e − br
where P = Market price of equity share
E = Earnings per share of firm
b = Retention Ratio (1 – payout ratio)
r = Rate of Return on Investment of the firm. Ke = Cost of equity
share capital
br = g i.e. growth rate of firm
1.4.2 The Irrelevance Concept of Dividend

The other school of thought on dividend policy and valuation of the firm
argues that what a firm pays as dividends to share holders is irrelevant
and the shareholders are indifferent about receiving current dividend in
future. The advocates of this school of thought argue that dividend policy
has no effect on market price of share. Two theories have been discussed
here to focus on irrelevance of dividend policy for valuation of the firm
which are as follows:
u Residual Approach
According to this theory, dividend decision has no effect on the wealth of
shareholders or the prices of the shares and hence it is irrelevant so far
as valuation of firm is concerned. This theory regards dividend decision
merely as a part of financing decision because earnings available may
be retained in the business for reinvestment. But if the funds are not
required in the business they may be distributed as dividends. Thus, the
decision to pay dividend or retain the earnings may be taken as residual
decision. This theory assumes that investors do not differentiate between
dividends and retentions by firm. Their basic desire is to earn higher
return on their investment. In case the firm has profitable opportunities
giving higher rate of return than cost of retained earnings, the investors
would be content with the firm retaining the earnings to finance the same.
166 PAGE
However, if the firm is not in a position to find profitable investment Notes

opportunities, the investors would prefer to receive the earnings in the
form of dividends. Thus, a firm should retain earnings if it has profitable
investment opportunities otherwise it should pay them as dividends.
Under the Residuals theory, the firm would treat the dividend decision
in three steps:
u Determining the level of capital expenditures which is determined
by the investment opportunities.
u Using the optimal financing mix, find out the amount of equity
financing need to support the capital expenditure in step (i) above.
u As the cost of retained earnings kr is less than the cost of new equity
capital, the retained earnings would be used to meet the equity
portions financing in step (ii) above. If available profits are more
than this need, then the surplus may be distributed as dividends of
shareholder. As far as the required equity financing is in excess of
the amount of profits available, no dividends would be paid to the
shareholders.
Hence, in residual theory the dividend policy is influenced by (i) the
company’s investment opportunities and (ii) the availability of internally
generated funds, where dividends are paid only after all acceptable
investment proposals have been financed. The dividend policy is totally
passive in nature and has no direct influence on the market price of the
share.
u Modigliani and Miller Approach (MM Model)
Modigliani and Miller have expressed in the most comprehensive manner
in support of theory of irrelevance. They argued that dividend policy has
no effect on market prices of shares and the value of firm is determined
by earning capacity of the firm or its investment policy. As observed by
M.M., “Under conditions of perfect capital markets, rational investors,
absence of tax discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its dividend policy may
have no influence on the market price of shares”. Even, the splitting of
earnings between retentions and dividends does not affect value of firm.
PAGE 167
Notes Assumptions of MM Hypothesis

1. There are perfect capital markets.
2. Investors behave rationally.
3. Information about company is available to all without any cost.
4. There are no floatation and transaction costs.
5. The firm has a rigid investment policy.
6. No investor is large enough to effect the market price of shares.
7. There are either no taxes or there are no differences in tax rates
applicable to dividends and capital gains.
The Argument of MM
The argument given by MM in support of their hypothesis is that whatever
increase in value of the firm results from payment of dividend, will be
exactly off set by achieve in market price of shares because of external
financing and there will be no change in total wealth of the shareholders.
For example, if a company, having investment opportunities distributes all
its earnings among the shareholders, it will have to raise additional funds
from external sources. This will result in increase in number of shares
or payment of interest charges, resulting in fall in earnings per share in
future. Thus whatever a shareholder gains on account of dividend payment
is neutralized completely by the fall in the market price of shares due to
decline in expected future earnings per share. To be more specific, the
market price of share in beginning of period is equal to present value of
dividends paid at end of period plus the market price of shares at end
of period plus the market price of shares at end of the period. This can
be put in form of following formula:
D1 + P1
P0 =
1 + Ke
Where,
P0 = Market price per share at beginning of period. D1 = Dividend
to be received at end of period.
P1 = Market price per share at end of period.
Ke = Cost of equity capital.
168 PAGE
The value of P1 can be derived by above equation as under. Notes

P1 = P0 (1 + K e ) − D1
The MM Hypothesis can be explained in another form also presuming

that investment required by the firm on account of payment of dividends
is financed out of the new issue of equity shares.
In such a case, the number of shares to be issued can be computed with
the help of the following equation:
1( E − nD1 )
m−
P1
Further, the value of the firm can be ascertained with the help of the
following formula:
(n + m) P1 − ( I − E )
nP0 −
1 + Ke
where,
m = number of shares to be issued. I = Investment required.
E = Total earnings of the firm during the period.
P1 = Market price per share at the end of the period. Ke = Cost
of equity capital.
n = number of shares outstanding at the beginning of the period.
D1 = Dividend to be paid at the end of the period.
nP0 = Value of the firm.
This equation shows that dividends have no effect on the value of
the firm when external financing is used. Given the firm’s investment
decision, the firm has two alternatives, it can retain its earnings to finance
the investments or it can distribute the earnings to the shareholders
as dividends and can arise an equal amount externally. If the second
alternative is preferred, it would involve arbitrage process. Arbitrage
refers to entering simultaneously into two transactions which exactly
balance or completely offset each other. Payment of dividends is associated
with raising funds through other means of financing. The effect of
dividend payment on shareholder’s wealth will be exactly offset by the
effect of raising additional share capital. When dividends are paid to the
PAGE 169
Notes shareholder, the market price of the shares will increase. But the issue
of additional block of shares will cause a decline in the terminal value
of shares. The market price before and after the payment of the dividend
would be identical. This theory thus signifies that investors are indifferent
about dividends and capital gains. Their principal aim is to earn higher
on investment. If a firm has investment opportunities at hand promising
higher rate of return than cost of capital, investor will be inclined more
towards retention. However, if the expected return is likely to be less
than what it would cost, they would be least interested in reinvestment
of income. Modigliani and Miller are of the opinion that value of a firm
is determined by earning potentiality and investment policy and never
by dividend decision.
Criticism of MM Approach
MM Hypothesis has been criticized on account of various unrealistic
assumptions as given below:
1. Perfect capital markets does not exist in reality.
2. Information about company is not available to all persons.
3. The firms have to incur floatation costs which issuing securities.
4. Taxes do exit and there is normally different tax treatment for
dividends and capital gains.
5. The firms do not follow rigid investment policy.
6. The investors have to pay brokerage, fees etc. which doing any
transaction.
7. Shareholders may prefer current income as compared to further gains.
IN-TEXT QUESTIONS
1. The three basic decisions which a financial manager may be
required to take are ___________,___________ and ___________.
2. The value of the firm can be maximized if the shareholders
________is maximized.
3. Prof. Walter’s model is based on the relationship between the
firm’s return on investment and ______________________.
170 PAGE
4. Which of the following is not an assumption of Walter’s model Notes
(a) The firm has a very long life

(b) Earnings and dividends do not change while determining
the value
(c) The Internal rate of return is constant
(d) IRR is variable
5. Which of the following is not an assumption of MM model.
(a) There are perfect capital markets
(b) Investors behave rationally
(c) Information about company is available to all without any
cost
(d) There is a floatation cost
1.5 Illustrations
Dividend Policy in Practice
The main consideration in determining the dividend policy is the objective
of maximization of wealth of shareholders. Thus, a firm should retain
earnings if it has profitable opportunities, giving a higher rate of return
than cost of retained earnings, otherwise it should pay them as dividends.
It implies that a firm should treat retained earnings as the active decision
variable, and dividends as the passive residual.
In actual practice, however, we find that most firms determine the
amount of dividends first, as an active decision variable, and the residue
constitutes the retained earnings. In fact, there is no choice with the
companies between paying dividends and not paying dividends. Most of
the companies believe that by following a stable dividend policy with
a high pay out ratio, they can maximize the market value of shares.
Moreover, the image of such companies also improved on the market
and the investors also favour such companies. The firms following this
policy, can thus successfully approach the market for raising additional
funds for future expansion and growth, as and when required. It has
therefore, been rightly said that theoretically retained earnings should be
PAGE 171
Notes treated as the active decision variable and dividends as passive residual
but practice does not conform to this in most cases.
Illustration 1: ABC Ltd. belongs to a risk class for which the appropriate
capitalization rate is 10%. It currently has outstanding 5,000 shares selling
at Rs. 100 each. The firm is contemplating the declaration of dividend
of Rs. 6 per share at the end of the current financial year. The company
expects to have net income of Rs. 50,000 and has a proposal for making
new investments of Rs. 1,00,000. Show that under the MM hypothesis,
the payment of dividend does not affect the value of the firm.
Solution:
A. Value of the firm when dividends are paid:
(i) Price of the share at the end of the current financial year
P1 = P0 (1 + Ke) – D1
= 100 (1 + 10) – 6
= 100 × 1.10 – 6
= 110 – 6 = Rs. 104
(ii) Number of shares to be issued
I − ( E − nD1 )
m=
P1
1, 00, 000 − (50, 000 − 5, 00 × 6)
=
104
80, 000
=
104
(iii) Value of the firm
nP0 = (n + m) P1 − ( I − E )1 + K e

 5, 000 − 80, 000 
  ×104 − (1, 00, 000 − 50, 000)
 104 
1 + 10
5, 000 80, 000
+ ×104 − (50, 000)
104 1
1.10
172 PAGE
6, 00, 000 − 50, 000 Notes

=
1.10
5,50, 000
=
1.10
= Rs. 5, 00, 000

B. Value of the firm when dividends are not paid:
(i) Price per share at the end of the current financial year
P1 = P0 (1 + ke) – D1
= 100 (1+.10)-0
= 100 × 1.10
= Rs. 110
(ii) Number of shares to be issued
I − (E − nD1 )
m=
P1
1, 00, 000 − (50, 000 − 0)
=
110
50, 000
=
110
(iii) Value of the firm
(n + m)P1 − (I − E)
nP0 =
1 + ke
 50, 000 
 5, 000 +  ×1.10 − (1, 00, 0000 − 50, 000)
 110 
=
1 + .10
5,50, 000 50, 000
+ × 110 − 50, 0000
= 110 1
1.10
5,50, 000
=
1.10
= 5,50, 000
PAGE 173
Notes Hence, whether dividends are paid or not, the value of the firm remains
the same Rs. 5,00,000.
Illustration 2: Expandent Ltd. had 50,000 equity shares of Rs. 10 each
outstanding on January 1. The shares are currently being quoted at par
the market. In the wake of the removal of dividend restraint, the company
now intends to pay a dividend of Rs. 2 per share for the current calendar
year. It belongs to a risk-class whose appropriate capitalization rate is
15%. Using MM model and assuming no taxes, ascertain the price of
the company’s share as it is likely to prevail at the end of the year (i)
when dividend is declared, and (ii) when no dividend is declared. Also
find out the number of new equity shares that the company must issue
to meet its investment needs of Rs. 2 lakhs, assuming a net income of
Rs. 1.1 lakhs and also assuming that the dividend is paid.
Solution:
(i) Price as per share when dividends are paid
P1 = P0 (1+ke) – D1
= 10 (1+.15)-2
= 11.5-2
= Rs. 9.5
(ii) Price per share when dividends are not paid:
P1 = P0 (1+ke)-D1
= 10 (1+.15)-0
= Rs. 11.5
(iii) Number of new equity shares to be issued if dividend is paid
I − (E − nD1 )
m=
P1
2, 00, 000 − (1,10, 000 − 50, 000 × 2)

=
9.5
1,90, 000
=
9.5
= 20, 000 shares
174 PAGE
Illustration 3: The following information is available in respect of a firm: Notes

Capitalisation rate = 10%
Earnings per share = Rs. 50
Assumed rate of return on investments:
(i) 12%
(ii) 8%
(iii) 10%
Show the effect of dividend policy on market price of shares applying
Walter’s formula when dividend pay out ratio is (a) 0%, (b) 20%, (c)
40%, (d) 80%, and (e) 100%.
Solution:
D r(E − D) / k e
P= +
ke ke
Effect of dividend Policy on market price of shares

(i) r = 12% (ii) r = 8% (iii) r = 100
(a) When dividend pay-out ratio is 0%
0 .12(50 − 0) / .10 0 .8(50 − 0) / .10 0 .10(50 − 0) / .10
P= + P= + P= +
.10 .10 .10 .10 .10 .10
.12 .8 .10
(50) (50) (50)
= 0 + .10 = 0+ .10 = 0 + .10
.10 .10 .10
= Rs. 600 = Rs. 400 = Rs. 500
(b) When dividend pay-out is 20%

.12 .8 .10
10 10 10 .10 10 .10
P= + (50 − 10) P= + (50 − 10) P= + (50 − 10)
.10 .10 .10 .10 .10 .10
48 = 100 + 320 = Rs. 500
= 100 +
10
PAGE 175
Notes (c) When dividend pay out is 40%

.12 .8 .10
20 .10 20 .10 20 .10
P= + (50 − 20) P= + (50 − 20) P= + (50 − 20)
.10 .10 .10 .10 .10 .10
36 = 200 + 240 = 200 + 300
= 200 +
.10
= Rs. 560 = Rs. 440 = Rs. 500
(d) When dividend pay-out is 80%

.12 .8 .10
40 .10 40 .10 40 .10
P= + (50 − 40) P= + (50 − 40) P= + (50 − 40)
.10 .10 .10 .10 .10 .10
= 400 + 120 = 400 + 80 = 400 + 100
= Rs. 520 = Rs. 480 = Rs. 500
(e) When dividend pay-out is 100%

.12 .8 .10
(50 − 50) (50 − 50) (50 − 50)
50 .10 50 .10 50 .10
P= + P= + P= +
.10 .10 .10 .10 .10 .10
= 500 + 0 = 500 + 0 = 500 + 0
= Rs. 500 = Rs. 500 = Rs. 500
Conclusion: From the above analysis we can draw the conclusion that
when,
(i) r >k, the company should retain the profits, i.e., when r=12%. ke=10%;
(ii) r is 8%, i.e., r<k, the pay-out should be high; and
(iii) r is 10%; i.e., r=k; the dividend pay-out does not affect the price of
the share.
Illustration 4: The earnings per share of company are Rs. 8 and the rate
of capitalisation applicable to the company is 10%. The company has
before it an option of adopting a payout ratio of 25% or 50% or 75%.
Using Walter’s formula of dividend payout, compute the market value of
the company’s share if the productivity of retained earnings is (i) 15%
(ii) 10% and (iii) 5%
176 PAGE
Solution: Notes
According to Walter’s formula
D r(E − D) / k e
P= +
ke ke
where, P = Market price per share

D = Dividend per share
R = Internal rate of return of productivity of retained earnings
E = Earnings per share, and
ke = Cost of equity capital or capitalisation rate
Computation of Market Value of Company’s Shares
(i) r=15% (ii) r=10% (iii) r=5%
(a) When dividend payout ratio is 25%
2 .15(8 − 2) /10 2 10(8 − 2) / .10 2 .5(8 − 2) / .10
P= + P= + P= +
.10 .10 .10 .10 .10 .10
.15(6) .10(6) .5(6)

2 2 2
= + .10 = + .10 = + .10
.10 .10 .10 .10 .10 .10
2 9 2 6 2 3
= + = + = +
.10 .10 .10 .10 .10 .10
11 8 5
= = =
.10 .10 .10
= Rs. 110 = Rs. 80 = Rs. 50
(b) When dividend payout ratio is 25%

4 15(8 − 4) / .10 4 10(8 − 4) / .10 2 .5(8 − 4) / .10
P= + P= + P= +
.10 .10 .10 .10 .10 .10
.15 .10 .5
(4) (4) (4)
4 4 4
= + .10 = + .10 = + .10
.10 .10 .10 .10 .10 .10
10 8 6
= = =
.10 .10 .10
= Rs. 100 = Rs. 80 = Rs. 60
PAGE 177
Notes (c) When dividend payout ratio is 75%

6 15(8 − 6) / .10 4 10(8 − 4) / .10 6 5(8 − 6) / .10
P= + P= + P= +
.10 .10 .10 .10 .10 .10
.15 6 10(8 − 6) / .10 6 5(8 − 6) / .10

(2) P= + P= +
6
= + .10 .10 .10 .10 .10
.10 .10
6 3 6 2 6 1
= + = + = +
.10 .10 .10 .10 .10 .10
9 8 7
= = =
.10 .10 .10
= Rs. 90 = Rs. 80 = Rs. 70
Illustration 5: The earnings per share of a share of the face value of

Rs. 100 to PQR Ltd. is Rs. 20. It has a rate of return of 25%. Capitalisation
rate of its risk class is 12.5%. If Walter’s model is used:
(a) What should be the optimum payout ratio?
(b) What should be the market price per share if the payout ratio is
zero?
(c) Suppose, the company has a payout of 25% of EPS, what would be
the price per share?
Solution: As per Walter’s formula, the price of the share is
D (r / k e )(E − D)
P= +
ke ke
(a) If r > ke, the value of share will increase with every increase in
retention. The price of the share should be the maximum when the
firm retains all the earnings. Thus, the optimum payout ratio is zero
for PQR Ltd.
(b) Calculation of market price when the payout ratio is zero.
P − 0 + (.25 / 0.125)
(20) = Rs. 320
0.125
178 PAGE
(c) Payout of 25% of EPS i.e., 25% of Rs. 20 = Rs. 5 per share: Notes
D (r / k e )(E − D)
P= +
ke ke
5 + (.25 / 0.125)(20 − 5)
= = Rs. 280
0.125
Illustration 6: Determine the market value of equity shares of the company
from the following information:
Earnings of the company Rs. 5,00,000 Dividend paid
3,00,000
Number of shares outstanding 1,00,000 Price-earning ratio
8
Rate of return on investment 15%
Are you satisfied with the current dividend policy of the firm? If not,
what should be the optimal dividend payout ratio? Use Walter’s Model.
Solution:
Market Price
Price Earnings Ratio =
EPS
8
Market Price =
5
So, Market price = 8 × 5 = Rs. 40
5, 00, 000
EPS = = Rs. 5
1, 00, 000
3, 00, 000
DPS = = Rs. 3
1, 00, 000
DPS 3
Dividend payout ratio = ×100 = ×100 = 60%
EPS 5
Walter’s Model: As the P/E ratio is given 8, and the ke may be taken as
1/8 = .125
Since, this is a growth firm having rate of return (15%) > cost of capital
of 12.5%, the company will maximize its market price if it retains 100%
of profits. The current market price of Rs. 40 (based on P/E Ratio can
PAGE 179
Notes be increased by reducing the payout ratio. If the company opts for 100%
retention (i.e. 0% payout), the market price of the share as per Walter’s
formula would be as follows:
D (r / k e )(E − D)
P= +
ke ke
0 (.15 / .125)(5)
P= + = Rs. 48
.125 .125
So, the firm can increase the market price of the share up to Rs. 48 by
increasing the retention ratio to 100% or in other words, the optimal
dividend payout for the firm is 0.
Illustration 7: The Earnings Per Share (EPS) of a company is Rs. 10.
It has an internal rate of return of 15% and the capitalization rate of its
risk class is 12.5%. If Walter’s Model is used –
(i) What should be the optimum payout ratio of the company?
(ii) What would be the price of the share at this payout?
(iii) How shall the price of the share be affected, if a different payout
were employed?
Solution: Walter’s model to determine share value:
r
(E − D)
D1 k
P0 = +
ke ke
where, D = Dividend per share, E = Earning per share, r = return on

Investment and ke = Capitalisation rate.
If r > ke, the value of the share will increase as retention increases.
The price of the share would be maximum when the firm retains all the
earnings. Thus, the optimum payout ratio in this case is zero. When the
optimum payment is zero, the price of the share is:
0 + (0.15 / 0.125)(10 − 0) 12
P= = = Rs. 96
0.125 0.125
180 PAGE
If the firm chooses a payout other than zero, the price of the share will Notes
fall. Suppose, the firm has a payment of 20%, the price of the share
will be:
2 + (0.15 / 0.125)(10 − 2) 11.60
P= = = Rs. 92.80
0.125 0.125
Illustration 8: From the following information supplied to you, ascertain
whether the firm is following an optimal dividend policy as per Walter’s
model?
Total Earnings Rs. 2,00,000
Number of equity shares (of Rs. 100 each) 20,000
Dividend paid 1,50,000
Price/Earning ratio 12.5
The firm is expected to maintain its rate of return on fresh investment.
Also find out what should be the P/E ratio at which the dividend policy
will have no effect on the value of the share?
Solution: The EPS of the firm is Rs. 10 (i.e., Rs. 2,00,000/20,000). The
P/E Ratio is given at 12.5 and the cost of capital, ke may be taken at
the inverse of P/E ratio. Therefore, ke is 8 (i.e., 1/12.5). The firm is
distributing total dividends of Rs.1,50,000 among 20,000 shares giving
a dividend per share of Rs. 7.50. The value of the share as per Walter’s
model may be found as follows:
D (r / k e )(E − D)
P= +
ke ke
7.50 (.10 / .08)(10 − 7.5)

= + = Rs. 132.81
.08 .08
The firm has a dividend payout of 75% (i.e., Rs. 1,50,000) out of total
earnings of Rs. 2,00,000. Since, the rate of return of the firm, r, is
10% and it is more than the ke of 8%, therefore, by distributing 75% of
earnings, the firm is not following an optimal dividend policy.
In this case, the optimal dividend policy for the firm would be to pay
zero dividend and in such a situation, the market price would be
PAGE 181
Notes D (r / k e )(E − D)
P= +
ke ke
7.50 (.10 / .08)(10 − 7.5)

= + = Rs.156.25
.80 .08
So, the market price of the share can be increased by following a zero
payout.
The P/E ratio at which the dividend policy will have no effect on the
value of the firm is such at which the ke would be equal to the rate of
return, r, of the firm. The ke would be 10% (= r) at the P/E ratio of 10.
Therefore, at the P/E ratio of 10, the dividend policy would have no
effect on the value of the firm.
Illustration 9: A company has total investment of Rs. 5,00,000 assets and
50,000 outstanding equity shares of Rs. 10 each. It earns a rate of 15%
on its investments, and has a policy of retaining 50% of the earnings.
If the appropriate discount rate for the firm is 10%, determine the price
of its share using Gordon Model. What shall happen to the price, if the
company has a payout of 80% or 20%.
Solution: The Gordon’ share valuation model is as under:
(EPS)(1 − b)
P0
k − br
where, b = Retention ratio = .50 or .20 or .80 k = discount rate = .10
r = rate of return = .15 EPS = .15×10 = Rs. 1.50
At a payment of 50%, the price of the share is:
(1 − 0.5)0.15 ×10 0.75
P0 = = = Rs. 30
0.10 − 0.15 × 0.5 0.025
At a payment of 80%, the price of the share is:
(1 − 0.2)0.15 ×10 1.20
P0 = = = Rs.17.14
0.10 − 0.15 × 0.2 0.007
When the payment is 20%, the price of the share is:
(1 − 0.8)0.15 ×10 0.30
P0 = = = Rs.15
0.10 − 0.15 × 0.8 −0.02
In the last case, the share price is negative which is unrealistic.
182 PAGE
Illustration 10: Assuming that rate of return expected by investor is 11%; Notes
internal rate of return is 12%; and earnings per share is Rs. 15, calculate
price per share by ‘Gordon Approach’ method if dividend payout ratio
is 10% and 30%.
E(1 − b)
Solution : As per Gordon’s Approach, P0 =
k e − br
In the given case, ke = 11% r = 12%
EPS = Rs. 15
If Dividend Payout is 10%, then retention ratio, b, is 90%.
15(1 − 9) 15
P0 = = = Rs. 750
11 − .12 × .9 .002
If Dividend Payout is 30%, then retention ratio, b is 70%.
15(1.7) 4.5
P0 = = = Rs.173.08
11 − .12 × .7 .026
Illustration 11: Textrol Ltd. has 80,000 shares outstanding. The current
market price of these shares is Rs. 15 each. The company expect a net
profit of Rs. 2,40,000 during the year and it belongs to a risk-class for
which the appropriate capitalisation rate has been estimated to be 20%.
The Company is considering dividend of Rs. 2 per share for the current
year.
(a) What will be the price of the share at the end of the year (i) if the
dividend is paid and (ii) if the dividend is not paid?
(b) How many new shares must the Co. issue if the dividend is paid and
the Co. needs Rs. 5,60,000 for an approved investment expenditure
during the year? Use MM model for the calculation.
Solution:
As per MM model, the current market price of the share, P0, is
1
P0 = (D1 + P1 )
1+ ke
So, if the firm pays a dividend of Rs. 2, the price at the end of year 1,
P1, is
1
15 = (2 + P1 )
1 + 20
PAGE 183
Notes 1
15 = (2 + P1 )
1.20
P1 = Rs. 16
If the dividend is not paid, the price would be
1
P0 = (D1 + P1 )
1+ ke
1
15 = (0 + P1 ) = P1 = Rs.18
1 + .20
No. of new share, m, to be issued if the company pays a dividend of
Rs. 2: mP1=1-(E-nD1)
m ×16=5,60,000-[2,40,000-(80,000 × 2)] m ×16=5,60,000-80,000
m = 4,80,000/16 = 30,000 new shares
So, the company should issue 30,000 new shares at the rate of Rs. 16
per share in order to finance its investment proposals.
1.6 Summary
u Dividend decision is an important decision, which a financial manager
has to take. It refers to that profits of a company which is distributed
by company among its shareholders.
u There has been a difference of opinion on the effect of dividend
policy on value of firm. Two schools of thought have emerged on
relationship between dividend policy and value of firm.
u On one hand Walter model and Gordon model consider dividend as
relevant for value of firm as investors prefer current dividend over
future dividend.
u On other hand Residuals Approach and MM Model consider dividend
is irrelevant for value of firm. The detention of profit for reinvestment
is important. MM Model have introduced arbitrage process to prove
that value of firm remain same whether firm pays dividend or not.
u Different models market price can be ascertained as :
D r ( E − D) / Ke
n Walter’s Model = P = +
Ke Ke
184 PAGE
E (1 − b) Notes
n Gordon Model = P =
Ke − be
D +P
n MM Model = P0 = 1 1
1 + Ke
1. Investing, Financing and Dividend

2. Wealth
3. Cost of capital
4. (d) IRR is variable
5. (d) There is a floatation cost

1. Explain the Modigliani-Miller hypothesis of dividend irrelevance.
Does this dividend irrelevance. Does this hypothesis suffer from
deficiencies?
2. How far do you agree that dividends are irrelevant?
3. In Walter’s Approach, the dividend policy of firm depends on
availability of investment opportunity and relationship between
firm’s internal rate of return and its cost of capital. Discuss what
are shortcomings of this view?

PAGE 185
Notes u Maheshwari, S. N. (2019), Financial Management – Principles &

Delhi: S. Chand.
186 PAGE
UNIT - V
PAGE 187
L E S S O N
1
Working Capital:
Management and Finance
Smriti Chawla
STRUCTURE

1.2 Introduction
1.3 Classification or Kinds of Working Capital
1.4 Importance or Advantages of Adequate Working Capital
1.5 Excess or Inadequate Working Capital
1.6 Need or Objects of Working Capital
1.7 Factors determining Working Capital Requirements
1.8 Management of Working Capital Principles
1.9 Determining Working Capital Financing Mix
1.10 Summary

After studying this chapter students may be able to understand:–
u The types of working capital.
u Calculation of working capital.
u Determine the perfect working capital mix.
PAGE 189
Notes 1.2 Introduction

Capital required for a business can be classified under two main categories
viz.
(i) Fixed capital
(ii) Working capital.
Every business needs funds for two purposes for its establishment and
to carry out its day-to-day operations. Long-term funds are required to
create production facilities through purchase of fixed assets such as plant
and machinery, land, building etc. Investments in these assets represent
that part of firm’s capital which is blocked on permanent basis and
is called fixed capital. Funds are also needed for short-term purposes
for purchase of raw materials, payment of wages and other day-to-day
expenses etc. These funds are known as working capital which is also
known as Revolving or circulating capital or short term capital. According
to Shubin, “Working capital is amount of funds necessary to cover the
cost of operating the enterprise”.
Concept of Working Capital
There are two concepts of working capital:
(i) Gross working capital
(ii) Net working capital.
Gross working capital is the capital invested in total current assets of
the enterprise. Examples of current assets are: cash in hand and bank
balances, Bills Receivable, Short term loans and advances, prepaid
expenses, Accrued Incomes etc. The gross working capital is financial or
going concern concept. Net working capital is excess of Current Assets
over Current liabilities.
Net Working Capital = Current Assets – Current Liabilities
When current assets exceed the current liabilities the working capital is
positive and negative working capital results when current liabilities are
more than current assets. Examples of current liabilities are Bills Payable,
Sundry debtors, accrued expenses, Bank Overdraft, Provision for taxation
etc. Net working capital is an accounting concept of working capital.
190 PAGE
1.3 Classification or Kinds of Working Capital Notes
Working capital may be classified in two ways:

(a) On the basis of concept
(b) On the basis of time
On the basis of concept working capital is classified as gross working
capital and net working capital. On the basis of time working capital
may be classifies as Permanent or fixed working capital and Temporary
or variable working capital.
IMAGE
Permanent or Fixed Working MATTER
Capital
KINDS
It isOF
theWORKING
minimum CAPITAL
amount which is required to ensure effective utilisation
of fixed
On basis facilities and for maintaining the circulation of current assets.
of Concept
There is always a minimum level of current assets which is continuously
Gross workingby
required Capital
enterprise to carry out its normal business operations. As
Net the business
working Capitalgrows, the requirements of permanent working capital
also increase due to increase in current assets. The permanent working
On the basis of time
capital can further be classified as regular working capital and reserve
Permanent
workingor Fixed Working
capital Capital
required ensuring circulation of current assets from cash
to inventories,
Regular from inventories to receivables and from receivables to
Working Capital
cash and so on. Reserve working capital is the excess amount over the
Reserve Capital
requirement for regular working capital which may be provided for
Temporary or Variable Working Capital
Seasonal Capital PAGE 191
Special Working School of Open Learning, University of Delhi
Working Capital
Permanent or Fixed working capital

Notes contingencies that may arise at unstated periods such as strikes, rise in
prices, depression etc.
Temporary or Variable Working Capital
It is the amount of working capital which is required to meet the seasonal
demands and some special exigencies. Variable working capital is further
classified as seasonal working capital and special working capital. The
capital required to meet seasonal needs of the enterprise is called seasonal
working capital. Special working capital is that part of working capital
which is required to meet special exigencies such as launching of extensive
marketing campaigns for conducting research etc.
1.4 Importance or Advantages of Adequate Working Capital

Working capital is the life blood and nerve centre of a business. Hence,
it is very essential to maintain smooth running of a business. No business
can run successfully without an adequate amount of working capital. The
main advantages of maintaining adequate amount of working capital are
as follows:
1. Solvency of the Business: Adequate working capital helps in
maintaining solvency of business by providing uninterrupted flow
of production.
2. Goodwill: Sufficient working capital enables a business concern to
make prompt payments and hence helps in creating and maintaining
goodwill.
3. Easy Loans: A concern having adequate working capital, high solvency
and good credit standing can arrange loans from banks and others
on easy and favourable terms.
4. Cash Discounts: Adequate working capital also enables a concern
to avail cash discounts on purchases and hence it reduces cost.
5. Regular Supply of Raw Material: Sufficient working capital ensures
regular supply of raw materials and continuous production.
6. Regular payment of salaries, wages and other day-to-day commitments:
A company which has ample working capital can make regular
payment of salaries, wages and other day-to-day commitments which
raises morale of its employees, increases their efficiency, reduces
costs and wastages.
192 PAGE
7. Ability to face crisis: Adequate working capital enables a concern Notes

to face business crisis in emergencies such as depression.
8. Quick and regular return on investments: Every investor wants a
quick and regular return on his investments. Sufficiency of working
capital enables a concern to pay quick and regular dividends to be
investor as there may not be much pressure to plough back profits
which gains the confidence of investors and creates a favourable
market to raise additional funds in future.
9. Exploitation of Favourable market conditions: Only concerns with
adequate working capital can exploit favourable market conditions
such as purchasing its requirements in bulk when the prices are
lower and by holding its inventories for higher prices.
10. High Morale: Adequacy of working capital creates an environment
of security, confidence, high morale and creates overall efficiency
in a business.
1.5 Excess or Inadequate Working Capital

Every business concern should have adequate working capital to run its
business operations. It should have neither excess working capital nor
inadequate working capital. Both excess as well as short working capital
positions are bad for any business.
Disadvantages of Excessive Working Capital
1. Excessive working capital means idle funds which earn no profits
for business and hence business cannot earn a proper rate of return.
2. When there is a redundant working capital it may lead to unnecessary
purchasing and accumulation of inventories causing more chances
of theft, waste and losses.
3. It may result into overall inefficiency in organization.
4. Due to low rate of return on investments, the value of shares may
also fall.
5. The redundant working capital gives rise to speculative transaction.
6. When there is excessive working capital, relations with banks and
other financial institutions may not be maintained.
PAGE 193
Notes Disadvantages of Inadequate working capital

1. A concern which has inadequate working capital cannot pay its
short-term liabilities in time. Thus, it will lose its reputation and
shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts.
3. It becomes difficult for firm to exploit favourable market conditions
and undertake profitable projects due to lack of working capital.
4. The rate of return on investments also falls with shortage of working
capital.
5. The firm cannot pay day-to-day expenses of its operations and it
created inefficiencies, increases costs and reduces the profits of
business.
IN-TEXT QUESTIONS
1. The capital required in the business can be classified under two
main categories i.e ____________ and ___________.
2. Which of the following is a type of working capital?
(a) Gross Working Capital
(b) Net working capital
(c) Fixed working capital
3. Due to low rate of return on investments, the value of shares
increase.(True/False)
4. The rate of return on investments also falls with shortage of
working capital. (True/False)
1.6 Need or Objects of Working Capital

The need for working capital arises due to time gap between production
and realisation of cash from sales. There is an operating cycle involved
in sales and realisation of cash. There are time gaps in purchase of raw
materials and production, production and sales, and sales and realisation
of cash. Thus, working capital is needed for following purposes.
194 PAGE
1. For purchase of raw materials, components and spares. Notes

2. To pay wages and salaries.
3. To incur day-to-day expenses and overhead costs such as fuel,
power etc.
4. To meet selling costs as packing, advertisement.
5. To provide credit facilities to customers.
6. To maintain inventories of raw materials, work-in-progress, stores
and spares and finished stock.
Greater size of business unit large will be requirements of working capital.
The amount of working capital needed goes on increasing with growth
and expansion of business till it attains maturity. At maturity the amount
of working capital needed is called normal working capital.
1.7 Factors Determining Working Capital Requirements

The following are important factors which influence working capital
requirements:
1. Nature or Character of Business: The working capital requirements of
firm depend upon nature of its business. Public utility undertakings
like electricity, water supply need very limited working capital because
they offer cash sales only and supply services, not products, and
such no funds are tied up in inventories and receivables whereas
trading and financial firms require less investment in fixed assets
but have to invest large amounts in current assets and as such they
need large amount of working capital. Manufacturing undertaking
require sizeable working capital between these two.
2. Size of Business/Scale of Operations: Greater the size of a business
unit, larger will be requirement of working capital and vice versa.
3. Production Policy: The requirements of working capital depend upon
production policy. If the policy is to keep production steady by
accumulating inventories it will require higher working capital. The
production could be kept either steady by accumulating inventories
during slack periods with view to meet high demand during peak
season or production could be curtailed during slack season and
increased during peak season.
PAGE 195
Notes 4. Manufacturing process/Length of Production cycle: Longer the

process period of manufacture, larger is the amount of working
capital required. The longer the manufacturing time, the raw
materials and other supplies have to be carried for longer period in
the process with progressive increment of labour and service costs
before finished product is finally obtained. Therefore, if there are
alternative processes of production, the process with the shortest
production period should be chosen.
5. Credit Policy: A concern that purchases its requirements on credit and
sell its products/services on cash requires lesser amount of working
capital. On other hand a concern buying its requirements for cash
and allowing credit to its customers, shall need larger amount of
working capital as very huge amount of funds are bound to be tied
up in debtors or bills receivables.
6. Business Cycles: In period of boom i.e. when business is prosperous,
there is need for larger amount of working capital due to increase
in sales, rise in prices etc. On contrary in times of depression the
business contracts, sales decline, difficulties are faced in collections
from debtors and firms may have large amount of working capital
lying idle.
7. Rate of Growth of Business: The working capital requirements
of a concern increase with growth and expansion of its business
activities. In fast growing concerns large amount of working capital
is required whereas in normal rate of expansion in the volume of
business the firm may have retained profits to provide for more
working capital.
8. Earning Capacity and Dividend Policy: The firms with high earning
capacity generate cash profits from operations and contribute to
working capital. The dividend policy of concern also influences the
requirements of its working capital. A firm that maintains a steady
high rate of cash dividend irrespective of its generation of profits
needs more working capital than firm that retains larger part of its
profits and does not pay so high rate of cash dividend.
9. Price Level Changes: Changes in price level affect the working
capital requirements. Generally, the rising prices will require the
firm to maintain large amount of working capital as more funds
196 PAGE
will be required to maintain the same current assets. The effect of Notes
rising prices may be different for different firms.
10. Working Capital Cycle: In a manufacturing concern, the working
capital cycle starts with the purchase of raw material and ends with
realisation of cash from the sale of finished products. This cycle
involves purchase of raw materials and stores, its conversion into
stocks of finished goods through work in progress with progressive
increment of labour and service costs, conversion of finished stock
into sales, debtors and receivables and ultimately realisation of cash
and this cycle again from cash to purchase of raw material and so
on. The speed with which the working capital completes one cycle
determines the requirements of working capital longer the period
of cycle larger is requirement of working capital.
1.8 Management of Working Capital Principles

Working capital refers to excess of current assets over current liabilities.
Management of working capital therefore is concerned with the problems
that arise in attempting to manage current assets, current liabilities and
inter relationship that exists between them. The basic goal of working
capital management is to manage the current assets and current of a firm
in such a way that satisfactory level of working capital is maintained i.e.
it is neither inadequate nor excessive. This is so because both inadequate
as well as excessive working capital positions are bad for any business.
Inadequacy of working capital may lead the firm to insolvency and
excessive working capital implies idle funds which earns no profits for
the business. Working Capital Management policies of a firm have a great
effect on its profitability, liquidity and structural health of organization. In
this context, evolving capital management is three dimensional in nature.
1. Dimension I is concerned with formulation of policies with regard
to profitability, risk and liquidity.
2. Dimension II is concerned with decisions about composition and
level of current assets.
3. Dimension III is concerned with decisions about composition and
level of current liabilities.
PAGE 197
Notes
Principles of Working Capital Management

Principles of Working Capital Management
Principle of Risk Principle of Principle of Principle of
Variation Cost of Capital Equity position Maturity of

Payment
1. Principle of Risk Variation: Risk refers to inability of firm to meet
its obligation as and when they become due for payment. Larger
investment in current assets with less dependence on short-term
borrowings increases liquidity, reduces risk and thereby decreases
opportunity for gain or loss. On other hand less investment in current
assets with greater dependence on short-term borrowings increases risk,
reduces liquidity and increases profitability. There is definite direct
relationship between degree of risk and profitability. A conservative
management prefers to minimize risk by maintaining higher level
of current assets while liberal management assumes greater risk
by reducing working capital. However, the goal of management
should be to establish suitable trade-off between profitability and
risk. The various working capital policies indicating relationship
between current assets and sales are depicted below.
2. Principle of Cost of Capital: The various sources of raising working
capital finance have different cost of capital and degree of risk
involved. Generally, higher the risks lower is cost and lower the
risk higher is the cost. A sound working capital management should
always try to achieve proper balance between these two.
198 PAGE
3. Principle of Equity Position: This principle is concerned with planning Notes

the total investment in current assets. According to this principle,
the amount of working capital invested in each component should be
adequately justified by firm’s equity position. Every rupee invested
in current assets should contribute to the net worth of firm. The
level of current assets may be measured with help of two ratios.
(i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.
(i) 4. Principle of Maturity
Current assets of Payment:
as a percentage of totalThis
assetsprinciple
and is concerned with
planning the sources of finance for working capital. According to
(ii) this
Current assets as
principle, a percentage
a firm should of totalevery
make sales. effort to relate maturities
4. ofPrinciple
payment of to its flow
Maturity of internally
of Payment: This generated
principle is funds.
concernedGenerally,
with planning
the sources ofshorter
finance the maturity capital.
for working schedule of current
According liabilities
to this principle,ina relation to make
firm should
every effort to
expected cash inflows, the greater inability to meet its obligations funds.
relate maturities of payment to its flow of internally generated
Generally, shorter the maturity schedule of current liabilities in relation to expected cash
in time.
inflows, the greater inability to meet its obligations in time.
1.9 Determining
1.9 Determining Working
Working Capital Capital
Financing Mix Financing Mix
There are threearebasic
There approaches
three for determining
basic approaches an appropriate
for determining working capital
an appropriate workingfinancing
mix.
capital financing mix.
1. The Hedging or MatchingIMAGE Approach:

MATTERThe term ‘hedging’ refers to
two off-selling transactions of a simultaneous but opposite nature
APPROACHES TO FINANCING MIX
which counter balance effect of each other. With reference to
The Heading or financing
Matchingmix, the term hedging refers to ‘process of matching of
Approach
maturities of debt with maturities of financial needs’. According
The Conservative Approach
to this approach the maturity of sources of funds should match
The Aggressive theApproach
nature of assets to be financed. This approach is also known
as ‘matching approach’ which classifies the requirements of total
working capital into permanent and temporary working capital.
(1) The Hedging or Matching Approach: The term ‘hedging’ refers to two off-
selling transactions of a simultaneous but opposite nature which counterbalance effect of each
PAGE 199
other. With reference to financing mix, the term hedging refers to ‘process of matching of
maturities of debt with maturities ofSchool
financial needs’. According to this approach the maturity
of Open Learning, University of Delhi
of sources of funds should match the nature of assets to be financed. This approach is also
known as ‘matching approach’ which classifies the requirements of total working capital into
permanent and temporary working capital.
The hedging approach suggests that permanent working capital requirements should be
Notes The hedging approach suggests that permanent working capital

requirements should be financed with funds from long-term sources
while temporary working capital requirements should be financed
with short-term funds.
Current assets Conservative
Moderate
Aggressive
Sales level
2. The Conservative Approach: This approach suggests that the entire

estimated investments in current assets should be financed from
long-term sources and short-term sources should be used only for
emergency requirements. The distinct features of this approach are:
(i) Liquidity is greater
(ii) Risk is minimised
(iii) The cost of financing is relatively more as interest has to be
paid even on seasonal requirements for entire period.
Trade-off between the Hedging and Conservative Approaches
The hedging approach implies low cost, high profit and high risk
while the conservative approach leads to high cost, low profits and
low risk. Both the approaches are the two extremes and neither of
them serves the purpose of efficient working capital management.
A trade-off between the two will then be an acceptable approach.
The level of trade off may differ from case to case depending
upon the perception of risk by the persons involved in financial
decision making. However, one way of determining the trade off is
by finding the average of maximum and the minimum requirements
of current assets. The average requirements so calculated may be
200 PAGE
financed out of long-term funds and excess over the average from Notes
short-term funds.
3. Aggressive Approach: The aggressive approach suggests that entire
estimated requirements of current asset should be financed from
short-term sources even a part of fixed assets investments be financed
from short-term sources. This approach makes the finance – mix
more risky, less costly and more profitable.
Hedging v. Conservative Approach
Hedging Approach Conservative Approach
1. The cost of financing is reduced. 1. The cost of financing is higher
2. The investment in net working 2. Large Investment is blocked in
capital is nil. temporary working capital.
3. Frequent efforts are required to 3. The firm does not face frequent
arrange funds. financing problems.
4. The risk is increased as firm 4. It is less risky and firm is able
is vulnerable to sudden shocks. to absorb shocks.
1.10 Summary
u The term working capital may be used to denote either the gross
working capital which refers to total current assets or net working
capital which refers to excess of current asset over current liabilities.
u The working capital requirement for a firm depends upon several
factors such as Nature or Character of Business, Credit Policy, Price
level changes, business cycles, manufacturing process, production
policy.
u The working capital need of the firm may be bifurcated into
u The Hedging Approach says that permanent requirement should be
financed by long term sources while the temporary requirement
should be financed by short-term sources of finance. The Conservative
approach on the other hand says that the working capital requirement
be financed from long-term sources. The Aggressive approach says
that even a part of permanent requirement may be financed out of
short-term funds.
PAGE 201
Notes u Every firm must monitor the working capital position and for this
purpose certain accounting ratios may be calculated.
1. Fixed and Working Capital

3. False
4. True

1. Explain various factors influencing working capital?
2. What are the advantages of adequate working capital?
3. Discuss various approaches to determine an appropriate financing
mix of working capital?

Delhi: Taxmann, New Delhi: 6EC(1264)-03.02.2023.
202 PAGE
u Singh, J.K. (2016), Financial Management: Theory and Practice, New Notes
Delhi: S. Chand.
PAGE 203
L E S S O N
2
Working Capital:
Estimation and Calculation
Smriti Chawla
STRUCTURE

2.2 Introduction
2.3 Working Capital as % of Net Sales
2.4 Working Capital as % of Total Assets or Fixed Assets
2.5 Working Capital Based on Operating Cycle
2.6 Illustrations
2.7 Summary

u How to estimate the working capital requirement.
u Calculation of working capital.
2.2 Introduction
“Working Capital is the life blood and controlling nerve centre of a business.” No business
can be successfully run without an adequate amount of working capital. To avoid the
shortage of working capital at once, an estimate of working capital requirements should be
made in advance so that arrangements can be made to procure adequate working capital.
But estimation of working capital requirements is not an easy task and large numbers
204 PAGE
of factors have to be considered before starting this exercise. There are Notes
different approaches available to estimate the working capital requirements
of a firm which are as follows:
2.3 Working Capital as % of Net Sales

This approach to estimate the working capital requirement is based on the
fact that the working capital for any firm is directly related to the sales
volume of that firm. So, the working capital requirement is expressed
as a percentage of expected sales for a particular period. This approach
is based on the assumption that higher the sales level, the greater would
be the need for working capital. There are three steps involved in the
estimation of working capital.
(a) To estimate total current assets as a % of estimated net sales.
(b) To estimate current liabilities as a % of estimated net sales, and
(c) The difference between the above two, is the net working capital
as a % of net sales.
2.4 Working Capital as % of Total Assets or Fixed Assets

This approach of estimation of working capital requirement is based on
the fact that the total assets of the firm are consisting of fixed assets and
current assets. On the basis of past experience, a relationship between (i)
total current assets i.e., gross working capital; or net working capital i.e.
Current assets - Current liabilities; and (ii) total fixed assets or total assets
of the firm is established. The estimation of working capital therefore,
depends upon the estimation of fixed capital which depends upon the
capital budgeting decisions.
Both the above approaches to the estimation of working capital requirement
are simple in approach but difficult in calculation.
2.5 Working Capital Based on Operating Cycle

In this approach, the working capital estimate depends upon the operating
cycle of the firm. A detailed analysis is made for each component of
working capital and estimation is made for each of these components.
PAGE 205
Notes The different components of working capital may be enumerable as follows:

Current Assets Current Liabilities
Cash and Bank Balance Creditors for Purchases
Inventory of Raw Material Creditors for Inventory of
Inventory of Finished Goods Work-in-Progress
For manufacturing organisation, the following factors have to be taken into

consideration while making an estimate of working capital requirements.
Factors Requiring Consideration While Estimating Working Capital
1. Total costs incurred on material, wages and overheads.
2. The length of time for which raw material are to remain in stores
before they are issued for production.
3. The length of production cycle or work in process i.e. the time
taken for conversion of raw material into finished goods.
4. The length of sales cycle during which finished goods are to be
kept waiting for sales.
5. The average period of credit allowed to customers.
6. The amount of cash required to pay day to day expenses of the
business.
7. The average amount of cash required to make advance payments,
if any.
8. The average credit period expected to be allowed by suppliers.
9. Time lag in the payment of wages and other expenses.
From the total amount blocked in current assets estimated on the basis of
the first seven items given above, the total of the current liabilities i.e.
the last two item, is deducted to find out the requirements of working
capital. In case of purely trading concern, points 1, 2, 3 would not arise
but all other factors from points 4 to 9 are to be taken into consideration.
In order to provide for contingencies, some extras amount generally
calculated as a fixed percentage of the working capital may be added as
margin of safety.
Suggested Proforma for estimation of working capital requirements under
operating cycle is given below:
206 PAGE
I. Current Assets: Amount Amount Amount Notes

Minimum Cash Balance Inventories: ****
Raw Materials
****
Work-in-Progress ****
Finished Goods **** ****
Receivables
Debtors ****
Bills ****
****
Gross Working Capital (CA) **** ****
II. Current Liabilities: Amount Amount

Creditors for purchases ****
Creditors for Wages ****
Creditors for Overheads ****
Total Current Liabilities (CL) **** ****

Excess of CA over CL ****
+ Safety Margin ****
Net Working Capital ****
IN-TEXT QUESTIONS
1. No business can be successfully run without an adequate amount
of _______.
2. Approach to estimate the working capital requirement is based
on the fact that the working capital for any firm is directly
related to the sales volume of that firm.
3. __________ approach of estimation of working capital requirement
is based on the fact that the total assets of the firm are consisting
of fixed assets and current assets.
PAGE 207
Notes 2.6 Illustrations

Illustration 1: XYZ Ltd. has obtained the following data concerning the
average working capital cycle for other companies in the same industry:
Raw material stock turnover 20 Days
Credit received 40 Days
Work-in-Progress Turnover 15 Days
Finished goods stock turnover 40 Days
Debtors’ collection period 60 Days
95 Days
Using the following data, calculate the current working capital cycle for
XYZ Ltd. And briefly comment on it.
(Rs. in ‘000)
Sales 3,000
Cost of Production 2,100
Purchase 600
Average raw material stock 80
Average work-in-progress 85
Average finished goods stock 180
Average creditors 90
Average debtors 350
Solution: Operating cycle of XYZ Ltd.
1. Raw material
Average Raw Material 80
= × 365 = × 365 = 49 Days
Total Raw Material 600
2. Work-in-progress
Average Work-in-Progress 85
= × 365 = × 365 = 15 Days
Total Cost of Production 2,100
3. Finished Goods
Average Stock 180
= × 365 = × 365 = 31 Days
Total Cost of Production 2,100
208 PAGE
4. Debtors Notes
Average Debtors 350
= × 365 = × 365 = 43 Days
Total Credit Sales 3, 000
5. Creditors
Average Creditors 90
= × 365 = × 365 = 55 Days
Total Purchases 60
Net Operating Cycle = 49 Days + 15 Days + 31 Days + 43 Days – 55 Days
= 138 Days – 55 Days = 83 Days
Comment: For XYZ Ltd., the working capital cycle is below the industry
average, including a lower investment in net current assets. However,
the following points should be noted about the individual elements of
working capital.
(a) The stock of raw materials is considerably higher than average. So
there is a need for stock control procedure to be reviewed.
(b) The value of creditors is also above average; this indicates that
XYZ Ltd. is delaying the payment of creditors beyond the credit
period. Although this is an additional source of finance, it may
result in a higher cost of raw materials or loss of goodwill among
the suppliers.
(c) The finished goods stock is below average. This may be due to a
high demand for the firm’s goods or to efficient stock control. A
low finished goods stock can, however, reduce sales since it can
cause delivery delays.
(d) Debts are collected more quickly than average. The company might
have employed good credit control procedure or offer cash discounts
for early payments.
Illustration 2: From the following data, compute the duration of operating
cycle for each of the two years and comment on the increase/decrease:
Stock: Year 1 Year 2
Raw Materials 20,000 27,000
Work-in-progress 14,000 18,000
Finished goods 21,000 24,000
Purchases 96,000 1,35,000
PAGE 209
Notes Stock: Year 1 Year 2

Cost of goods sold 1,40,000 1,80,000
Sales 1,60,000 2,00,000
Debtors 32,000 50,000
Creditors 16,000 18,000
Assume 350 Days per year for computational purposes.
Solution:
(a) Calculation of Operating Cycle
Year 1 Year 2
1. Raw Material Stock 20/96 × 360 = 75 Days 27/135 × 360 = 72 Days
(Average Raw Material/Total Purchase × 360)
2. Creditors period 16/96 × 360 = 60 days 18/135 × 360 = 48 days
(Average Creditor/Total Purchase) × 360
3. Work-in-progress 14/140 × 360 = 36 days 18/180 × 360 = 36 days
(Average Work-in-progress/Total cost of goods sold) × 360
4. Finished goods 21/140 × 360 = 54 days 24/180 × 360 = 48 days
(Average Finished goods/Total cost of goods sold) × 360
5. Debtors 32/160 × 360 = 72 days 50/200 × 360 = 90 days
(Average Debtors/Total Sales) × 360
Net operating cycle 177 days 198 days
This is an increase in length of operating cycle by 21 days i.e., 12%
increase approximately. Reasons for increase are as follows:
Debtors taking longer time to pay (90 - 72) 18 days
Creditors receiving payment earlier (60 - 48) 12 days
30 days
-- Finished goods turnover lowered (54 - 48) 6 days
-- Raw material stock turnover lowered (75 - 72) 3 days
Increase in Operating Cycle 21 days
Illustration 3: A proforma cost sheet of a company provides the following
particulars:
Elements of Cost
Material 40%
Direct Labour 20%
Overheads 20%
210 PAGE
The following further particulars are available: Notes

(a) It is proposed to maintain a level of activity of 2,00,000 units.
(b) Selling price is Rs. 12 per unit.
(c) Raw materials are expected to remain in stores for an average period
of one month.
(d) Materials will be in process, on averages half a month.
(e) Finished goods are required to be in stock for an average period of
one month.
(f) Credit allowed to debtors is two months.
(g) Creditor allowed by suppliers is one month.
You may assume that sales and production follow a consistent pattern.
You are required to prepare a statement of working capital requirements,
a forecast Profit and Loss Account and Balance Sheet of the company
assuming that:
Rs.
Share Capital 15,00,000
8% Debentures 2,00,000
Fixed Assets 13,00,000
Solution:
Statement of Working Capital
Current Assets: Rs. Rs.
Stock of Raw Materials (1 month)
24, 00, 000 × 40 80,000
100 ×12
Work-in-progress (1/2 month):
24, 00, 000 × 40 1 40,000
Materials ×
100 ×12 2
24, 00, 000 × 20 1
Labour ×
100 ×12 2 20,000
24, 00, 000 × 20 1 80,000
Overheads ×
100 ×12 2 20,000
PAGE 211
Notes Stock of Finished Goods (1 month)
24, 00, 000 × 40

Materials 80,000
100 ×12
24, 00, 000 × 20
Labour 40,000
100 ×12
24, 00, 000 × 20 40,000 1,60,000
Overheads
100 ×12
Debtors (2 months)
at cost Material 1,60,000
Labour 80,000
Overheads 80,000 3,20,000
Less: Current Liabilities: 6,40,000
Creditors (1 month) for raw materials
24, 00, 000 × 20
80,000
100 ×12
Net Working Capital Required: 5,60,000
(Note: Sales = 2,00,000 × 12 = Rs. 24,00,000)
Forecast Profit and Loss Account
For the year ended….
Rs. Rs.
To Materials 9,60,000 By Cost of good old 19,20,000
To Wages 4,80,000
To Overheads 4,80,000
19,20,000 19,20,000
To Cost of goods sold 19,20,000 By Sales 24,00,000
To Gross profit c/d 4,80,000
24,00,000 24,00,000
To Interest on Debentures 16,000 By Gross Profit b/d 4,80,000
To Net Profit 4,64,000
4,80,000 4,80,000
212 PAGE
Forecast Balance Sheet Notes

as at……
Liabilities Rs. Assets Rs.
Share Capital 15,00,000 Fixed Assets 13,00,000
8% Debentures 2,00,000 Stocks:
Net Profit 4,64,000 Raw Materials 80,000
Creditors 80,000 Work-in-Progress 80,000
Finished Goods 1,60,000
Debtors 4,00,000
Cash & Bank Balance
(Balancing figure) 2,24,000
22,44,000 22,44,000
Working Notes:
(a) Profits have been ignored while preparing working capital requirements
for the following reasons:
(i) Profits may or may not be used for working capital.
(ii) Even if profits have to be used for working capital, they have
to be reduced by the amount of income tax, dividends, etc.
(b) Interest on debentures has been assumed to have been paid.
Illustration 4: A performa cost sheet of a company provides the following
particulars:
Elements of Cost Amount per unit (Rs.)
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 on an average for one month. Materials are
in process on an average for half a month. Finished goods are in stock
on an average for one month. Credit allowed by suppliers is one month.
Credit allowed to customers is two months. Lag in payment of wages
is 1½ weeks. Lag in payment of overhead expenses is one month. One-
PAGE 213
Notes fourth of the output is sold against cash. Cash in hand and at bank is
expected to be Rs. 25,000.
You are required to prepare a statement showing the working capital
needed to finance a level of activity of 1,04,000 units of production.
You may assume that production is carried on evenly throughout the year,
wages and overheads accrue similarly and a time period of 4 weeks is
equivalent to a month.
Solution:
Statement Showing the Working Capital Needed
Current Assets Rs. Rs.
Minimum cash balance 25,000
(i) Stock of raw materials (4 weeks) 1,60,000 × 4 6,40,000
(ii) Work-in-Process (2 weeks):
Raw materials 1,60,000 × 2 3,20,000
Direct Labour 60,000 × 2 1,20,000
Overheads 1,20,000 × 2 2,40,000 6,80,000
(iii) Stock of Finished goods (4 weeks):
Raw Materials 1,60,000 × 4 6,40,000
Direct Labour 60,000 × 4 2,40,000
Overheads 1,20,000 × 4 4,80,000 13,60,000
(iv) Sundry Debtors (8 weeks):
Raw materials 1,60,000 × 3/4 × 8 9,60,000
Direct Labour 60,000 × 3/4 × 8 3,60,000
Overheads 1,20,000 × 3/4 × 8 7,20,000 20,40,000
Less Current Liabilities:
(i) Sundry Creditors (4 weeks) 1,60,000 × 4 6,40,000
(ii) Wages outstanding (1-1/2 weeks): 60,000 × 90,000
3/2
(iii) Lag in payment of overheads (4 weeks) 1,20,000 4,80,000 47,45,000
× 4
12,10,000
Net Working Capital Needed 35,35,000
214 PAGE
Working Notes: Notes

(i) It has been assumed that a time period of 4 weeks is equivalent to
one month.
(ii) It has been assumed that direct labour and overheads are in process,
on average, half a month.
(iii) Profit has been ignored and debtors have been taken at cost.
(iv) Weekly calculations have been made as follows:
(a) Weekly average of raw materials = 1,04,000 × 80/52 = 1,60,000
(b) Weekly labour cost = 1,04,000 × 30/52 = 60,000
(c) Weekly Overheads = 1,04,000 × 60/52 = 1,20,000
Illustration 5: From the following information you are required to estimate
the net working capital:
Cost per unit
Rs.
Raw Materials 400
Direct labour 150
Overheads (excluding depreciation) 300
Total Cost 850
Additional Information: 30
Selling-Price Rs. 1,000 per unit
Output 52,000 units per annum
Raw Material in stock average 4 weeks
Work-in-process:(assume 50% completion stage average 2 weeks
with full material consumption)
Finished goods in stock average 4 weeks
Credit allowed by supplier’s average 4 weeks
Credit allowed to debtors average 8 weeks
Cash at bank is expected to be Rs. 50,000
Assume that production is sustained at an even pace during the 52 weeks
of the year. All sales are on credit basis. State any other assumption that
you might have made while computing.
PAGE 215
Notes Solution:
Statement Showing Net Working Capital Requirements
Current Assets : Rs.
Minimum cash balance 50,000
Stock of Raw Materials (4 weeks) 16,00,000
4
52, 000 × 400 ×
52
Stock of work-in-progress (2 weeks) 8,00,000
2
Raw material 52, 000 × 400 ×
52
Direct labour (50% completion) 1,50,000
2 50
52, 000 ×150 × ×
52 100
Overheads (50% completion) 3,00,000 12,50,000
2 50
52, 000 × 300 × ×
52 100
Stock of Finished goods (4 weeks) 34,00,000
4
52, 000 × 850 ×
52
Amount blocked in Debtors at cost (8 weeks) 68,00,000
8
52, 000 × 850 ×
52
Total Current Assets
Less: Current Liabilities: 1,31,00,000
Creditors for raw materials (4 weeks) 16,00,000
4
52, 00, 000 × 400 ×
52
Net Working Capital Required 1,15,00,000
Illustration 6: Texas Manufacturing Company Ltd. is to start production
on 1st January, 1995. The prime cost of a unit is expected to be Rs. 40
out of which Rs. 16 is for materials and Rs. 24 for labour. In addition,
variable expenses per unit are expected to be Rs. 8 and fixed expenses
216 PAGE
per month Rs. 30,000. Payment for materials is to be made in the month Notes
following the purchases. One-third of sales will be for cash and the rest
on credit for settlement in the following month. Expenses are payable
in the month in which they are incurred. The selling price is fixed at
Rs. 80 per unit. The numbers of units manufactured and sold are expected
to be as under:
January 900
February 1,200
March 1,800
April 2,100
May 2,100
June 2,400
Draw up a statement showing requirements of working capital from month
to month, ignoring the question of stocks.
Solution:
Statement Showing Requirement of Working Capital
January February March April May June
Rs. Rs. Rs. Rs. Rs. Rs.
Payments:
Materials - 14,400 19,200 28,800 33,600 33,600
Wages 21,600 28,800 43,200 50,400 50,400 57,600
Fixed Expenses 30,000 30,000 30,000 30,000 30,000 30,000
Variable Expenses 7,200 9,600 14,400 16,800 16,800 19,200
58,800 82,800 1,06,800 1,26,000 1,30,800 1,40,400
Receipts:
Cash Sales 24,000 32,000 48,000 56,000 56,000 64,000
Debtors - 48,000 64,000 96,000 1,12,000 1,12,000
24,000 80,000 1,12,000 1,52,000 1,68,000 1,76,000
Working Capital Required 34,800 2,800 - - - -
Payments-Receipts
Surplus - - 5,200 26,000 37,200 35,600
Cumulative Requirements 34,800 37,600 32,400 6,400 - -
of Working Capital
Surplus Working Capital - - - - 30,800 66,400
PAGE 217
Notes Working Notes:

(i) As payment for material is made in the month following the purchase,
there is no payment for material in January. In February, material
payment is calculated as 900 × 16 = Rs. 14,400 and in the same
manner for other months.
(ii) Cash sales are calculated as:

For January 900 × 80 × 1/3 = Rs. 24,000 and in the same manner
for other months.
(iii) Receipts from debtors are calculated as:

For Jan. – Nil because cash from debtors is collected in the month
following the sales.
For Feb. – 900 × 80 × 2/3 = Rs. 48,000.
For March – 1200 × 80 × 2/3 = Rs. 64,000 and so on.
2.7 Summary
The current lesson talks about the importance of working capital in a
business. The working capital requirements should be calculated prior
to the need so that the same can be provided at the adequate time. But
estimation of working capital requirements is not an easy task and large
numbers of factors have to be considered before starting this exercise.
There are different approaches like Working Capital as a Percentage of
Net Sales, Working Capital as a Percentage of Total Assets or Fixed
Asset and Working Capital based on Operating Cycle are available for
the estimation of working capital in a business.
1. Working Capital
2. Working Capital as a Percentage of Net Sales
3. Working Capital as a Percentage of Total Assets or Fixed Asset
218 PAGE
2.9 Self-Assessment Questions Notes
1. What are the steps involved in the estimation of working capital?

2. What are the factors requiring consideration while estimating working
capital?

u Maheshwari, S.N. (2019), Elements of Financial Management, Delhi:
u Maheshwari, S.N. (2019), Financial Management – Principles &
u Pandey, I.M. (2022), Essentials of Financial Management, Pearson.
Delhi: Taxmann. New Delhi: 6EC (1264)-03.02.2023.
Delhi: S. Chand.
PAGE 219
L E S S O N
3
Financing of Working
Capital
Smriti Chawla
STRUCTURE

3.2 Introduction
3.3 Financing of Permanent/Fixed or Long-Term Working Capital
3.4 Financing of Temporary or Working Capital
3.5 New Trend in Financing Working Capital by Banks
3.6 Summary

u How to finance the long-term working capital.
u How to finance the short-term working capital.
3.2 Introduction
The working capital requirements of concern can be classified as:
(a) Permanent or Fixed working capital requirements
(b) Temporary or Variable working capital requirements
In any concern, a part of the working capital investments are as permanent investments in
fixed assets. This is so because there is always a minimum level of current assets which
are continuously required by enterprise to carry out its day-to-day business operations and
220 PAGE
this minimum cannot be expected to reduce at any time. This minimum Notes
level of current assets give rise to permanent or fixed working capital
as this part of working capital is permanently blocked in current assets.
Similarly, some amount of working capital may be required to meet the
seasonal demands and some special exigencies such as rise in prices,
strikes etc. This proportion of working capital gives rise to temporary or
variable working capital which cannot be permanently employed gainfully
in business.
The fixed proportion of working capital should be generally financed
from the fixed capital sources while temporary or variable working capital
requirements of a concern may be met from the short-term sources of
capital.
The various sources for financing of working capital are as follows:
Sources of Working Capital
Permanent or Fixed Temporary or Variable
1. Shares 1. Trade Credit
2. Debentures 2. Accrued Expenses
3. Public deposits 3. Commercial Paper
4. Ploughing back of profits 4. Factoring or Accounts Receivable
5. Loans from Financial Institutions. Credit
5. Instalment Credit
6. Commercial Banks
3.3 Financing of Permanent/Fixed or Long-Term Working

Capital
Permanent working capital should be financed in such a manner that the
enterprise may have its uninterrupted use for a sufficiently long period.
There are five important sources of permanent or long-term working capital.
(a) Shares: Issue of shares is the most important source for raising the
permanent or long-term capital. A company can issue various types
of shares as equity shares, preference shares and deferred shares.
According to the Companies Act, 1956, however, a public company
cannot issue deferred shares. Preference shares carry preferential
PAGE 221
Notes rights in respect of dividend at a fixed rate and in regard to the

repayment of capital at the time of winding up the company. Equity
shares do not have any fixed commitment charge and the dividend
on these shares is to be paid subject to the availability of sufficient
profits. As far as possible, a company should raise the maximum
amount of permanent capital by the issue of shares.
(b) Debentures: A debenture is an instrument issued by the company
acknowledging its debt to its holder. It is also an important method
of raising long-term or permanent working capital. The debenture-
holders are the creditors of the company. A fixed rate of interest is
paid on debentures. The interest on debentures is a charge against
profit and loss account. The debentures are generally given floating
charge on the assets of the company. When the debentures are secured
they are paid on priority to other creditors. The debentures may be
of various kinds such as simple, naked or unsecured debentures,
secured or mortgaged debentures, redeemable debentures, irredeemable
debentures, convertible debentures and non-convertible debenture.
The firm issuing debentures also enjoys a number of benefits such
as trading on equity, retention of control, tax benefits, etc.
(c) Public Deposits: Public deposits are the fixed deposits accepted by a
business enterprise directly from the public. This source of raising
short term and medium term finance was very popular in the absence
of banking facilities. Public deposits as a source of finance have
a large number of advantages such as very simple and convenient
source of finance, taxation benefits, trading on equity, no need of
securities and an inexpensive source of finance. But it is not free
from certain dangers such as: it is uncertain, unreliable, unsound
and inelastic source of finance. The Reserve Bank of India has also
laid down certain limits on public deposits.
(d) Ploughing back of profits: Ploughing back of profits means the
reinvestments by concern of its surplus earnings in its business.
It is an internal source of finance and is most suitable for an
established firm for its expansion, modernisation and replacement
etc. This method of finance has a number of advantages as it is
the cheapest rather cost-free source of finance; there is no need
to keep securities; there is no dilution of control; it ensures stable
222 PAGE
dividend policy and gains confidence of the public. But excessive Notes
resort to ploughing back of profits may lead to monopolies, misuse
of funds, over capitalization and speculation etc.
(e) Loans from Financial Institutions: Financial institutions such as
Commercial Banks, Life Insurance Corporation, Industrial Finance
Corporation of India, State financial Corporations, State Industrial
Development Corporations, Industrial Development Bank of India,
etc. also provide short-term, medium-term and long-term loans.
This source of finance is more suitable to meet the medium term
demands of working capital. Interest is charged on such loans at
a fixed rate and the amount of the loan is to be repaid by way of
instalments in a number of years.
3.4 Financing of Temporary or Working Capital

1. Trade Credit: Trade credit refers to the credit extended by the
suppliers of goods in the normal course of business. As present day
commerce is built upon credit, the trade credit arrangement of a
firm with its suppliers is an important source of short-term finance.
The creditworthiness of a firm and the confidence of its suppliers
are the main basis of securing trade credit. It is mostly granted on
an open account basis whereby supplier sends goods to the buyer
for the payment to be received in future as per terms of the sales
invoice. It may also take the form of bills payable whereby the
buyer signs a bill of exchange payable on a specified future date.
When a firm delays the payment beyond the due date as per the
terms of sales invoice, it is called stretching accounts payable.
A firm may generate additional short-term finances by stretching
accounts payable, but it may have to pay penal interest charges
as well as to forgo cash discount. If a firm delays the payment
frequently, it adversely affects the creditworthiness of the firm and
it may not be allowed such credit facilities in future.
The main advantages of trade credit as a source of short-term finance
include:
(i) It is an easy and convenient method of finance.
PAGE 223
Notes (ii) It is flexible as the credit increases with the growth of the
firm.
(iii) It is informal and spontaneous source of finance.
However, the biggest disadvantage of this method of finance is
charging of higher prices by the suppliers and loss of cash discount.
2. Accrued Expenses: Accrued expenses are the expenses which have
been incurred but not yet due and hence not yet paid also. These
simply represent a liability that a firm has to pay for the services
already received by it. The most important item of accruals is wages
and salaries, interest and taxes. The longer the payment period of
wages and salaries the greater is the amount of liability towards
employees. In same manner, accrued interest and taxes also constitute
a short-term source of finance.
3. Commercial Paper: Commercial paper represents unsecured promissory
notes issued by firms to raise short-term funds. It is an important
money market instrument in advanced countries like U.S.A. In
India, the Reserve Bank of India introduced commercial paper in
the Indian money market on the recommendations of the Working
Group on Money Market (Vaghul Committee). But only large
companies enjoying high credit rating and sound financial health
can issue commercial paper to raise short-term funds. The Reserve
Bank of India has laid down a number of conditions to determine
eligibility of a company for the issue of commercial paper. Only
a company which is listed on the stock exchange, has a net worth
of at least Rs. 10 crores and a maximum permissible bank finance
of Rs. 25 crores can issue commercial paper not exceeding 30 per
cent of its working capital limit.

The maturity period of commercial paper, in India, mostly ranges
from 91 to 180 days. It is sold at a discount from its face value
and redeemed at face value on its maturity. Hence the cost of
raising funds, through this source, is a function of the amount of
discount and the period of maturity and no interest rate is provided
by the Reserve Bank of India for this purpose. Commercial paper is
usually bought by investors including banks, insurance companies,
224 PAGE
unit trusts and firms to invest surplus funds for a short-period. A Notes
credit rating agency called CRISIL, has been set up in India by
ICICI and UTI to rate commercial paper.
Commercial paper is a cheaper source of raising short-term finance as
compared to the bank credit and proves to be effective even during
period of tight bank credit. However, it can be used as a source of
finance only by large companies enjoying high credit rating and
sound financial health. Another disadvantage of commercial paper
is that it cannot be redeemed before the maturity date even if the
issuing firm has surplus funds to pay back.
4. Factoring or Accounts Receivable Credit: Another method of raising
short-term finance is through accounts receivable credit offered by
commercial banks and factors. Commercial banks provide finance
by discounting the bills. Thus, a firm gets immediate payment for
sales made on credit. A factor is a financial institution which offers
services relating to management and financing of debts arising out
of credit sales.
5. Instalment Credit: This is another method by which the assets are
purchased and the possession of goods is taken immediately but
payment is made in instalments over a predetermined period of
time. Generally, interest is charged on the unpaid price or it may
be adjusted in the price. But in any case it provides funds for
sometime and is used as a source of short-term working capital by
many business houses which have difficult fund position.
Working Capital Finance by Commercial Banks
Commercial banks are the most important source of short-term capital.
The major portion of working capital loans are provided by commercial
banks. They provide a wide variety of loans tailored to meet the specific
requirements of a concern. The different forms in which the banks normally
provide loans and advances are as follows:
(a) Loans
(b) Cash Credits
(c) Overdrafts
(d) Purchasing and Discounting of bills.
PAGE 225
Notes (a) Loans: When a bank makes an advance in lump-sum against some
security it is called a loan, In case of a loan, a specified amount
is sanctioned by the bank to the customer. The entire loan amount
is paid to the borrower either in cash or by credit to his account.
The borrower is required to pay interest on the entire amount of
the loan from the date of the sanction. A loan may be repayable in
lump sum or instalments, Interest on loans is calculated at quarterly
rests and where repayments are stipulated in instalments, and the
interest is calculated at quarterly rests on the reduced balances.
Commercial banks generally provide short-term loans up to one
year for meeting working capital requirements. But now-a-days
term loans exceeding one year are also provided by banks. The
term loans may be either medium-term or long-term loans.
(b) Cash Credits: A cash credit is an arrangement by which a bank
allows his customer to borrow money upto a certain limit against
some tangible securities or guarantees.
(c) Overdrafts: Overdrafts means an agreement with a bank by which
a current account- holder is allowed to withdraw more than the
balance to his credit upto a certain limit. There are no restrictions
for operation of overdraft limits. The interest is charged on daily
overdrawn balances. The main difference between cash credit and
overdraft is that overdraft is allowed for a short period and is a
temporary accommodation whereas the cash credit is allowed for
a longer period. Overdraft accounts can either be clean overdrafts,
partly secured or fully secured.
(d) Purchasing and Discounting of Bills: Purchasing and discounting
of bills is the most important form in which a bank lends without
any collateral security. Present day commerce is built upon credit.
The seller draws a bill of exchange on the buyer of goods on credit.
Such a bill may be either a clean bill or a documentary bill which
is accompanied by documents of title to goods such as a railway
receipt. The bank purchases the bills payable on demand and credits
the customer’s account with the amount of bill less discount. At
the maturity of the bills, bank presents the bill to its acceptor for
payment. In case the bill discounted is dishonoured by non-payment,
226 PAGE
the bank recovers the full amount of the bill from the customer Notes
along with expenses in that connection.
In addition to the above mentioned forms of direct finance, commercial
banks help their customers in obtaining credit from their suppliers through
the letter of credit arrangement.
Letter of Credit
A letter or credit popularly known as L/c is an undertaking by a bank to
honour the obligations of its customer upto a specified amount, should
the customer fail to do so. It helps its customers to obtain credit from
suppliers because it ensures that there is no risk of non-payment. L/c
is simply a guarantee by the bank to the suppliers that their bills upto
a specified amount would be honoured. In case the customer fails to
pay the amount, on the due date, to its suppliers, the bank assumes the
liability of its customer for the purchases made under the letter of credit
arrangement.
A letter of credit may be of many types, such as:
(i) Clean Letter of Credit. It is a guarantee for the acceptance and
payment of bills without any conditions.
(ii) Documentary Letter of Credit. It requires that the exporter’s bill of
exchange be accompanied by certain documents evidencing title to
the goods.
(iii) Revocable Letter of Credit. It is one which can be withdrawn by the
issuing bank without the prior consent of the exporter.
(iv) Irrevocable Letter of Credit. It cannot be withdrawn without the
Consent of the beneficiary.
(v) Revolving Letter of Credit. In such type of letter of credit the amount
of credit it automatically reversed to the original amount after such
an amount has once been paid as per defined conditions of the
business transaction. There is no need for further application for
another letter of credit to be issued provided the conditions specified
in the first credit are fulfilled.
(vi) Fixed Letter of Credit. It fixes the amount of financial obligation of
the issuing bank either in one bill or in several bills put together.
PAGE 227
Notes Security Required in Bank Finance

Banks usually do not provide working capital finance without obtaining
adequate security. The following are the most important modes of security
required by a bank:
1. Hypothecation: Under this arrangement, bank provides working capital
finance against the security of movable property, usually inventories.
The borrower does not give possession of the property to the bank.
It remains with the borrower and hypothecation is merely a charge
against property for the amount of debt. If the borrower fails to
pay his dues to the bank, the banker may file a case to realise his
dues by sales of the goods/property hypothecated.
2. Pledge: Under this arrangement, the borrower is required to transfer
the physical possession of the property or goods to the bank as
security. The bank will have the right of lien and can retain the
possession of goods unless the claim of the bank is met. In case of
default, the bank can even sell the goods after giving due notice.
3. Mortgage: In addition to the hypothecation or pledge, banks usually
ask for mortgages as collateral or additional security. Mortgage is
the transfer of a legal or equitable interest in a specific immovable
property for the payment of a debt. Although, the possession of the
property remains with the borrower, the full legal title is transferred
to the lender. In case of default, the bank can obtain decree from
the court to sell the immovable property mortgaged so as to realise
its dues.
IN-TEXT QUESTIONS
1. The ___________ level of current assets give rise to permanent
or fixed working capital as this part of working capital is
permanently blocked in current assets.
2. A ________ is an instrument issued by the company acknowledging
its debt to its holder.
3. ____________ expenses are the expenses which have been
incurred but not yet due and hence not yet paid also.
228 PAGE
3.5 New Trend in Financing Working Capital by Banks Notes
National Credit Council constituted a committee under the chairmanship

of Shri V.T. Dehejia in 1968 to ‘determine the extent to which credit
needs of industry and trade are likely to be inflated and how such trends
could be checked’ and to go into establishing some norms for lending
operations by commercial banks. The committee was of the opinion that
there was also a tendency to divert short-term credit for long-term assets.
Although committee was of the opinion that it was difficult to evolve
norms for lending to industrial concerns, the committee recommended that
the banks should finance industry on the basis of a study of borrower’s
total operations rather than security basis alone. The Committee further
recommended that the total credit requirements of the borrower should
be segregated into ‘Hard Core’ and ‘Short-term’ component. The ‘Hard
Core’ component which should represent the minimum level of inventories
which the industry was required to hold for maintaining a given level
of production should be put on a formal term loan basis and subject to
repayment schedule. The committee was also of the opinion that generally
a customer should be required to confine his dealings to one bank only.
u Tandon Committee Report

Reserve Bank of India set up a committee under the chairmanship
of Shri P.L. Tandon in July 1974. The terms of reference of the
Committee were:
1. To suggest guidelines for commercial banks to follow up and
supervise credit from the point of view of ensuring proper end
use of funds and keeping a watch on the safety of advances;
2. To suggest the type of operational data and other information
that may be obtained by banks periodically from the borrowers
and by the Reserve Bank of India from the leading banks;
3. To make suggestions for prescribing inventory norms for the
different industries, both in the private and public sectors and
indicate the broad criteria for deviating from these norms;
4. To make recommendations regarding resources for financing
the minimum working capital requirements;
PAGE 229
Notes 5. To suggest criteria regarding satisfactory capital structure and

sound financial basis in relation to borrowings;
6. To make recommendations as to whether the existing pattern
of financing working capital requirements by cash credit/
overdraft system etc., requires to be modified, if so, to suggest
suitable modifications.
The committee was of the opinion that: (i) bank credit is extended
on the amount of security available and not according to the level
of operations of the customer, (ii) bank credit instead of being taken
as a supplementary to other sources of finance is treated as the
first source of finance, Although the Committee recommended the
continuation of the existing cash credit system, it suggested certain
modifications so as to control the bank finance. The banks should
get the information regarding the operational plans of the customer
in advance so as to carry a realistic appraisal of such plans and
the banks should also know the end-use of bank credit so that the
finances are used only for purposes for which they are lent.
The recommendations of the committee regarding lending norms
have been suggested under three alternatives. According to the first
method, the borrower will have to contribute a minimum of 25%
of the working capital gap from long-term funds, i.e., owned funds
and term borrowing; this will give a minimum current ratio of 1.17:
1. Under the second method the borrower will have to provide a
minimum of 25% of the total current assets from long-term funds;
this will give a minimum current ratio of 1.33: 1. In the third
method, the borrower’s contribution from long-term funds will be
to the extent of the entire core current assets and a minimum of
25% of the balance current assets, thus strengthening the current
ratio further.
u Chore Committee Report

The Reserve Bank of India in March, 1979 appointed another committee
under the chairmanship of Shri K.B. Chore to review the working
of cash credit system in recent years with particular reference to
the gap between sanctioned limits and the extent of their utilisation
and also to suggest alternative type of credit facilities which should
ensure greater credit discipline.
230 PAGE
The important recommendations of the Committee are as follows: Notes

(i) The banks should obtain quarterly statements in the prescribed
format from all borrowers having working capital credit limits
of Rs. 50 lacs and above.
(ii) The banks should undertake a periodical review of limits of
Rs. 10 lacs and above.
(iii) The banks should not bifurcate cash credit accounts into
demand loan and cash credit components.
(iv) If a borrower does not submit the quarterly returns in time the
banks may charge penal interest of one per cent on the total
amount outstanding for the period of default.
(v) Banks should discourage sanction of temporary limits by charging
additional one per cent interest over the normal rate on these
limits.
(vi) The banks should fix separate credit limits for peak level and
non-peak level, wherever possible. .
(vii) Banks should take steps to convert cash credit limits into bill
limits for financing sales.
u Marathe Committee Report

The Reserve Bank of India, in 1982 appointed a committee under
the chairmanship of Marathe to review the working of Credit
Authorisation Scheme (CAS) and suggest measures for giving
meaningful directions to the credit management function of the
Reserve Bank. The recommendations of the committee have been
accepted by the Reserve Bank of India with minor modifications.
The principal recommendations of the Marathe Committee include;
(i) The committee has declared the Third Method of Lending as
suggested by the Tandon Committee to be dropped. Hence,
in future, the banks would provide credit for working capital
according the Second Method of Lending.
(ii) The committee has suggested the introduction of the ‘Fast Track
Scheme’ to improve the quality of credit appraisal in Banks. It
recommended that commercial banks can release without prior
approval of the Reserve Bank 50% of the additional credit
PAGE 231
Notes required by the borrowers (75% in case of export oriented

manufacturing units) where the following requirements are
fulfilled:
(a) The estimates/projections in regard to production, sales
chargeable current assets, other current assets, current
liabilities other than bank borrowings and net working
capital are reasonable in terms of the past trends and
assumptions regarding most likely trends during the
future projected period.
(b) The classification of assets and liabilities as ‘current’
and ‘non-current’ is in conformity with the guidelines
issued by the Reserve Bank of India.
(c) The projected current ratio is not below 1.33:1.
(d) The borrower has been submitting quarterly information
and operating statements (Form I, II and III) for the past
six months within the prescribed time and undertakes
to do the same in future also.
(e) The borrower undertakes to submit to the bank his
annual account regularly and promptly further, the
bank is required to review the borrower’s facilities at
least once in a year even if the borrower does not need
enhancement in credit facilities.
u Kannan Committee

The Kannan Committee was the first committee to have suggested
that the prescribed uniform formula for MPBF should go and the
banks should have the sole discretion to determine borrowing limits
of corporates. However, the change from the MPBF system should
keep in view the size of various banks, their delegation system,
exposure limit etc. Banks and the borrowers should be left free to
decide the system they adopt for financing working capital.
The main recommendations of the committee are summarized as
under:
(i) The system of cash credit should be replaced by a system of
loans for working capital.
232 PAGE
(ii) The uniform formula for MPBF should be abolished and banks Notes
should be given discretion for determining borrowing limits
for corporates.
(iii) The corporate borrowers may be allowed to issue short-term
debentures for meting short-term requirements and banks may
subscribe to these debentures.
(iv) Margins and holding levels of stocks and receivables as security
may be left to the discretion of the banks.
(v) Benchmark current ratio of 1.33:1 should be left to the discretion
of the banks.
(vi) A credit information bureau should be floated independently
by banks.
(vii) Banks should be allowed to decide policy norms for issue of
commercial papers.
(viii) Borrowers will have to obtain prior approval for investments
of funds outside the business in inter corporate deposits etc.
(ix) Banks should also try out the syndicate form of lending.
(x) Periodical statement of stocks, debtors coupled with verification
of securities to be the credit-monitoring tool.
IN-TEXT QUESTIONS
4. The Reserve Bank of India, in 1982 appointed ___________
committee to review the working of Credit Authorisation Scheme
(CAS) and suggest measures for giving meaningful directions
to the credit management function of the Reserve Bank.
5. The __________ committee suggested that the system of cash
credit should be replaced by a system of loans for working
capital.
3.6 Summary
u The total requirement of working capital may be bifurcated in
PAGE 233
Notes u The permanent working capital which is required irrespective of

the fluctuations in the sale level should be financed by arranging
funds from long-term sources such as debt and equity.
u However, the temporary requirement should be financed from short-
term sources of finance.
u Commercial papers as unsecured promissory note can also be used
by a firm, under the guidelines provided by the RBI, to arrange
funds for a short period.
u Commercial banks also provide short-term credit in terms of cash
credit, bills purchased, letter of credit and working capital term
loans.
1. Minimum
2. Debenture
3. Accrued
4. Marathe
5. Kannan

1. Examine the importance of trade credit and accrued expenses as a
source of working capital financing?
2. Write short note on commercial paper?
3. Describe important features of Tandon Committee?

234 PAGE
u Kothari, R. (2016), Financial Management: A Contemporary Approach, Notes

Delhi: S. Chand.
PAGE 235
L E S S O N
4
Management of Cash
Smriti Chawla
STRUCTURE
4.2 Introduction
4.3 Nature of Cash
4.4 Motives for Holding Cash
4.5 Cash Management
4.6 Managing Cash Flows
4.7 Methods of Accelerating Cash Inflows
4.8 Methods of Slowing Cash Outflows
4.9 Determining Optimum Cash Balance
4.10 Baumol’s Model
4.11 Miller-Orr Model
4.12 Investment of Surplus Funds
4.13 Illustrations
4.14 Summary

u The relevance of cash management in the business.
u Methods of managing cash flows.
u How to reach optimum cash balance.
236 PAGE
Cash is one of the current assets of a business. It is needed at all times to

keep the business going. A business concern should always keep sufficient
cash for meeting its obligations. Any shortage of cash will hamper
the operations of a concern and any excess of it will be unproductive.
Cash is the most unproductive of all the assets. While fixed assets like
machinery, plant, etc. and current assets such as inventory will help the
business in increasing its earning capacity, cash in hand will not add
anything to the concern. It is in this context that cash management has
assumed much importance.
4.3 Nature of Cash

For some persons, cash means only money in the form of currency (cash
in hand). For other persons, cash means both cash in hand and cash at
bank. Some even include near cash assets in it. They take marketable
securities too as part of cash. These are the securities which can easily
be converted into cash.
Cash itself does not produce goods or services. It is used as a medium to
acquire other assets. It is the other assets which are used in manufacturing
goods or providing services. The idle cash can be deposited in bank to
earn interest.
A business has to keep required cash for meeting various needs. The
assets acquired by cash again help the business in producing cash. The
goods manufactured of services produced are sold to acquire cash. A
firm will have to maintain a critical level of cash. If at a time it does
not have sufficient cash with it, it will have to borrow from the market
for reaching the required level.
There remains a gap between cash inflows and cash outflows. Sometimes
cash receipts are more than the payments or it may be vice versa at
another time. A financial manager tries to synchronize the cash inflow
and cash outflows.
PAGE 237
Notes 4.4 Motives for Holding Cash

The firm’s needs for cash may be attributed to the following needs:
Transactions motive, Precautionary motive and Speculative motive. These
motives are discussed as follows:
1. Transaction Motive: A firm needs cash for making transactions in
the day-to-day operations. The cash is needed to make purchases,
pay expenses, taxes, dividend, etc. The cash needs arise due to the
fact that there is no complete synchronization between cash receipts
and payments. Sometimes cash receipts exceed cash payments or
vice versa. The transaction needs of cash can be anticipated because
the expected payments in near future can be estimated. The receipts
in future may also be anticipated but the things do not happen as
desired. If more cash is needed for payments than receipts, it may
be raised through bank overdraft. On the other hand if there are
more cash receipts than payments, it may be spent on marketable
securities.
2. Precautionary Motive: A firm is required to keep cash for meeting
various contingencies. Though cash inflows and cash outflows are
anticipated but there may be variations in these estimates. For
example a debtor who was to pay after 7 days may inform of his
inability to pay; on the other hand a supplier who used to give
credit for 15 days may not have the stock to supply or he may not
be in a position to give credit at present. In these situations cash
receipts will be less than expected and cash payments will be more
as purchases may have to be made for cash instead of credit. Such
contingencies often arise in a business. A firm should keep some
cash for such contingencies or it should be in a position to raise
finances at a short period.
3. Speculative Motive: The speculative motive relates to holding of cash
for investing in profitable opportunities as and when they arise. Such
opportunities do not come in a regular manner. These opportunities
cannot be scientifically predicted but only conjectures can be made
about their occurrence. The price of shares and securities may be
low at a time with an expectation that these will go up shortly. Such
opportunities can be availed of if a firm has cash balance with it.
238 PAGE
4.5 Cash Management Notes
Cash management has assumed importance because it is the most significant

of all the current assets. It is required to meet business obligations and
it is unproductive when not used.
Cash management deals with the following:
(i) Cash inflows and outflows.
(ii) Cash flows within the firm.
(iii) Cash balances held by the firm at a point of time.
Cash Management needs strategies to deal with various facets of cash.
Following are some of its facets:
(a) Cash Planning: Cash planning is a technique to plan and control the
use of cash. A projected cash flow statement may be prepared, based
on the present business operations and anticipated future activities.
The cash inflows from various sources may be anticipated and cash
outflows will determine the possible uses of cash.
(b) Cash Forecasts and Budgeting: A cash budget is the most important
device for the control of receipts and payments of cash. A cash budget
is an estimate of cash receipts and disbursements during a future
period of time. It is an analysis of flow of cash in a business over
a future, short or long period of time. It is a forecast of expected
cash intake and outlay.
The short-term forecasts can be made with the help of cash flow
projections. The finance manager will make estimates of likely receipts
in the near future and the expected disbursements in that period. Though
it is not possible to make exact forecasts even then estimates of cash
flow will enable the planners to make arrangement for cash needs. A
financial manager should keep in mind the sources from where he will
meet short-term needs. He should also plan for productive use of surplus
cash for short periods.
The long-term cash forecasts are also essential for proper cash planning.
These estimates may be for three, four, five or more years. Long-term
forecasts indicate company’s future financial needs for working capital,
capital projects, etc.
PAGE 239
Notes Both short term and long term cash forecasts may be made with help of
following methods:
(a) Receipts and Disbursements Method.
(b) Adjusted net income Method.
Receipts and Disbursements Method
In this method the receipt and payment of cash are estimated. The cash
receipts may be from cash sales, collections from debtors, sale of fixed
assets, receipts of dividend or other income of all the items; it is difficult
to forecast the sales. The sales may be on cash as well as credit basis.
Cash sales will bring receipts at the time of sales while credit sale will
bring cash later on. The collections from debtors will depend upon the
credit policy of the firm. Any fluctuation in sales will disturb the receipts
of cash. Payments may be made for cash purchases, to creditors for goods,
purchase of fixed assets etc.
The receipts and disbursements are to be equal over a short as well as
long periods. Any shortfall in receipts will have to be met from banks
or other sources. Similarly, surplus cash may be invested in risk free
marketable securities. It may be easy to make estimates for payments
but cash receipts may not be accurately made.
Adjusted Net Income Method
This method may also be known as sources and uses approach. It
generally has three sections: sources of cash, uses of cash and adjusted
cash balance. The adjusted net income method helps in projecting the
company’s need for cash at some future date and to see whether the
company will be able to generate sufficient cash. If not, then it will have
to decide about borrowing or issuing shares etc. in preparing its statement
the items like net income, depreciation, dividends, taxes etc. can easily be
determined from company’s annual operating budget. The estimation of
working capital movement becomes difficult because items like receivables
and inventories are influenced by factors such as fluctuations in raw
material costs, changing demand for company’s products. This method
helps in keeping control on working capital and anticipating financial
requirements.
240 PAGE
IN-TEXT QUESTIONS Notes
1. Cash is one of the ____________ of a business.

(a) Asset
(b) Liability
(c) Current asset
(d) Current liability
2. Which of the following is not a motive of cash?
(a) Transaction Motive
(b) Precautionary Motive
(c) Speculative Motive
3. Cash ___________ is a technique to plan and control the use of
cash.
4. In ___________ method the receipt and payment of cash are
estimated.
5. In ___________ method helps in projection of cash needs in the
future.
4.6 Managing Cash Flows

Methods of accelerating Cash Inflows
After estimating the cash flows, efforts should be made to adhere to the
estimates or receipts and payments of cash. Cash management will be
successful only if cash collections are accelerated and cash disbursements,
as far as possible, are delayed. The following methods of cash management
will help:
4.7 Methods of Accelerating Cash Inflows

1. Prompt Payment by Customers: In order to accelerate cash inflows,
the collections from customers should be prompt. This will be
possible by prompt billing. The customers should be promptly
informed about the amount payable and the time by which it should
PAGE 241
Notes be paid. Another method for prompting customers to pay earlier is

to allow them cash discount.
2. Quick Conversion of Payment into Cash: Cash inflows can be
accelerated by improving the cash collecting process. Once the
customer writes a cheque in favour of the concern the collection can
be quickened by its early collection. There is a time gap between
the cheque sent by the customer and the amount collected against
it. This is due to many factors, (i) mailing time, i.e. time taken
by post office for transferring cheque from customer to the firm,
referred to as postal float; (ii) time taken in processing the cheque
within the organization and sending it to bank for collection, it is
called lethargy and (iii) collection time within the bank, i.e. time
taken by the bank in collecting the payment from the customer’s
bank, called bank float. The postal float, lethargy and bank float
are collectively referred to as deposit float. The term deposit float
refers to cheques written by customers but the amount not yet usable
by the firm.
3. Decentralised Collections: A big firm operating over wide geographical
area can accelerate collections by using the system of decentralised
collections. A number of collecting centres are opened in different
areas instead of collecting receipts at one place. The idea of
opening different collecting centres is to reduce the mailing time
for customer’s dispatch of cheque and its receipt in the firm and
then reducing the time in collecting these cheques.
4. Lock Box System: Lock box system is another technique of reducing
mailing, processing and collecting time. Under this system the firm
selects some collecting centres at different places. The places are
selected on the basis of number of consumers and the remittances
to be received from a particular place.
4.8 Methods of Slowing Cash Outflows

A company can keep cash by effectively controlling disbursements. The
objective of controlling cash outflows is slow down the payments as far
as possible. Following methods can be used to delay disbursements:
242 PAGE
1. Paying on Last Date: The disbursements can be delayed on making Notes

payments on the last due date only. It is credit is for 10 days then
payment should be made on 10th day only. It can help in using
the money for short periods and the firm can make use of cash
discount also.
2. Payments through Drafts: A company can delay payments by issuing
drafts to the suppliers instead of giving cheques. When a cheque is
issued then the company will have to keep a balance in its account
so that the cheque is paid whenever it comes. On the other hand
a draft is payable only on presentation to the issuer. The receiver
will give the draft to its bank for presenting it to the buyer’s bank.
It takes a number of days before it is actually paid. The company
can economise large resources by using this method.
3. Adjusting Payroll Funds: Some economy can be exercised on
payroll funds also. It can be done by reducing the frequency of
payments. If the payments are made weekly then this period can
be extended to a month. Secondly, finance manager can plan the
issuing of salary cheques and their disbursements. If the cheques
are issued on Saturday then only a few cheque may be presented
for payment, even on Monday all cheques may not be presented.
4. Centralisation of Payments: The payments should be centralised and
payments should be made through drafts or cheques. When cheques
are issued from the main office then it will take time for the cheques
to be cleared through post. The benefit of cheque collecting time
is availed.
5. Inter-bank Transfer: An efficient use of cash is also possible by inter-
bank transfers. If the company has accounts with more than one bank
then amounts can be transferred to the bank where disbursements
are to be made. It will help in avoiding excess amount in one bank.
6. Making use of Float: Float is a difference between the balance
shown in company’s cash book (Bank column) and balance in
passbook of the bank. Whenever a cheque is issued, the balance
at bank in cashbook is reduced. The party to whom the cheque is
issued may not present it for payment immediately. If the party is
at some other station then cheque will come through post and it
may take a number of days before it is presented. Until the time;
PAGE 243
Notes the cheques are not presented to bank for payment there will be a
balance in the bank. The company can make use of this float if it
is able to estimate it correctly.
4.9 Determining Optimum Cash Balance

A firm has to maintain a minimum amount of cash for settling the dues
in time. The cash is needed to purchase raw materials, pay creditors,
day-to-day expenses, dividend etc.
An appropriate amount of cash balance to be maintained should be
determined on the basis of past experience and future expectations. If a
firm maintains less cash balance then its liquidity position will be weak.
If higher cash balance is maintained then an opportunity to earn is lost.
Thus, a firm should maintain an optimum cash balance, neither a small
nor a large cash balance.
There are basically two approaches to determine an optimal cash balance,
namely, (i) Minimising Cost Models and (ii) Preparing Cash Budget. Cash
budget is the most important tool in cash management.
Cash Budget
A cash budget is an estimate of cash receipts and disbursements of
cash during a future period of time. In the words of soloman Ezra, a
cash budget is “an analysis of flow of cash in a business over a future,
short or long period of time. It is a forecast of expected cash intake and
outlay.” It is a device to plan and control the use of cash. Thus a firm
by preparing a cash budget can plan the use of excess cash and make
arrangements for the necessary cash as and when required.
The cash receipts from various sources are anticipated. The estimated
cash collections for sales, debts, bills receivable, interests, dividends and
other incomes and sale of investments and other assets will be taken into
account. The amounts to be spent on purchase of materials, payment to
creditors and meeting various other revenue and capital expenditure needs
should be considered. Cash forecasts will include all possible sources
from which cash will be received and the channels in which payments
are to be made so that a consolidated cash position is determined.
244 PAGE
4.10 Baumol’s Model Notes
William J. Baumol has suggested a model for determining the optimum

balance of cash based upon carrying and transaction costs of cash. The
carrying cost refers to the cost of the holding cash i.e. interest; and
transaction cost refers to the cost involved in getting the marketable
securities converted into cash, the algebraic representation of the model is:
2A × F
C=
O
where, C = Optimum cash balance
A = Annual (or monthly) cash disbursements) F = Fixed cost
per transaction
O = Opportunity cost of cash
Limitations of Model:
1. The model assumes a constant rate of use of cash. This is hypothetical
assumption. Generally the cash outflows in any firm are not regular
and hence this model may not give correct results.
2. The transaction cost will also be difficult to be measured since
these depend upon the type of investment as well as the maturity
period.
4.11 Miller-Orr Model

The Miller–Orr model argues that changes in cash balance over a given
period are random in size as well as in direction. The cash balance of a
firm may fluctuate irregularly over a period of time. The model assumes
(i) out of the two assets i.e. cash and marketable securities, the latter has
a marginal yield, and (ii) transfer of cash to marketable securities and
vice versa is possible without any delay but of course of at some cost.
The model has specified two control limits for cash balance. An upper
limit, H, beyond which cash balance need not be allowed to go and a
lower limit, L, below which the cash level is not allowed to reduce. The
cash balance should be allowed to move within these limits. If the cash
level reaches the upper control limit, H, then at this point, apart of the
cash should be invested in marketable securities in such a way that the
PAGE 245
Notes cash balance comes down to a predetermined level called return level, R,
If the cash balance reaches the lower level, L then sufficient marketable
securities should be sold to realize cash so that cash balance is restored
to the return level, R. No transaction between cash and marketable
securities is undertaken so long as the cash balance is between the two
limits of H and L.
The Miller–Orr model has superiority over the Baumol’s model. The latter
assumes constant need and constant rate of use of funds, the Miller-Orr
model, on the other hand is more realistic and maintains that the actual
cash balance may fluctuate between higher and the lower limits. The
model may be defined as:
Z = (3TV / 4i)1/3
Where, T = Transaction cost of conversion

V = Variance of daily cash flows
i = Daily % interest rate on investments.
4.12 Investment of Surplus Funds

There are sometimes surplus funds with the companies which are required
after sometime. These funds can be employed in liquid and risk free
securities to earn some income. There are number of avenues where these
funds can be invested. The selection of securities or method of investment
is very important. Some of these methods are discussed herewith:
Treasury Bills: The treasury bills or T-Bills are the bills issued by the
Reserve Bank of India for different maturity periods. These bills are highly
safe investment and are easily marketable. These treasury bills usually have
a very low level of yield and that too in the form of difference purchase
price and selling price as there is no interest payable on these bills.
Bank Deposits: All the commercial banks are offerings short-term deposits
schemes at varying rate of interest depending upon the deposit period.
A firm having excess cash can make deposit for even short period of
few days only. These deposits provide full safety, facility of pre-mature
retirement and a comfortable return.
Inter-Corporate Deposits: A firm having excess cash can make deposit
with other firms also. When company makes deposits with another company,
246 PAGE
such deposit is known as inter corporate deposits. These deposits are Notes
usually for a period of three months to one year. Higher rate of interest
is an important characteristic of these deposits.
Bill Discounting: A firm having excess cash can also discount the bills
of other firms in the same way as the commercial banks do. On the bill
maturity date, the firm will get the money. However, the bill discounting
as a marketable securities is subject to 2 constraints (i) the safety of this
investment depends upon the credit rating of the acceptor of the bill, and
(ii) usually the pre mature retirement of bills is not available.
4.13 Illustrations
Illustration 1: From the following forecast of income and expenditure,
prepare cash budget for the months January to April, 1995.
Months Sales Purchases Wages Manufac- Adminis- Selling
turing trative Expenses
Expenses Expenses
Nov. 30,000 15,000 3,000 1,150 1,060 500
1994
Dec. 35,000 20,000 3,200 1,225 1,040 550
1995
Jan. 25,000 15,000 2,500 990 1,100 600
Feb. 30,000 20,000 3,000 1,050 1,150 620
March 35,000 22,500 2,400 1,100 1,220 570
April 40,000 25,000 2,600 1,200 1,180 710
Additional information is as follows:
1. The customers are allowed a credit period of 2 months.
2. A dividend of Rs. 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant purchased on 15th January
for Rs. 5,000; a Building has been purchased on 1st March and
the payments are to be made in monthly instalments of Rs. 2,000
each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st of the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on 1st January, 1995 is Rs. 15,000.
PAGE 247
Notes Solution:
Details January February March April
Receipts
Opening Balance of cash 15,000 18,985 28,795 30,975
Cash realized from
Debtors 30,000 35,000 25,000 30,000
Payments
Payments to customers
Wages 15,000 20,000 15,000 20,000
Manufacturing expenses
Administrative expenses 3200 2500 3000 2400
Selling expenses 1225 990 1050 1100
Payment of dividend
Purchase of plant 1040 1100 1150 1220
Instalment of building
plant 560 600 620 570
Total Payments ------ ------ ------ 10,000
Closing Balance
5000 ----- ------ ------
----- ---- 2,000 2,000
26,015 25,190 22,820 37,290
18,985 28,795 30,975 23,685
Illustration 2: ABC Co. wishes to arrange overdraft facilities with its
bankers during the period April to June, 1995 when it will be manufacturing
mostly for stock. Prepare a cash budget for the above period from the
following data, indicating the extent of the bank facilities the company
will require at the end of each month:
(a) 1995 Sales Purchases Wages
Rs. Rs. Rs.
February 1,80,000 1,24,800 12,000
March 1,92,000 1,44,000 14,000
April 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
June 1,26,000 2,68,000 15,000
248 PAGE
(b) 50 per cent of credit sales are realised in the month following the Notes
sales and remaining 50 per cent in the second month following.
Creditors are paid in the month following the month of purchase.
(c) Cash at bank on 1-4-1995 (estimated) Rs. 25000
Solution:
Receipts April May June
Opening Balance 25,000 53000 (-) 51000
Sales 90,000 96,000 54000
Amount received from sales 96,000 54,000 87000
Total Receipts
Payments 2,11,000 2,03,000 90000
Purchase
Wages 1,44,000 2,43,000 2,46,000
Total Payments 14,000 11,000 10000
Closing Balance (a - b) 1,58,000 2,54,000 2,56,000
53,000 (-)51,000 (-)1,66,000
IN-TEXT QUESTIONS
6. Cash management will be successful only if cash ____________
are accelerated and cash___________ , as far as possible, are
delayed.
7. The disbursements can be delayed on making payments on the
last due date only. (True/False)
8. The Baumol’s Model assumes a varying rate of use of cash.
(True/False)
4.14 Summary
u Cash Management refers to management of Cash and Bank balance
or in a broader sense it is the management of cash inflows and
outflows.
u Every firm must have minimum cash. There may be different motives
for holding cash. These may be Transactionary motive, Precautionary
motive or Speculative motive for holding cash.
PAGE 249
Notes u The objectives of cash management may be defined as meeting the

cash outflows and minimising the cost of cash balance.
u Cash budget is the most important technique for planning the cash
movement. It is a summary of cash inflows and outflows during
particular period. In cash budget all expected receipts and payments
are noted to find out the cash shortage or surplus during that period.
u Optimum level of cash balance is the balance which firm should
have in order to minimise the cost of maintaining cash. Baumol’s
model gives optimum cash balance which aims at minimising the
total cost of maintaining cash. The Miller – Orr model says that a
firm should maintain its cash balance within a range of lower and
higher limit.
1. (c) Current asset

3. Planning
4. Receipts and Disbursements Method
5. Adjusted net income Method
6. Collection and Disbursement
7. True
8. False

1. What are objectives of cash management?
2. Write short notes on:
(a) Lock box system
(b) Paying the Float
3. Explain the Baumol’s model of cash management?
4. Discuss the Miller – Orr model for determining the cash balance for
the firm?
250 PAGE
5. “Cash budget is an appropriate technique of cash management” Explain. Notes

What are the different methods of preparing the cash budget?

u Brealey, R.A., Myers S.C., Allen F. & Mohanty P. (2020), Principles
Delhi: Taxmann, New Delhi: 6EC (1264)-03-02-2023
Delhi: S. Chand.
PAGE 251
L E S S O N
5
Receivables Management
Smriti Chawla
STRUCTURE
5.2 Introduction
5.3 Meaning of Receivables
5.4 Costs of Maintaining Receivables
5.5 Factors Influencing the Size of Receivables
5.6 Meaning and Objectives of Receivable Management
5.7 Dimensions of Receivable Management
5.8 Illustrations
5.9 Summary

After studying this chapter students may be able to understand:—
u The concept of receivables.
u How the receivables are being managed.
u Various dimensions of receivables.
5.2 Introduction
A sound managerial control requires proper management of liquid assets and inventory. These
assets are a part of working capital of the business. An efficient use of financial resources
is necessary to avoid financial distress. Receivables result from credit sales. A concern is
252 PAGE
required to allow credit sales in order to expand its sales volume. It is Notes
not always possible to sell goods on cash basis only. Sometimes, other
concerns in that line might have established a practice of selling goods
on credit basis. Under these circumstances, it is not possible to avoid
credit sales without adversely affecting sales. The increase in sales is
also essential to increase profitability. After a certain level of sales the
increase in sales will not proportionately increase production costs. The
increase in sales will bring in more profits.
Thus, receivables constitute a significant portion of current assets of a
firm. But, for investment in receivables, a firm has to incur certain costs.
Further, there is a risk of bad debts also. It is, therefore, very necessary
to have a proper control and management of receivables.
5.3 Meaning of Receivables

Receivables represent amounts owed to the firm as a result of sale of
goods or services in the ordinary course of business. These are claims
of the firm against its customers and form part of its current assets.
Receivables are also known as accounts receivables, trade receivables,
customer receivables or book debts. The receivables are carried for the
customers. The period of credit and extent of receivables depends upon
the credit policy followed by the firm. The purpose of maintaining or
investing in receivables is to meet competition, and to increase the sales
and profits.
5.4 Costs of Maintaining Receivables

The allowing of credit to customers means giving funds for the customer’s
use. The concern incurs the following cost on maintaining receivables:
1. Cost of Financing Receivables: When goods and services are provided
on credit then concern’s capital is allowed to be used by the
customers. The receivables are financed from the funds supplied by
shareholders for long term financing and through retained earnings.
The concern incurs some cost for collecting funds which finance
receivables.
PAGE 253
Notes 2. Cost of Collection: A proper collection of receivables is essential

for receivables management. The customers who do not pay the
money during a stipulated credit period are sent reminders for early
payments. Some persons may have to be sent for collection these
amounts. All these costs are known as collection costs which a
concern is generally required to incur.
3. Bad Debts: Some customers may fail to pay the amounts due towards
them. The amounts which the customers fail to pay are known as
bad debts. Though a concern may be able to reduced bad debts
through efficient collection machinery but one cannot altogether
rule out this cost.
5.5 Factors Influencing the Size of Receivables

Besides sales, a number of other factors also influence the size of
receivables. The following factors directly and indirectly affect the size
of receivables.
1. Size of Credit Sales: The volume of credit sales is the first factor
which increases or decreases the size of receivables. If a concern
sells only on cash basis as in the case of Bata Shoe Company, then
there will be no receivables. The higher the part of credit sales out
of total sales, figures of receivables will also be more or vice versa.
2. Credit Policies: A firm with conservative credit policy will have
a low size of receivables while a firm with liberal credit policy
will be increasing this figure. If collections are prompt then even
if credit is liberally extended the size of receivables will remain
under control. In case receivables remain outstanding for a longer
period, there is always a possibility of bad debts.
3. Terms of Trade: The size of receivables also depends upon the
terms of trade. The period of credit allowed and rates of discount
given are linked with receivables. If credit period allowed is more
than receivables will also be more. Sometimes trade policies of
competitors have to be followed otherwise it becomes difficult to
expand the sales.
254 PAGE
4. Expansion Plans: When a concern wants to expand its activities, it Notes

will have to enter new markets. To attract customers, it will give
incentives in the form of credit facilities. The period of credit can
be reduced when the firm is able to get permanent customers. In
the early stages of expansion more credit becomes essential and
size of receivables will be more.
5. Relation with Profits: The credit policy is followed with a view
to increase sales. When sales increase beyond a certain level the
additional costs incurred are less than the increase in revenues. It
will be beneficial to increase sales beyond the point because it will
bring more profits. The increase in profits will be followed by an
increase in the size of receivables or vice versa.
6. Credit Collection Efforts: The collection of credit should be streamlined.
The customers should be sent periodical reminders if they fail to
pay in time. On the other hand, if adequate attention is not paid
towards credit collection then the concern can land itself in a serious
financial problem. Efficient credit collection machinery will reduce
the size of receivables.
7. Habits of Customers: The paying habits of customers also have
bearing on the size of receivables. The customers may be in the
habit of delaying payments even though they are financially sound.
The concern should remain in touch with such customers and should
make them realise the urgency of their needs.
IN-TEXT QUESTIONS
1. Liquid assets and inventory are a part of:
(a) Liquid assets
(b) Quick assets
(c) Working capital
(d) Receivables
2. Receivables are also known as:
(a) Accounts receivables
(b) Trade receivables
PAGE 255
Notes (c) Customer receivables

3. The receivables are financed from the funds supplied by
shareholders for long term financing and through ___________.
5.6 Meaning and Objectives of Receivable Management

Receivables management is the process of making decisions relating to
investment in trade debtors. We have already stated that certain investment
in receivables is necessary to increase the sales and the profits of a firm.
But at the same time investment in this asset involves cost considerations
also. Further, there is always a risk of bad debts too. Thus, the objective of
receivables management is to take a sound decision as regards investment
in debtors. In the words of Bolton, S.E., the objectives of receivables
management is “to promote sales and profits until that point is reached
where the return on investment in further funding of receivables is less
than the cost of funds raised to finance that additional credit.”
5.7 Dimensions of Receivable Management

Receivables management involves the careful consideration of the following
aspects:
1. Forming of credit policy.
2. Executing the credit policy.
3. Formulating and executing collection policy.
1. Forming of Credit Policy
For efficient management of receivables, a concern must adopt a
credit policy. A credit policy is related to decisions such as credit
standards, length of credit period, cash discount and discount period,
etc.
(a) Quality of Trade Accounts of Credit Standards: The volume
of sales will be influenced by the credit policy of a concern.
By liberalising credit policy the volume of sales can be
increased resulting into increased profits. The increased volume
256 PAGE
of sales is associated with certain risks too. It will result in Notes

enhanced costs and risks of bad debts and delayed receipts.
The increase in number of customers will increase the clerical
work of maintaining the additional accounts and collecting of
information about the creditworthiness of customers. There
may be more bad debt losses due to extension of credit to
less worthy customers. These customers may also take more
time than normally allowed in making the payments resulting
into tying up of additional capital in receivables. On the other
hand, extending credit to only creditworthy customers will
save costs like bad debt losses, collection costs, investigation
costs, etc. The restriction of credit to such customers only
will certainly reduce sales volume, thus resulting in reduced
profits.
A finance manager has to match the increased revenue with
additional costs. The credit should be liberalised only to the
level where incremental revenue matches the additional costs.
The quality of trade accounts should be decided so that credit
facilities are extended only upto that level. The optimum level
of investment in receivables should be where there is a trade
off between the costs and profitability. On the other hand, a
tight credit policy increases the liquidity of the firm. On the
other hand, a tight credit policy increases the liquidity of the
firm. Thus, optimum level of investment in receivables is
achieved at a point where there is a trade off between cost,
profitability and liquidity as depicted below:
IMAGE MATTER
Cash and Profitability
PAGE 257
Profitability © Department of Distance & Continuing Education, Campus of Open Learning,
Liquidity
Stringent
Liberal
Notes (b) Length of Credit Period: Credit terms or length of credit

period means the period allowed to the customers for making
the payment. The customers paying well in time may also be
allowed certain cash discount. A concern fixes its own terms of
credit depending upon its customers and the volume of sales.
The competitive pressure from other firms compels to follow
similar credit terms, otherwise customers may feel inclined to
purchase from a firm which allows more days for paying credit
purchases. Sometimes more credit time is allowed to increase
sales to existing customers and also to attract new customers.
The length of credit period and quantum of discount allowed
determine the magnitude of investment in receivables.
(c) Cash Discount: Cash discount is allowed to expedite the
collection of receivables. The concern will be able to use
the additional funds received from expedited collections due
to cash discount. The discount allowed involves cost. The
discount should be allowed only if its cost is less than the
earnings from additional funds. If the funds cannot be profitably
employed then discount should not be allowed.
(d) Discount Period: The collection of receivables is influenced by
the period allowed for availing the discount. The additional
period allowed for this facility may prompt some more
customers to avail discount and make payments. This will
mean additional funds released from receivables which may
be alternatively used. At the same time the extending of
discount period will result in late collection of funds because
those who were getting discount and making payments as per
earlier schedule will also delay their payments.
2. Executing Credit Policy
After formulating the credit policy, its proper execution is very
important. The evaluation of credit applications and finding out the
creditworthiness of customers should be undertaken.
(a) Collecting Credit information: The first step in implementing
credit policy will be to gather credit information about the
customers. This information should be adequate enough so that
proper analysis about the financial position of the customers
258 PAGE
is possible. This type of investigation can be undertaken only Notes

upto a certain limit because it will involve cost.
The sources from which credit information will be available
should be ascertained. The information may be available from
financial statements, credit rating agencies, reports from banks,
firm’s records etc. Financial reports of the customer for a
number of years will be helpful in determining the financial
position and profitability position. The balance sheet will help
in finding out the short term and long term position of the
concern. The income statements will show the profitability
position of concern. The liquidity position and current assets
movement will help in finding out the current financial position.
A proper analysis of financial statements will be helpful in
determining the creditworthiness of customers. There are credit
rating agencies which can supply information about various
concerns. These agencies regularly collect information about
business units from various sources and keep this information
upto date. The information is kept in confidence and may be
used when required.
Credit information may be available with banks too. The banks
have their credit departments to analyse the financial position
of a customer.
In case of old customers, business own records may help to
know their creditworthiness. The frequency of payments, cash
discounts availed, interest paid on overdue payments etc. may
help to form an opinion about the quality of credit.
(b) Credit Analysis: After gathering the required information,
the finance manager should analyse it to find out the credit
worthiness of potential customers and also to see whether
they satisfy the standards of the concern or not. The credit
analysis will determine the degree of risk associated with the
account, the capacity of the customer borrow and his ability
and willingness to pay.
(c) Credit Decision: After analysing the creditworthiness of the
customer, the finance manager has to take a decision whether
the credit is to be extended and if yes then upto what level.
PAGE 259
Notes He will match the creditworthiness of the customer with the

credit standards of the company. If customer’s creditworthiness
is above the credit standards then there is no problem in taking
a decision. It is only in the marginal case that such decisions
are difficult to be made. In such cases the benefit of extending
the credit should be compared to the likely bad debt losses
and then decision should be taken. In case the customers are
below the company credit standards then they should not
be outrightly refused. Rather they should be offered some
alternative facilities. A customer may be offered to pay on
delivery of goods, invoices may be sent through bank. Such
a course help in retaining the customers at present and their
dealings may help in reviewing their requests at a later date.
(d) Financing Investments in Receivables and Factoring: Accounts
receivables block a part of working capital. Efforts should
be made that funds are not tied up in receivables for longer
periods. The finance manager should make efforts to get
receivables financed so that working capital needs are met in
time. The quality of receivables will determine the amount of
loan. The banks will accept receivable of dependable parties
only. Another method of getting funds against receivables
is their outright sale to the bank. The bank will credit the
amount to the party after deducting discount and will collect
the money from the customers later. Here too, the bank will
insist on quality receivables only. Besides banks, there may
be other agencies which can buy receivables and pay cash
for them. This facility is known as factoring. The factoring
may be with or without recourse. It is without recourse then
any bad debt loss is taken up by the factor but if it is with
recourse then bad debts losses will be recovered from the
seller.
Factoring is collection and finance service designed to improve he
cash flow position of the sellers by converting sales invoices into
ready cash. The procedure of factoring can be explained as follows:
1. Under an agreement between the selling firm and factor firm, the
latter makes an appraisal of the creditworthiness of potential
260 PAGE
customers and may also set the credit limit and term of credit Notes
for different customers.
2. The sales documents will contain the instructions to make
payment directly to factor that is responsible for collection.
3. When the payment is received by the factor on the due date
the factor shall deduct its fees, charges etc. and credit the
balance to the firm’s accounts.
4. In some cases, if agreed the factor firm may also provide
advance finance to selling firm for which it may charge from
selling firm. In a way this tantamount to bill discounting by
the factor firm. However factoring is something more than
mere bill discounting, as the former includes analysis of the
creditworthiness of the customer also. The factor may pay
whole or a substantial portion of sales value to the selling
firm immediately on sales being affected. The balance if any,
may be paid on normal due date.
Benefits and Cost of Factoring

Firm availing factoring services may have the following benefits:
u Better Cash Flows
u Better Assets Management
u Better Working Capital Management
u Better Administration
u Better Evaluation
u Better Risk Management
However, the factoring involves some monetary and non-monetary
costs as follows:
Monetary Costs

(a) The factor firm charges substantial fees and commission for
collection of receivables. These charges sometimes may be
too much in view of amount involved.
(b) The advance finance provided by factor firm would be available
at a higher interest costs than usual rate of interest.
PAGE 261
Notes Non-Monetary Costs

(a) The factor firm doing the evaluation of creditworthiness of the
customer will be primarily concerned with the minimization
of risk of delays and defaults. In the process it may over look
sales growth aspect.
(b) A factor is in fact a third party to the customer who may not
feel comfortable while dealing with it.
(c) The factoring of receivables may be considered as a symptom
of financial weakness.
Factoring in India is of recent origin. In order to study the
feasibility of factoring services in India, the Reserve Bank of India
constituted a study group for examining the introduction of factoring
services, which submitted its report in 1988. On the basis of the
recommendations of this study group the RBI has come out with
specific guidelines permitting a banks to start factoring in India
through their subsidiaries. For this country has been divided into
four zones. In India the factoring is still not very common. The
first factor i.e. The SBI Factor and Commercial Services Limited
started working in April 1991. The guidelines for regulation of a
factoring are as follows:
(1) A factor firm requires an approval from Reserve Bank of
India.
(2) A factor firm may undertake factoring business or other
incidental activities.
(3) A factor firm shall not engage in financing of other firms or
firms engaged in factoring.
3. Formulating and Executing Collection Policy

The collection of amounts due to the customers is very important.
The collection policy termed as strict and lenient. A strict policy
of collection will involve more efforts on collection. Such a policy
has both positive and negative effects. This policy will enable early
collection of dues and will reduce bad debt losses. The money collected
will be used for other purposes and the profits of the concern will
go up. On the other hand a rigorous collection policy will involve
increased collection costs. It may also reduce the volume of sales.
262 PAGE
A lenient policy may increase the debt collection period and more Notes
bad debt losses. A customer not clearing the dues for long may not
repeat his order because he will have to pay earlier dues first, thus
causing.
The objective is to collect the dues and not to annoy the customer. The
steps should be like (i) sending a reminder for payments (ii) Personal
request through telephone etc. (iii) Personal visits to the customers (iv)
Taking help of collecting agencies and lastly (v) Taking legal action. The
last step should be taken only after exhausting all other means because
it will have a bad impact on relations with customers.
IN-TEXT QUESTIONS
4. By liberalizing credit policy the volume of sales can be decreased
resulting into low level of profits. (True/False)
5. A tight credit policy increases the liquidity of the firm.
(True/False)
5.8 Illustrations
Illustration 1: A company has prepared the following projections for a year
Sales 21000 units
Selling Price per unit Rs. 40
Variable Costs per unit Rs. 25
Total Costs per unit Rs. 35
Credit period allowed One month
The company proposes to increase the credit period allowed to its customers
from one month to two months. It is envisaged that the change in policy
as above will increase the sales by 8%. The company desires a return of
25% on its investment. You are required to examine and advise whether
the proposed credit policy should be implemented or not?
Solution:
Particulars Present Proposed Incremental
Sales (units) 21000 22680 1680
Contribution per unit Rs.15 Rs.15 Rs.15
Total Contribution Rs. 3,15,000 Rs. 3,40,000 Rs. 25,200
PAGE 263
Notes Particulars Present Proposed Incremental

Variable cost @ Rs. 25 5,25,000 5,67,000 42,000
Fixed Cost 2,10,000 2,10,000 ------
Total Cost 7,35,000 7,77,000 42,000
Credit period 1 month 2 month -----
Average debtors at cost Rs. 61250 Rs. 1,29,500 Rs. 68,250
Incremental Return = Increased Contribution/Extra Funds Blockage × 100
= Rs. 25,200/Rs. 68,250 × 100
= 36.92%
Illustration 2: ABC & Company is making sales of Rs.16,00,000 and it
extends a credit of 90 days to its customers. However, in order to overcome
the financial difficulties, it is considering changing the credit policy. The
proposed terms of credit and expected sales are given hereunder:
Policy Terms Sales
I 75 days Rs. 15,00,000
II 60 days Rs. 14,50,000
III 45 days Rs. 14,25,000
IV 30 days Rs. 13,50,000
V 15 days Rs. 13,00,000
The firm has variable cost of 80% and fixed cost of Rs. 1,00,000. The
cost of capital is 15%. Evaluate different policies and which policy
should be adopted?
Solution:
Figures in Rs.
Particulars Present I II III IV V
Sales 16,00,000 15,00,000 14,50,000 14,25,000 13,50,000 13,00,000
-- Variable 12,80,000 12,00,000 11,60,000 11,40,000 10,80,000 10,40,000
Cost
-- Fixed Cost 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Profit (A)
Total Cost 2,20,000 2,00,000 1,90,000 1,85,000 1,70,000 1,60,000
Average 13,80,000 13,00,000 12,60,000 12,40,000 11,80,000 11,40,000
264 PAGE
Receivable 3,45,000 2,70,833 2,10,000 1,55,000 98,333 47,500 Notes

(at cost)
(Cost÷360×
Credit
Period)
Cost of 51,750 40,625 31,500 23,250 14,750 7,125
debtors @
15% (B)
Net profit (A 1,68,250 1,59,350 1,58,500 1,61,750 1,55,250 1,52,875
– B)
Illustration 3: A trader whose current sales is Rs. 15 lakhs per annum
and average collection period is 30 days wants to pursue a more liberal
credit policy to improve sales. A study made by consultant firm reveals
the following information.
Credit Policy Increase in collection period Increase in sales
A 15 days Rs. 60,000
B 30 days Rs. 90,000
C 45 days Rs. 1,50,000
D 60 days Rs. 1,80,000
E 90 days Rs. 2,00,000
The selling price per unit is Rs. 5. Average Cost per unit is Rs. 4 and
variable cost per unit is Rs. 2.75 paise per unit. The required rate of
return on additional investments is 20 per cent Assume 360 days a year
and also assumes that there are no bad debts. Which of the above policies
would you recommend for adoption?
Solution:
Particulars Present A B C D E
Credit period 30 days 45 days 60 days 75 days 90 days 120 days
No. of units 3,00,000 3,12,000 3,18,000 3,30,000 3,36,000 3,40,000
@ Rs. 5 15,00,000 15,60,000 15,90,000 16,50,000 16,80,000 17,00,000
Sales 8,58,000 8,74,500 9,07,500 9,24,000 9,35,000

Variable 3,75,000 3,75,000 3,75,000 3,75,000 3,75,000
cost@ 2.75 12,33,000 12,49,500 12,82,500 12,99,000 13,10,000
Fixed Cost 8,25,000 3,27,000 3,40,500 3,67,500 3,81,000 3,90,000
Total Cost 3,75,000 1,54,125 2,08,250 2,67,188 3,24,750 4,36,667
Profit (A)
PAGE 265
Notes Particulars Present A B C D E

Average 12,00,000
Debtors (at
cost)
c o s t ÷ 3 6 0 × 3,00,000
credit period
Cost of 1,00,000 30,825 41,650 53,437 64,950 87,333
investment@
20% (B) 20,000
Net Profit 2,80,000 2,96,175 2,98,850 3,14,063 3,16,050 3,02,667
(A-B)
5.9 Summary
u The receivables emerge when goods are sold on credit and the
payments are deferred by the customers. So, every firm should have
a well-defined credit policy.
u The receivables management refers to managing the receivables
in the light of costs and benefit associated with a particular credit
policy.
u Receivables management involves the careful consideration of the
following aspects: Forming of credit policy, Executing the credit
policy, Formulating and executing collection policy.
u The credit policy deals with the setting of credit standards and
credit terms relating to discount and credit period.
u The credit evaluation includes the steps required for collection
and analysis of information regarding the creditworthiness of the
customer.
1. (c) Working Capital

3. Retained Earnings
266 PAGE
4. False Notes
5. True

1. What do you understand by Receivables Management? Discuss the
factors which influence the size of receivables?
2. What should be the considerations in forming a credit policy?
3. “Receivables forecasting is important for the proper management of
receivables forecasting.” Explain.
4. Discuss the various aspects or dimensions of receivable management?
5. Write short note on Factoring.

PAGE 267
Notes u Singh, S. and Kaur, R. (2020), Fundamentals of Financial Management,

Delhi: S. Chand.
268 PAGE
L E S S O N
6
Inventory Management
Smriti Chawla
STRUCTURE
6.2 Introduction
6.3 Meaning and Nature of Inventory
6.4 Purpose/Benefits of Holding Inventory
6.5 Risks/Costs of Holding Inventory
6.6 Inventory Management
6.7 Objects of Inventory Management
6.8 Tools and Techniques of Inventory Management
6.9 Risks in Inventory Management
6.10 Summary

u The concept of inventory.
u The inventory management.
u Techniques used for inventory management.
6.2 Introduction
Every enterprise needs inventory for smooth running of its activities. It serves as a link
between production and distribution processes. There is, generally, a time lag between
PAGE 269
Notes the recognition of need and it’s fulfilment. The greater the time lag, the
higher the requirements for inventory.
The investment in inventories constitutes the most significant part of
current assets/working capital in most of the undertakings. Thus, it is
very essential to have proper control and management of inventories. The
purpose of inventory management is to ensure availability of materials in
sufficient quantity as and when required and also to minimise investment
in inventories.
6.3 Meaning and Nature of Inventory

In accounting language it may mean stock of finished goods only. In a
manufacturing concern, it may include raw materials, work in process
and stores, etc. Inventory includes the following things:
(a) Raw Material: Raw material form a major input into the organisation.
They are required to carry out production activities uninterruptedly.
The quantity of raw materials required will be determined by the rate
of consumption and the time required for replenishing the supplies.
The factors like the availability of raw materials and government
regulations etc. too affect the stock of raw materials.
(b) Work-in-Progress: The work-in-progress is that stage of stocks which
are in between raw materials and finished goods. The raw materials
enter the process of manufacture but they are yet to attain a final
shape of finished goods. The quantum of work in progress depends
upon the time taken in the manufacturing process. The greater the
time taken in manufacturing, the more will be the amount of work
in progress.
(c) Consumables: These are the materials which are needed to smoothen
the process of production. These materials do not directly enter
production but they act as catalysts, etc. Consumables may be
classified according to their consumption and criticality.
(d) Finished Goods: These are the goods which are ready for the
consumers. The stock of finished goods provides a buffer between
production and market. The purpose of maintaining inventory is to
ensure proper supply of goods to customers.
270 PAGE
(e) Spares: Spares also form a part of inventory. The consumption pattern Notes
of raw materials, consumables, finished goods are different from
that of spares. The stocking policies of spares are different from
industry to industry. Some industries like transport will require more
spares than the other concerns. The costly spare parts like engines,
maintenance spares etc. are not discarded after use, rather they are
kept in ready position for further use.
6.4 Purpose/Benefits of Holding Inventory

There are Four main purposes or motives of holding inventories:
(i) The Transaction Motive which facilitates continuous production
and timely execution of sales orders.
(ii) The Precautionary Motive which necessitates the holding of
inventories for meeting the unpredictable changes in demand and
supplies of materials.
(iii) The Speculative Motive which induces to keep inventories for
taking advantage of price fluctuations, saving in re-ordering costs
and quantity discounts, etc.
(iv) The Compensation Motive is due to the requirement of commercial
banks for keeping some minimum cash balance in the bank
account of the firm.
6.5 Risks/Costs of Holding Inventory

The holding of inventories involves blocking of a firm’s funds and
incurrence of capital and other costs. It also exposes the firm to certain
risks. The various costs and risks involved in holding inventories are as
below:
(i) Capital Costs: Maintaining of inventories results in blocking of the
firm’s financial resources. The firm has, therefore, to arrange for
additional funds to meet the cost of inventories. The funds may be
arranged from own resources or from outsiders. But in both cases,
the firm incurs a cost. In the former case, there is an opportunity
cost of investment while in later case the firm has to pay interest
to outsiders.
PAGE 271
Notes (ii) Cost of Ordering: The costs of ordering include the cost of acquisition
of inventories. It is the cost of preparation and execution of an order,
including cost of paper work and communicating with supplier.
There is always minimum cost involve whenever an order for
replenishment of good is placed. The total annual cost of ordering
is equal to cost per order multiplied by the number of order placed
in a year.
(iii) Cost of Stock-Outs: A stock out is a situation when the firm is
not having units of an item in store but there is demand for that
either from the customers or the production department. The stock
out refer to demand for an item whose inventory level is reduced
to zero and insufficient level. There is always a cost of stock out
in the sense that the firm faces a situation of lost sales or back
orders. Stock out are quite often expensive.
(iv) Storage and Handling Costs: Holding of inventories also involves
costs on storage as well as handling of materials. The storage costs
include the rental of the godown, insurance charge etc.
(v) Risk of Price Decline: There is always a risk of reduction in the
prices of inventories by the suppliers in holding inventories. This
may be due to increased market supplies, competition or general
depression in the market.
(vi) Risk of Obsolescence: The inventories may become obsolete due to
improved technology, changes in requirements, change in customer’s
tastes etc.
(vii) Risk Deterioration in Quality: The quality of the materials may
also deteriorate while the inventories are kept in stores.
IN-TEXT QUESTIONS
1. Every enterprise needs __________ for smooth running of its
activities.
2. Which of the following is not a part of inventory:
(a) Raw material
(b) Work-in-progress
272 PAGE
(c) Receivables Notes
(d) Consumables
3. Maintaining of inventories results in blocking of the firm’s
_____________.
6.6 Inventory Management

It is necessary for every management to give proper attention to inventory
management. A proper planning of purchasing, handling storing and
accounting should form a part of inventory management. An efficient
system of inventory management will determine (a) what to purchase (b)
how much to purchase (c) from where to purchase (d) where to store, etc.
There are conflicting interests of different departmental heads over
the issue of inventory. The finance manager will try to invest less in
inventory because for him it is an idle investment, whereas production
manager will emphasize to acquire more and more inventory as he does
not want any interruption in production due to shortage of inventory. The
purpose of inventory management is to keep the stocks in such a way that
neither there is over-stocking nor under-stocking. The over-stocking will
mean reduction of liquidity and starving of other production processes;
under-stocking, on the other hand, will result in stoppage of work. The
investments in inventory should be kept in reasonable limits.
6.7 Objects of Inventory Management

The main objectives of inventory management are operational and financial.
The operational objectives mean that the materials and spares should be
available in sufficient quantity so that work is not disrupted for want of
inventory. The financial objective means that investments in inventories
should not remain idle and minimum working capital should be locked
in it. The following are the objectives of inventory management:
(1) To ensure continuous supply of materials spares and finished goods
so that production should not suffer at any time and the customers
demand should also be met.
PAGE 273
Notes (2) To avoid both over-stocking and under-stocking of inventory.

(3) To keep material cost under control so that they contribute in
reducing cost of production and overall costs.
(4) To minimise losses through deterioration, pilferage, wastages and
damages.
(5) To ensure perpetual inventory control so that materials shown in
stock ledgers should be actually lying in the stores.
(6) To ensure right quality goods at reasonable prices.
(7) To maintain investments in inventories at the optimum level as
required by the operational and sales activities.
(8) To eliminate duplication in ordering or replenishing stocks. This is
possible with help of centralising purchases.
(9) To facilitate furnishing of data for short term and long term planning
and control of inventory.
(10) To design proper organisation of inventory. Clear cut accountability
should be fixed at various levels of management.
6.8 Tools and Techniques of Inventory Management

Effective Inventory management requires an effective control system
for inventories. A proper inventory control not only helps in solving the
acute problem of liquidity but also increases profits and causes substantial
reduction in the working capital of the concern. The following are the
important tools and techniques of inventory management and control:
1. Determination of Stock Levels.
2. Determination of Safety Stocks.
3. Determination of Economic Order Quantity.
4. A.B.C. Analysis.
5. VED Analysis.
6. Inventory Turnover Ratios.
7. Ageing Schedule of Inventories.
8. Just in Time Inventory.
274 PAGE
1. Determination of Stock Levels Notes

Carrying of too much and too little of inventories is detrimental to the
firm. If the inventory level is too little, the firm will face frequent stock-
outs involving heavy ordering cost and if the inventory level is too high
it will be unnecessary tie-up of capital. Therefore, an efficient inventory
management requires that a firm should maintain an optimum level of
inventory where inventory costs are the minimum and at the same time
there is not stock-out which may result in loss of sale or stoppage of
production. Various stock levels are discussed as such.
(a) Minimum Level: This represents the quantity which must be maintained
in hand at all times. If stocks are less than the minimum level then
the work will stop due to shortage of materials. Following factors
are taken into account while fixing minimum stock level.
Lead Time: A purchasing firm requires some time to process the

order and time is also required by supplying firm to execute the
order. The time taken in processing the order and then executing
it is known as lead time.
Rate of Consumption: It is the average consumption of materials in

the factory. The rate of consumption will be decided on the basis
pas experiences and production plans.
Nature of Material: The nature of material also affects the minimum

level. If material is required only against special orders of customer
then minimum stock will not be required for such materials.
Minimum stock level = R
e-ordering level - (Normal consumption
× Normal Re-order period).
(b) Re-ordering Level: When the quantity of materials reaches at a certain
figure then fresh order is sent to get materials again. The order is
sent before the materials reach minimum stock level. Reordering
level is fixed between minimum and maximum level. The rate of
consumption, number of days required replenishing the stock and
maximum quantity of material required on any day are taken into
account while fixing reordering level.
Re-ordering Level = Maximum Consumption × Maximum Re-order

period.
PAGE 275
Notes (c) Maximum Level: It is the quantity of materials beyond which a firm
should not exceed its stocks. If the quantity exceeds maximum level
limit then it will be overstocking. A firm should avoid overstocking
because it will result in high material costs.
Maximum Stock Level = Re-ordering Level + Re-ordering Quantity

- (Minimum Consumption × Minimum
Re-ordering period).
(d) Danger Level: It is the level beyond which materials should not
fall in any case. If danger level arises then immediate steps should
be taken to replenish the stock even if more cost is incurred in
arranging the materials. If materials are not arranged immediately
there is possibility of stoppage of work.
Danger Level = Average Consumption × Maximum reorder period

for emergency purchases.
(e) Average Stock Level:

The average stock level is calculated as such:
Average Stock level = Minimum Stock Level + ½ of re-order quantity

2. Determination of Safety Stocks
Safety stock is a buffer to meet some unanticipated increase in usage. It
fluctuates over a period of time. The demand for materials may fluctuate
and delivery of inventory may also be delayed and in such a situation the
firm can face a problem of stock-out. The stock-out can prove costly by
affecting the smooth working of the concern. In order to protect against
the stock out arising out of usage fluctuations, firms usually maintain
some margin of safety or safety stocks. Two costs are involved in the
determination of this stock i.e. opportunity cost of stock-outs and the
carrying costs. The stock out of raw materials causes production disruption
resulting in higher cost of production. Similarly, the stock out of finished
goods result into failure of firm in competition, as firm cannot provide
proper customer service. If a firm maintains low level of safety frequent
stock out will occur resulting in large opportunity cost. On the other hand
larger quantity of safety stock involves higher carrying costs.
276 PAGE
3. Economic Order Quantity (EOQ) Notes

A decision about how much to order has great significance in inventory
management. The quantity to be purchased should neither be small nor big
because costs of buying and carrying materials are very high. Economic
order quantity is the size of the lot to be purchased which is economically
viable. This is the quantity of materials which can be purchased at
minimum costs. Generally, economic order quantity is the point at which
inventory carrying costs are equal to order costs. In determining economic
order quantity it is assumed that cost of a managing inventory is made
of solely of two parts i.e. ordering costs and carrying costs.
(A) Ordering Costs: These are costs that are associated with the purchasing
or ordering of materials. These costs include:
(1) Inspection costs of incoming materials.
(2) Cost of stationery, typing, postage, telephone charges etc.
(3) Expenses incurred on transportation of goods purchased.
These costs are also know as buying costs and will arise only when
some purchases are made.
(B) Carrying Costs: These are costs for holding the inventories. These
costs will not be incurred if inventories are not carried. These costs
include:
(1) The cost of capital invested in inventories. An interest will
be paid on the amount of capital locked up in inventories.
(2) Cost of storage which could have been used for other purposes.
(3) Insurance Cost.
(4) Cost of spoilage in handling of materials.
Assumptions of EOQ: While calculating EOQ the following assumptions
are made:
1. The supply of goods is satisfactory. The goods can be purchased
whenever these are needed.
2. The quality to be purchased by the concern is certain.
3. The prices of goods are stable. It results to stabilise carrying costs.
PAGE 277
Notes Economic order quantity can be calculated with the help of the following
formula:
2AS
EOQ =
I
where, A = Annual consumption in rupees.
S = Cost of placing an order.
I = Inventory carrying costs of one unit.
Illustration 1: The finance department of a Corporation provides the
following information:
(i) The carrying costs per unit of inventory are Rs. 10
(ii) The fixed costs per order are Rs. 20
(iii) The number of units required is 30,000 per year.
Determine the Economic Order Quantity (EOQ) total number of orders
in a year and the time gap between orders.
Solution: The economic order quantity may be found as follow:
2AS
EOQ =
I
A = 30,000
S = Rs. 20
I = Rs. 10
Now, EOQ = ((2 × 30,000 × 20) ÷ 10 )1/2 = 346 units
So, the EOQ is 346 units and the number of orders in a year would be
30,000/346 = 86.7 or 87 orders. The time gap between two orders would
be 365/87 = 4.2 or 4 days.
4. A-B-C Analysis
Under A-B-C analysis, the materials are divided into three categories viz.,
A, B and C. Past experience has shown that almost 10 per cent of the
items contribute to 70 per cent of value of consumption and this category
is called ‘A’ Category. About 20 per cent of value of consumption and
this category is called ‘A’ Category. About 20 per cent of the items
contribute about 20 per cent of value of consumption and this is known
278 PAGE
umption and this category is called ‘A’ Category. About 20 per cent of the items
ibute about 20 per cent of value of consumption and this is known as category ‘B’
rials. Category ‘C’ covers about 70 per cent of items of materials which contribute only
er cent of value of consumption. There may be some variation in different organisations
n adjustment can be made in these percentages.
nformation is shown in the following diagram:

as category ‘B’ materials. Category ‘C’ covers about 70 per cent of items Notes
lass No.which
of materials of Items (%) only 10 per cent of valueValue
contribute of Items (%)
of consumption.
There may be some variation in different organisations and an adjustment
A 10 percentages.
can be made in these 70
B The information is20shown in the following diagram: 20
Class No. of Items (%) Value of Items (%)
C A 70 10 70 10
B 20 20
C 70 10
A-B-C analysis helps to concentrate more efforts on category A since

C analysis helps to concentrate more efforts on category A since greatest monetary
greatest monetary advantage will come by controlling these items. An
ntage willattention
come by controlling
should these items.
be paid in estimating An attention
requirements, should
purchasing, be paid in estimating
maintaining
rements, safety
purchasing, maintaining
stocks and safety
properly storing stocks
of ‘A’ and materials.
category properlyThese
storing
itemsof ‘A’ category
are kept under a constant review so that substantial material cost may
be controlled. The control of ‘C’ items may be relaxed and these stocks
may be purchased for the year. A little more attention should be given
towards ‘B’ category items and their purchase should be undertaken a
quarterly or half-yearly intervals.
5. VED Analysis
The VED analysis is used generally for spare parts. The requirements and
urgency of spare parts is different from that of materials. A-B-C analysis
may not be properly used for spare parts. Spare parts are classified as
Vital (V), Essential (E) and Desirable (D). The vital spares are a must
for running the concern smoothly and these must be stored adequately.
The non-availability of vital spares will cause havoc in the concern. The
PAGE 279
Notes E types of spares are also necessary but their stocks may be kept at low
figures. The stocking of D type of spares may be avoided at times. If
the lead time of these spares is less, then stocking of these spares can
be avoided.
6. Inventory Turnover Ratios
Inventory turnover ratios are calculated to indicate whether inventories
have been used efficiently or not. The purpose is to ensure the blocking
of only required minimum funds in inventory. The Inventory Turnover
Ratio also known as stock velocity is normally calculated as sales/average
inventory or cost of goods sold/average inventory cost.
Cost of Goods Sold
Inventory Turnover Ratio =
Average Inventory at Cost
Net Sales
=
(Average) Inventory
Days in a year
and, Inventory Conversion Period =
Inventory Turnover Ratio
7. Ageing Schedule of Inventories

Classification of inventories according to the period (age) of their holding
also helps in identifying slow moving inventories thereby helping in
effective control and management of inventories. The following table
shows aging of inventories of a firm.
Ageing Schedule of Inventories
Item Name/ Age Date of Acquisition Amount %age
Code Classification (Rs.) to total
001 0-15 days June 25, 1996 30,000 15
002 16-30 days June 10, 1996 60,000 30
003 31-45 days May 20, 1996 50,000 25
004 46-60 days May 5, 1996 40,000 20
005 61 and above April 12, 1996 20,000 10
2,00,000 100
8. Just in Time Inventory (JIT)
JIT is a modern approach to inventory management and goal is essentially
to minimize such inventories and thereby maximizing the turnover. In JIT,
280 PAGE
affirm keeps only enough inventory on hand to meet immediate production Notes
needs. The JIT system reduces inventory carrying costs by requiring that
the raw materials are procured just in time to be placed into production.
Additionally, the work in process inventory is minimized by eliminating
the inventory buffers between different production departments. If JIT is
to be implemented successfully there must be high degree of coordination
and cooperation between the suppliers and manufacturers and among
different production centers.
6.9 Risks in Inventory Management

The main risk in inventory management is that market value of inventory
may fall below what firm paid for it, thereby causing inventory losses. The
sources of market value of risk depend on type of inventory. Purchased
inventory of manufactured goods is subject to losses due to changes in
technology. Such changes may sharply reduced final prices of goods
when they are sold or may even make the goods unsaleable. There are
also substantial risks in inventories of goods dependent on current styles.
The ready-made industry is particularly susceptible to risk of changing
consumer tastes. Agricultural commodities are a type of inventory subject
to risks due to unpredictable changes in production and demand.
Moreover, all inventories are exposed to losses due to spoilage, shrinkage,
theft or other risks of this sort. Insurance is available to cover many of
these risks and if purchased is one of the costs of holding inventory.
Hence, the financial manager must be aware of the degree of risk involve
infirm investment in inventories. The manager must take those risks into
account in evaluating the appropriate level of investment.
6.10 Summary
u Inventory includes and refers to raw material, work in progress and
finished goods. Inventory management refers to management of
level of these components.
u The inventory management involves a trade-off between costs
and benefits of inventory. In a systematic approach to inventory
management, a financial manager has to identify (i) the items that
PAGE 281
Notes are more important than others and (ii) the size of each order for
different items.
u Two important techniques of deal with the inventory management
are ABC Analysis and the Economic Order Quantity (EOQ) model.
u The EOQ model attempts to find out the number of units to be
ordered every time in order to minimize the total cost of ordering
and carrying the inventory.
IN-TEXT QUESTIONS
4. The main objectives of inventory management are ______ and
_________.
5. The inventory managements only help in managing the problem of
under stocking and do not help with the problem of overstocking.
(True/False)
6. Re-ordering Level = Minimum Consumption × Maximum Re-
order period. (True/False)
1. Inventories
2. (c) Receivables
3. Financial Resources
4. Operational and Financial
5. False
6. False

1. Write short notes on:
(a) ABC Analysis of inventory control.
(b) Economic order quantity.
2. Define safety stock. How is it determined? What is the role of safety
stock in inventory management?
282 PAGE
3. What is the need for holding inventory? Why inventory management Notes
is important?
4. Explain briefly techniques of inventory management.

Delhi: Taxmann, New Delhi: 6EC (1264)-03.02.2023.
Delhi: S. Chand.
PAGE 283
Glossary
Capital Costs: Additional funds to meet the cost of inventories.
Capital Structure: Combination of debt and equity that leads to the maximum value of
the firm
CAPM: Capital Asset Pricing Model
Cash Budget: A cash budget is an estimate of cash receipts and disbursements during a
future period of time.
Cash Planning: Cash planning is a technique to plan and control the use of cash.
Cash: Cash means both cash in hand and cash at bank.
Combined Leverage: The Combined Leverage (CL) is not a distinct type of leverage
analysis: rather it is a product of the OL and the FL. The CL may be defined as the %
change in EPS for a given % change in the sales level.
Compound Value Concept: In case of this concept, the interest earned on the initial
principal becomes a part of principal at the end of the compounding period.
Consumables: These are the materials which are needed to smoothen the process of
production.
Cost of Capital: The cost of capital of a firm is the minimum rate of return expected
by its investors.
Cost of Debt: The cost of debt is the rate of interest payable on debt.
Cost of Equity Share Capital: The cost of equity is the maximum rate of return that the
company must earn on equity.
Cost of Preference Capital: It is referred to Annual Preference Dividend divided by
preference share capital proceeds.
Debentures: A debenture is an instrument issued by the company acknowledging its debt
to its holder.
Dividend Decision: The decision regarding the distribution of profits to shareholders.
Dividend Payout Ratio: Portion of the profit that is to be distributed amongst shareholders.
EBIT: Earning Before Interest and Taxes.
EPS: Earnings per share.
PAGE 285
Notes Financial Distress: A situation stressing the finances of the company

due to large portion of debt.
Financial Leverage: The Financial Leverage (FL) measures the relationship
between the EBIT and the EPS and it reflects the effect of change in
EBIT on the level of EPS.
Financial Management: The term financial management can be defined
as the management of flow of funds in a firm and it deals with the
financial decision making of the firm.
Finished Goods: These are the goods which are ready for the consumers.
Gross Working Capital: Gross working capital is the capital invested
in total current assets of the enterprise.
Hedging: Hedging refers to two off-selling transactions of a simultaneous
but opposite nature which counter balance effect of each other.
Internal Rate of Return: This technique is also known as yield on
investment, marginal efficiency of capital. Like the present value method
the IRR method also considers the time value of money by discounting
the cash streams.
Lead Time: The time taken in processing the order and then executing
it is known as lead time.
Leverage: The term leverage, in general, refers to a relationship between
two interrelated variables.
Liquidity: The ease in converting the asset into cash.
Marginal Cost of Capital: The marginal cost of capital is the weighted
average cost of new capital calculated by using the marginal weights.
Minimum Level: This represents the quantity which must be maintained
in hand at all times.
Modigliani-Miller Approach: M&M hypothesis is identical with the
Net Operating Income approach if taxes are ignored. However, when
corporate taxes are assumed to exist, their hypothesis is similar to the
Net Income Approach.
Net Income Approach: According to this approach, a firm can minimise
the weighted average cost of capital and increase the value of the firm
286 PAGE
as well as market price of equity shares by using debt financing to the Notes
maximum possible extent.
Net Operating Income Approach: According to this approach, change
in the capital structure of a company does not affect the market value
of the firm and the overall cost of capital remains constant irrespective
of the method of financing.
Net Present Value: The net present value is equal to the present value
of future cash flows and any immediate cash outflow.
Net Working Capital: It is Current Assets minus Current Liabilities.
Operating Leverage: The operating leverage measures the relationship
between the sales revenue and the EBIT. It measures the effect of change
in sales revenue on the level of EBIT.
Permanent or Fixed Working Capital: It is the minimum amount
which is required to ensure effective utilisation of fixed facilities and
for maintaining the circulation of current assets.
Present Value: The present value of a rupee that will be received in the
future will be less than the value of a rupee in hand today.
Public Deposits: Public deposits are the fixed deposits accepted by a
business enterprise directly from the public.
Rate of Consumption: It is the average consumption of materials in
the factory. The rate of consumption will be decided on the basis past
experiences and production plans.
Receivables: Receivables represent amounts owed to the firm as a result
of sale of goods or services in the ordinary course of business.
Receivables Management: Receivables management is the process of
making decisions relating to investment in trade debtors.
Return: The motivating force, inspiring the investor in the form of
rewards, for undertaking the investment.
Risk: The uncertainty associated with the funds is known as the risk.
Temporary or Variable Working Capital: It is the amount of working
capital which is required to meet the seasonal demands and some special
exigencies.
PAGE 287
Notes The Aggressive Approach: The aggressive approach suggests that entire
estimated requirements of current asset should be financed from short-
term sources even a part of fixed assets investments be financed from
short-term sources.
The Conservative Approach: This approach suggests that the entire
estimated investments in current assets should be financed from long-
term sources and short-term sources should be used only for emergency
requirements.
The Hedging Approach: It suggests that permanent working capital
requirements should be financed with funds from long-term sources
while temporary working capital requirements should be financed with
short-term funds.
The Payback Period: The payback period measures the length of time
required to recover the initial outlay in the project.
Time Value of Money: The money received now is more valuable than
the same amount receivable after some time.
Traditional Approach: According to this theory, the value of the firm
can be increased initially, or the cost of capital can be decreased by using
more debt as the debt is a cheaper source of funds than equity.
WACC: Weighted average cost of capital is the average cost of the costs
of various source of financing.
Work in Progress: The work-in-progress is that stage of stocks which
are in between raw materials and finished goods.
Working Capital as a Percentage of Net Sales: This approach to estimate
the working capital requirement is based on the fact that the working
capital for any firm is directly related to the sales volume of that firm.
Working Capital as a Percentage of Total Assets or Fixed Asset: This
approach of estimation of working capital requirement is based on the
fact that the total assets of the firm are consisting of fixed assets and
current assets.
Working Capital based on Operating Cycle: In this approach, the
working capital estimate depends upon the operating cycle of the firm.
288 PAGE

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Editorial Board

Sh. K.B.Gupta, Dr. Rutika Saini

© Department of Distance and Continuing Education

This Study Material is duly recommended and approved in Academic Council

© Department of Distance & Continuing Education, Campus of Open Learning,

© Department of Distance & Continuing Education, Campus of Open Learning,

Lesson 2 : Cost of Capital-II

Lesson 3 : Capital Structure Theories

Lesson 4 : Capital Structure: Planning and Designing

Lesson 5 : Financing Decision: EBIT– EPS Analysis

5.4 Varying EBIT with Different Financing Patterns 135

Lesson 6 : Financing Decision – Leverage Analysis

1.8 Self-Assessment Questions 185

Lesson 2 : Working Capital: Estimation and Calculation

Lesson 3 : Financing of Working Capital

Lesson 4 : Management of Cash

Lesson 5 : Receivables Management

Lesson 6 : Inventory Management

1.1 Learning Objectives

1.3 Scope of Financial Management

Notes Alternatively, the principal contents of the modern approach to financial

Notes structure of the business/firm/corporate. The capital structure is considered

1.4 Objectives of Financial Management

1.5 Basic Principles of Financial Management

1.6 Time Value of Money

1.7 Valuation Techniques

Notes Compound Value of Re. 1

i = Interest rate Notes

Notes Future Value of An Annuity

Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Notes

Present Value: Present Value or Discounting Technique

Present Value of Re. 1 Notes

Present Value of a Series of Cash Flows

Notes Year Cash Flows (Rs.)

where PVA = Present value of an annuity

1.8 Concept of Risk and Return

undertaking the investment. The importance of returns in any investment Notes

D1 + ( Pt − Pt −1 ) 35 + (3,800 − 3,580) Notes

Rate of Return of a Bond (Debenture)

where VAR(k) = Variance of returns

A third and most popular way of measuring variability of returns is Notes

Notes 1.9 Summary

1.10 Answers to In-Text Questions

1.11 Self-Assessment Questions

1.12 Suggested Readings

1.1 Learning Objectives

1.3 Significance of Capital Budgeting Decisions

Notes affect the future position of the firm to a considerable extent.

1.4 Capital Budgeting Process

Notes instance the technique itself is to be selected and then is to be applied

1.5 (c)Capital Budgeting

Non-Discounting Methods Discounting Methods

Payback Period Accounting rate Net present Internal rate Profitability

1.6 The Payback

Pay Back Period = 3 years + (20000 – 18,000) / (28,000 – 18,000) =

u The emphasis in payback is on the early recovery of investment. Notes

Notes Average Annual Profit (after tax)

The average investment refers to the average quantum of funds that

Total profit after tax is 16000 Notes

1.7 Acceptance Rule

Notes As an investment appraisal criterion, ARR has the following merits:

1.8 Discounted Cash Flow Techniques (DCF)

Example: A company is considering a new project with initial outlays of

Notes equal to zero. If it happens, theoretically speaking, the decision-maker is