I

dhay
aColl
egeforWomen
Kumbakonam

PG&Resear
chDepar
tmentofCommer
ce
IM.
Com

Adv
ancedFi
nanci
alManagement
-
P16MC21
Uni
t–It
oV

Dr
.R.
V.Hema,
Assi
stantPr
ofessorofCommer
ce,
I
dhay
aCol
legef
orWomen,
Kumbakonam.
 UNI
T-I

Meani
ngofFi
nanci
alManagement

Fi
nanci
alManagementmeanspl
anni
ng,or
gani
zi
ng,di
rect
ingandcont
rol
l
ingt
he
f
inanci
alact
ivi
ti
essuchaspr
ocur
ementandut
il
izat
ionoff
undsoft
heent
erpr
ise.I
t
meansappl
yi
nggener
almanagementpr
inci
plest
ofi
nanci
alr
esour
cesoft
heent
erpr
ise.

Scope/El
ement
s:

● I
nvest
mentdeci
sionsi
ncl
udes i
nvest
menti
nfi
xed asset
s(cal
l
ed ascapi
tal
budget
ing)
.Inv
est
menti
ncur
rentasset
sar
eal
soapar
tofi
nvest
mentdeci
sions
cal
l
edaswor
kingcapi
tal
deci
sions.

● Fi
nanci
aldeci
sions-Theyr
elat
etot
her
aisi
ngoff
inancef
rom v
ari
ousr
esour
ces
whi
chwi
l
ldependupondeci
sionont
ypeofsour
ce,per
iodoff
inanci
ng,costof
f
inanci
ngandt
her
etur
nst
her
eby
.

● Di
vi
denddeci
sion-Thef
inancemanagerhast
otakedeci
sionwi
thr
egar
dst
othe
netpr
ofi
tdi
str
ibut
ion.Netpr
ofi
tsar
egener
all
ydi
vi
dedi
ntot
wo:

○ Di
vi
dendf
orshar
ehol
der
s-Di
vi
dendandt
her
ateofi
thast
obedeci
ded.

○ Ret
ainedpr
ofi
ts-Amountofr
etai
nedpr
ofi
tshast
obef
inal
i
zedwhi
chwi
l
l
dependuponexpansi
onanddi
ver
sif
icat
ionpl
ansoft
heent
erpr
ise.

Ev
olut
ionofFi
nanci
alManagement
:
Cor
por
ati
onf
inanceemer
gedasadi
sti
nctf
iel
dofst
udyonl
yint
heear
lypar
tof
t
hiscent
uryasar
esul
tofconsol
i
dat
ionmov
ementandf
ormat
ionofl
argesi
zed
busi
nessunder
taki
ngs.I
nthei
nit
ial
stagesoft
heev
olut
ionofcor
por
ati
onf
inance,
emphasi
swaspl
acedont
hest
udyofsour
cesandf
ormsoff
inanci
ngt
hel
argesi
zed
busi
nessent
erpr
ises.
 Thegr
aveeconomi
crecessi
onof1930’
srender
eddi
ff
icul
ti
esi
nri
singf
inance
f
rom banksandot
herf
inanci
ali
nst
it
uti
ons.Thus,
emphasi
swasl
aiduponi
mpr
oved
met
hodsofpl
anni
ngandcont
rol
,soundf
inanci
alst
ruct
ureoft
hef
ir
m andmor
e
concer
nforl
i
qui
dit
y.Theway
sandmeansofev
aluat
ingt
hecr
edi
twor
thi
nessoff
ir
ms
wer
edev
eloped.

Thepost
-Wor
ldWarI
Ier
anecessi
tat
edr
eor
gani
sat
ionofi
ndust
ri
esandt
heneed
f
orsel
ect
ingsoundf
inanci
alst
ruct
ure.I
ntheear
ly50’
stheemphasi
sshi
ft
edf
rom t
he
pr
ofi
tabi
l
ityt
oli
qui
dit
yandf
rom i
nst
it
uti
onal
financet
odayt
odayoper
ati
onsoft
hef
ir
m.
Thet
echni
quesofanal
ysi
ngcapi
tal
inv
est
menti
nthef
orm of‘
capi
tal
budget
ing’
wer
e
al
sodev
eloped.Thus,
thescopeoff
inanci
almanagementwi
denedt
oincl
udet
he
pr
ocessofdeci
sion-
maki
ngwi
thi
nthef
ir
m.

Themoder
nphasebegani
nmi
d-f
if
ti
esandt
hedi
sci
pli
neofcor
por
ati
onf
inance
orf
inanci
almanagementhasnowbecomemor
eanal
yti
cal
andquant
it
ati
ve.1960’
s
wi
tnessedphenomenal
adv
ancesi
nthet
heor
yof‘
por
tfol
i
oanal
ysi
s’byMi
crowi
tz,
Shar
pe,
Lint
neret
c.Capi
tal
AssetPr
ici
ngModel
(CAPM)wasdev
elopedi
nI970’
s.

TheCAPM suggest
edt
hatsomeoft
her
isksi
ninv
est
ment
scanbeneut
ral
i
sed
byhol
dingofdi
ver
sif
iedpor
tfol
i
oofsecur
it
ies.The‘
Opt
ionPr
ici
ngTheor
y’wasal
so
dev
elopedi
nthef
orm oft
heBi
nomi
alModel
andt
heBl
ack-
Schol
esModel
dur
ingt
his
per
iod.Ther
oleoft
axat
ioni
nper
sonal
andcor
por
atef
inancewasemphasi
sedi
n80’
s.

Fur
ther
,newerav
enuesofr
aisi
ngf
inancewi
tht
hei
ntr
oduct
ionofnewcapi
tal
mar
keti
nst
rument
ssuchasPCD’
s,FCD’
s,PSB’
sandCPP’
set
c.wer
eal
soi
ntr
oduced.
Gl
obal
i
sat
ionofmar
ket
shaswi
tnessedt
heemer
genceof‘
Fi
nanci
alEngi
neer
ing’
whi
ch
i
nvol
vest
hedesi
gn,
dev
elopmentandi
mpl
ement
ati
onofi
nnov
ati
vef
inanci
al
i
nst
rument
sandt
hef
ormul
ati
onofcr
eat
iveopt
imal
sol
uti
onst
opr
obl
emsi
nfi
nance.

Thet
echni
quesofmodel
s,mat
hemat
ical
progr
ammi
ngandsi
mul
ati
onsar
e
pr
esent
lybei
ngusedi
ncor
por
ati
onf
inanceandi
thasachi
evedt
hepr
imepl
aceof
i
mpor
tance.Wemayconcl
udet
hatf
inanci
almanagementhasev
olv
edf
rom abr
anchof
economi
cst
oadi
sti
nctsubj
ectofdet
ail
edst
udyofi
tsown.
Obj
ect
ivesofFi
nanci
alManagement

Ef
fect
ivepr
ocur
ementandef
fi
cientuseoff
inancel
eadt
opr
operut
il
izat
ionof
t
hef
inancebyt
hebusi
nessconcer
n.I
tist
heessent
ialpar
toft
hef
inanci
almanager
.
Hence,t
hef
inanci
almanagermustdet
ermi
net
hebasi
cobj
ect
ivesoft
hef
inanci
al
management
.Obj
ect
ivesofFi
nanci
alManagementmaybebr
oadl
ydi
vi
dedi
ntot
wo
par
tssuchas:

1.Pr
ofi
tmaxi
mizat
ion

2.Weal
thmaxi
mizat
ion.

I
mpor
tanceofFi
nanci
alManagement

Fi
nance i
sthe l
i
febl
ood ofbusi
ness or
gani
zat
ion.I
tneeds t
o meett
he
r
equi
rementoft
hebusi
nessconcer
n.Eachandev
erybusi
nessconcer
nmustmai
ntai
n
adequat
eamountoff
inancef
ort
hei
rsmoot
hrunni
ngoft
hebusi
nessconcer
nandal
so
mai
ntai
nthebusi
nesscar
eful
l
yto achi
evet
hegoaloft
hebusi
nessconcer
n.The
busi
nessgoalcanbeachi
evedonl
ywi
tht
hehel
pofef
fect
ivemanagementoff
inance.
Wecan’
tnegl
ectt
hei
mpor
tanceoff
inanceatanyt
imeatandatanysi
tuat
ion.Someof
t
hei
mpor
tanceoft
hef
inanci
almanagementi
sasf
oll
ows:

 Fi
nanci
alPl
anni
ng: Fi
nanci
almanagementhel
pst
o det
ermi
net
hef
inanci
al
r
equi
rementoft
hebusi
nessconcer
nandl
eadst
otakef
inanci
alpl
anni
ngoft
he
concer
n.Fi
nanci
alpl
anni
ngi
sani
mpor
tantpar
toft
hebusi
nessconcer
n,whi
ch
hel
pst
opr
omot
ionofanent
erpr
ise.

 Acqui
sit
ionofFunds:Fi
nanci
almanagementi
nvol
vest
heacqui
sit
ionofr
equi
red
f
inancet
othebusi
nessconcer
n.Acqui
ri
ngneededf
undspl
ayamaj
orpar
toft
he
f
inanci
almanagement
,whi
chi
nvol
vepossi
blesour
ceoff
inanceatmi
nimum
cost
.

 Pr
operUseofFunds:Pr
operuseandal
l
ocat
ionoff
undsl
eadst
oimpr
ovet
he
oper
ati
onalef
fi
ciencyoft
hebusi
nessconcer
n.Whent
hef
inancemanageruses
 t
hef
undspr
oper
ly,t
heycanr
educet
hecostofcapi
talandi
ncr
easet
hev
alueof
t
hef
ir
m.

 Fi
nanci
alDeci
sion:Fi
nanci
almanagementhel
pst
otakesoundf
inanci
aldeci
sion
i
nthe busi
ness concer
n.Fi
nanci
aldeci
sion wi
l
laf
fectt
he ent
ir
e busi
ness
oper
ati
onoft
heconcer
n.Becauset
her
eisadi
rectr
elat
ionshi
pwi
thv
ari
ous
depar
tmentf
unct
ionssuchasmar
ket
ing,
product
ionper
sonnel
,et
c.

 I
mpr
ove Pr
ofi
tabi
li
ty:Pr
ofi
tabi
l
ity of t
he concer
n pur
ely depends on t
he
ef
fect
ivenessandpr
operut
il
izat
ionoff
undsbyt
hebusi
nessconcer
n.Fi
nanci
al
managementhel
pst
oimpr
ovet
hepr
ofi
tabi
l
ityposi
ti
onoft
heconcer
nwi
tht
he
hel
pofst
rongf
inanci
alcont
roldev
icessuchasbudget
arycont
rol
,rat
ioanal
ysi
s
andcostv
olumepr
ofi
tanal
ysi
s.

 I
ncr
easet
heVal
ueoft
heFi
rm:Fi
nanci
almanagementi
sver
yimpor
tanti
nthe
f
iel
dofi
ncr
easi
ngt
heweal
thoft
hei
nvest
orsandt
hebusi
nessconcer
n.Ul
ti
mat
e
ai
m ofanybusi
ness concer
n wi
l
lachi
evet
he maxi
mum pr
ofi
tand hi
gher
pr
ofi
tabi
l
ityl
eadst
omaxi
mizet
heweal
thoft
hei
nvest
orsaswel
last
henat
ion.

 Pr
omot
ingSav
ings:Sav
ingsar
epossi
bleonl
ywhent
hebusi
nessconcer
near
ns
hi
gherpr
ofi
tabi
l
ityandmaxi
mizi
ngweal
th.Ef
fect
ivef
inanci
almanagementhel
ps
t
opr
omot
ingandmobi
l
izi
ngi
ndi
vi
dual
andcor
por
atesav
ings.

Nowaday
sfi
nanci
almanagementi
sal
sopopul
arl
yknownasbusi
nessf
inanceor
cor
por
atef
inances.Thebusi
nessconcer
norcor
por
atesect
orscannotf
unct
ionwi
thout
t
hei
mpor
tanceoft
hef
inanci
almanagement
.

Fi
nanci
alPl
anni
ng

Smoot
handsuccessf
ulr
unni
ngofacompanyr
equi
resst
eadysuppl
yofi
ts
f
inanci
alr
equi
rement
s.Thel
ongt
erm andshor
tter
mrequi
rement
soff
inancear
etobe
meti
nti
me.Fi
nanci
almanagementl
ooksi
ntot
hef
utur
eandar
rangesf
orpr
ovi
sionof
adequat
efi
nancei
nti
me.

Obj
ect
ivesoff
inanci
alpl
anni
ng
 Fi
nanci
alPl
anni
nghasgotmanyobj
ect
ivest
olookf
orwar
dto:
1.Det
ermi
ningcapi
talr
equi
rement
s-Thi
swi
l
ldependuponf
act
orsl
i
kecostofcur
rent
andf
ixedasset
s,pr
omot
ionalexpensesandl
ong-r
angepl
anni
ng.Capi
talr
equi
rement
s
hav
etobel
ookedwi
thbot
haspect
s:shor
t-t
erm andl
ong-t
ermr
equi
rement
s.
2.Det
ermi
ningcapi
talst
ruct
ure-Thecapi
talst
ruct
urei
sthecomposi
ti
onofcapi
tal
,i
.e.
,
t
her
elat
iveki
ndandpr
opor
ti
onofcapi
tal
requi
redi
nthebusi
ness

3.Fr
ami
ngf
inanci
alpol
ici
eswi
thr
egar
dst
ocashcont
rol
,l
endi
ng,
bor
rowi
ngs,
etc.

4.A f
inance managerensur
es t
hatt
he scar
ce f
inanci
alr
esour
ces ar
e maxi
mal
ly
ut
il
izedi
nthebestpossi
blemanneratl
eastcosti
nor
dert
ogetmaxi
mum r
etur
nson
i
nvest
ment
.

UNI
T-I
I

Ti
meVal
ueofMoney

Under
standi
ngt
het
imev
alueofmoneyi
scr
uci
alt
oef
fect
ivef
inanci
almanagement
.
I
nfact
,any
onewhoi
sinv
olv
edwi
thmoneyshoul
dhav
esomecompr
ehensi
onoft
he
t
imev
alueofmoney
.Consi
dert
hef
oll
owi
ng:

 Abankerwhomakesl
oansandot
heri
nvest
ment
s

 Af
inanci
alof
fi
cerwhosej
obi
ncl
udest
heconsi
der
ati
onofv
ari
ousal
ter
nat
ive
sour
cesoff
undsi
nter
msoft
hei
rcost

 Acompanymanagerwhomustchooseamongv
ari
ousal
ter
nat
ivei
nvest
ment
pr
oject
s

 Asecur
it
iesanal
ystwhoev
aluat
est
hesecur
it
iest
hataf
ir
m sel
l
stoi
nvest
ors

 Ani
ndi
vi
dualwhoi
sconf
ront
edwi
thahostofdai
l
yfi
nanci
alpr
obl
emsr
angi
ng
f
rom per
sonalcr
edi
taccountmanagementt
odeci
dinghow t
ofi
nanceanew
homepur
chase
  Eachoft
hesei
ndi
vi
dual
smakesf
requentuseoft
het
imev
alueofmoney
.Many
peopl
efeart
hatawor
kingknowl
edgeoft
het
imev
alueofmoneyconceptmi
ght
bet
oodi
ff
icul
ttomast
er.Howev
er,t
heav
ail
abi
l
ityofi
nter
estt
abl
es,f
inanci
al
cal
cul
ator
s,andspr
eadsheetpr
ogr
amssuchasExcelmakest
hesubj
ectr
eadi
l
y
accessi
ble.

Al
thoughanunder
standi
ngoft
het
imev
alueofmoneyi
susef
uli
nandofi
tsel
f,i
t
i
sal
soanecessar
ypr
eludet
othef
oll
owi
ngt
opi
cs:

 Val
uat
ionofsecur
it
iesandot
herasset
s

 Capi
tal
budget
ing(
theanal
ysi
sofi
nvest
mentpr
oject
s)

 Thecostofcapi
tal

 Wor
kingcapi
tal
(shor
t-
ter
m assetandl
i
abi
l
ity
)management

 Leaseanal
ysi
s

Pr
esentv
aluecal
cul
ati
ons
Onecommont
ime-
val
uepr
obl
em deal
swi
thexpect
ingaspeci
fi
edsum ofmoney
atapoi
nti
nthef
utur
e.Becausemoneyear
nedi
nthef
utur
eiswor
thl
esst
hanmoney
ear
nednow,
youhav
etoappl
yadi
scountt
othef
utur
epay
menti
nor
dert
ogeti
ts
equi
val
entpr
esentv
alue.Of
ten,
thedi
scountr
ateusedi
sequal
tot
hepr
evai
l
ingr
isk-
fr
ee
r
atef
orasset
sli
keTr
easur
ysecur
it
ieswi
thoutdef
aul
tri
sk.Thef
urt
heri
ntot
hef
utur
e
t
hepay
menti
s,t
hegr
eat
ert
hedi
scount
.

Themat
hbehi
ndapr
esentv
aluecal
cul
ati
oni
sabi
tcompl
i
cat
edbutcanbedone
wi
thabasi
ccal
cul
ator
.Tocomeupwi
thpr
esentv
alue,
take1andaddi
ttot
hedi
scount
r
ateused.Thenr
aiset
hatnumbert
othepoweroft
henumberofy
ear
sint
hef
utur
ethat
y
ou'
l
lrecei
vet
hepay
ment
.Sav
ether
esul
ti
ngf
igur
e,andt
hendi
vi
det
hef
utur
epay
ment
amountbyt
hatf
igur
e.Thef
inal
resul
twi
l
lbet
hepr
esentv
alue.

Fori
nst
ance,sayy
ouknow t
haty
ou'
l
lrecei
ve$110.
25i
ntwoy
ear
sanddeci
de
t
hatadi
scountr
ateof5%i
sappr
opr
iat
e.I
nthatcase,1pl
us5%equal
s1.
05,and1.
05
r
aisedt
othesecondpoweri
s1.
1025.Di
vi
de$110.
25by1.
1025,andy
ouget$100,
whi
chi
sthepr
esentv
alue.

Techni
quesofTi
meVal
ueofMoney

Fut
urev
aluecal
cul
ati
onswor
kint
heopposi
temanner
.You'
l
lfol
l
ow t
hesame
st
epsasy
oudi
dforpr
esentv
alue,addi
ng1t
othedi
scountr
ateandt
henr
aisi
ngt
hat
numbert
othepoweroft
henumberofy
ear
sint
hef
utur
ethaty
ou'
remeasur
ingt
he
f
utur
eval
ue.Butt
hen,y
ou'
l
lneedt
omul
ti
plyt
her
esul
tbyt
hev
alueoft
hecur
rent
pay
ment
.Thef
inal
resul
tist
hef
utur
eval
ue.

Fori
nst
ance,
ify
ouwantt
oknowt
hef
utur
eval
ueof$100i
ntwoy
ear
sassumi
ng
ar
ateof5%,t
hen1+5%i
s1.
05,1.
05r
aisedt
othesecondpoweri
s1.
1025,and$100
mul
ti
pli
edby1.
1025i
s$110.
25.Asy
oucansee,
thi
smat
chesupwi
tht
hepr
esentv
alue
cal
cul
ati
onabov
e.

Recur
ri
ngv
aluet
echni
ques
Thet
womet
hodsdi
scussedabov
ewor
kwel
lforone-
ti
mepay
ment
s,butot
her
met
hodsar
ebet
terf
orr
ecur
ri
ngpay
ment
s.Youcanal
way
sjustcal
cul
atepr
esentor
f
utur
eval
uef
oreachpay
mentsepar
atel
y,butt
her
ear
esomet
imesshor
tcut
sav
ail
abl
e
f
orcommonsi
tuat
ions.

Fori
nst
ance,
sayy
ouhav
eanassett
hatpay
saper
pet
ualst
ream ofi
ncome.You
can'
tcal
cul
ateeachpay
mentsepar
atel
y,butt
heequat
ionf
ori
tspr
esentv
aluet
urnsout
t
obequi
tesi
mpl
e:t
aket
heamountofeachr
egul
arpay
mentanddi
vi
dei
tbyt
he
di
scountr
ate.Soi
fyour
ecei
ve$100eachy
earanduseadi
scountr
ateof5%,t
heni
ts
pr
esentv
aluei
s$100/5%=$2,
000.

Val
uat
ionofSecur
it
ies

Secur
it
yval
uat
ioni
simpor
tantt
odeci
deont
hepor
tfol
i
oofani
nvest
or.Al
l
i
nvest
mentdeci
sionsar
etobemadeonasci
ent
if
icanal
ysi
soft
her
ightpr
iceofashar
e.
Hence,
anunder
standi
ngoft
hev
aluat
ionofsecur
it
iesi
sessent
ial
.Inv
est
orsshoul
dbuy
under
pri
cedshar
esand sel
lov
erpr
iced shar
es.Shar
epr
ici
ngi
sthusani
mpor
tant
aspectoft
radi
ng.Concept
ual
l
y,f
ourt
ypesofv
aluat
ionmodel
sar
edi
scer
nibl
e.
Theyar
e

(
i)
.Bookv
alue,

(
ii
)Li
qui
dat
ingv
alue,

(
ii
i)I
ntr
insi
cval
ue,

(
iv)Repl
acementv
alueascompar
edt
omar
ketpr
ice.

i
)BookVal
ue:

Bookv
alueofasecur
it
yisanaccount
ingconcept
.Thebookv
alueofanequi
ty
shar
eisequalt
othenetwor
thoft
hef
ir
m di
vi
dedbyt
henumberofequi
tyshar
es,
wher
e
t
henetwor
thi
sequalt
oequi
tycapi
talpl
usf
reer
eser
ves.Themar
ketv
aluemay
f
luct
uat
ear
oundt
hebookv
aluebutmaybehi
gheri
fthef
utur
epr
ospect
sar
egood.

(
ii
)Li
qui
dat
ingVal
ue(
BreakdownVal
ue)
:

I
ftheasset
sar
eval
uedatt
hei
rbr
eakdownv
aluei
nthemar
ketandt
akenetf
ixed
asset
spl
uscur
rentasset
smi
nuscur
rentl
i
abi
l
iti
esasi
fthecompanyi
sli
qui
da¬t
ed,
then
di
vi
det
hisbyt
henumberofshar
es,
ther
esul
tantv
aluei
sthel
i
qui
dat
ingv
aluepershar
e.
Thi
sisal
soanaccount
ingconcept
.

(
ii
i)I
ntr
insi
cVal
ue:

Mar
ketv
alueofasecur
it
yist
hepr
iceatwhi
cht
hesecur
it
yist
radedi
nthe
mar
ketandi
tisgener
all
yhov
eri
ngar
oundi
tsi
ntr
insi
cval
ue.Ther
ear
edi
ff
erentschool
s
oft
houghtr
egar
dingt
her
elat
ionshi
pofi
ntr
insi
cval
uet
othemar
ketpr
ice.Mar
ketpr
ices
ar
ethosewhi
chr
ulei
nthemar
ket
,resul
ti
ngf
rom t
hedemandandsuppl
yfor
ces.
I
ntr
insi
cpr
icei
sthet
ruev
alueoft
heshar
e,whi
chdependsoni
tsear
ningcapaci
tyand
i
tst
ruewor
th.Accor
dingt
othef
undament
ali
stappr
oacht
osecur
it
yval
uat
ion,
thev
alue
oft
hesecur
it
ymustbeequalt
othedi
scount
edv
alueoft
hef
utur
eincomest
ream.The
i
nvest
orbuy
sthesecur
it
ieswhent
hemar
ketpr
icei
sbel
owt
hisv
alue.

Thus,
forf
undament
ali
sts,
ear
ningsanddi
vi
dendsar
etheessent
iali
ngr
edi
ent
sin
det
ermi
ningt
hemar
ketv
alueofasecur
it
y.Thedi
scountr
ateusedi
nsuchpr
esentv
alue
cal
cul
ati
onsi
sknownast
her
equi
redr
ateorr
etur
n.Usi
ngt
hisdi
scountr
ateal
lfut
ure
ear
ningsar
edi
scount
edbackt
othepr
esentt
odet
ermi
net
hei
ntr
insi
cval
ue.

Accor
dingt
othet
echni
calschool
,thepr
iceofasecur
it
yisdet
ermi
nedbyt
he
mar
ketdemandandsuppl
yandi
thasv
eryl
i
ttl
etodowi
thi
ntr
insi
cval
ues.Thepr
ice
mov
ement
sfol
l
ow cer
tai
ntr
ends f
orv
ary
ing per
iods oft
ime.Changes i
ntr
end
r
epr
esentt
heshi
ft
sindemandandsuppl
ywhi
char
epr
edi
ctabl
e.Thepr
esentt
rendsar
e
t
heof
fshootoft
hepastandhi
stor
yrepeat
sit
sel
faccor
dingt
othi
sschool
.

Accor
dingt
oef
fi
cientmar
kethy
pot
hesi
s,i
naf
air
lyl
argesecur
it
ymar
ketwher
e
compet
it
ivecondi
ti
onspr
evai
l
,mar
ketpr
icesar
egoodpr
oxi
esf
ori
ntr
insi
cval
ues.The
secur
it
ypr
icesar
edet
ermi
nedaf
terabsor
bingal
lthei
nfor
mat
ionav
ail
¬abl
etomar
ket
par
ti
cipant
s.Ashar
eist
husgener
all
ywor
thwhat
everi
tissel
l
ingf
ori
nthemar
ket
.

Gener
all
y,f
undament
alschooli
sthebasi
sforsecur
it
yval
uat
ion and many
model
sar
einuse,
basedont
heset
enet
s.

(
iv)Repl
acementVal
ue:

Whent
hecompanyi
sli
qui
dat
edandi
tsasset
sar
etober
epl
acedbynewones,
t
hei
rpr
icesbei
nghi
gher
,ther
epl
acementv
alueofashar
ewi
l
lbedi
ff
erentf
rom t
he
Br
eakdownv
alue.Someanal
yst
staket
hisr
epl
acementv
aluet
ocompar
ewi
tht
he
mar
ketpr
ice.

Fact
orsI
nfl
uenci
ngSecur
it
yVal
uat
ion

Secur
it
ypr
icedependsonahostoff
act
orsl
i
keear
ningspershar
e,pr
ospect
sof
expansi
on,
fut
ureear
ningspot
ent
ial
,possi
blei
ssueofbonusorr
ight
sshar
es,
etc.Some
demandf
orapar
ti
cul
arst
ockmaygi
vepl
easur
eofpowerasashar
ehol
derorpr
est
ige
andcont
rolonmanagement
.Sat
isf
act
ionandpl
easur
eint
henon-
monet
arysense
cannotbeconsi
der
edi
nanypr
act
icalandquant
if
iabl
esense.Manypsy
chol
ogi
¬caland
emot
ional
fact
orsi
nfl
uencet
hedemandf
orashar
e.

I
nmoneyt
erms,t
her
etur
ntoasecur
it
yonwhi
chi
tsv
aluedependsconsi
stsoft
wo
component
s:
(
i)Regul
ardi
vi
dendsori
nter
est
,and

(
ii
)Capi
tal
gai
nsorl
ossesi
nthef
orm ofchangesi
nthecapi
tal
val
ueoft
heasset
.

I
fther
iski
shi
gh,
ret
urnshoul
dal
sobehi
gh.Ri
skher
eref
erst
ouncer
tai
ntyofr
ecei
ptof
pr
inci
pal
andi
nter
estordi
vi
dendandv
ari
abi
l
ityoft
hisr
etur
n.

UNI
T-I
II

CostofCapi
tal

Thecostofcapi
talofaf
ir
mist
hemi
nimum r
ateofr
etur
nexpect
edbyi
ts
i
nvest
ors.I
tist
hewei
ght
edav
eragecostofv
ari
oussour
cesoff
inanceusedbyaf
ir
m.
Thecapi
talusedbyaf
ir
m maybei
nthef
orm ofdebt
,pr
efer
encecapi
tal
,ret
ained
ear
ningsandequi
tyshar
es.Theconceptofcostofcapi
tali
sver
yimpor
tanti
nthe
f
inanci
almanagement
.Adeci
siont
oinv
esti
napar
ti
cul
arpr
ojectdependsupont
he
costofcapi
taloft
hef
ir
m ort
hecutof
frat
ewhi
chi
sthemi
nimum r
ateofr
etur
n
expect
edbyt
hei
nvest
ors.

Def
ini
ti
on

JamesC.VanHor
nedef
inescostofcapi
talas,
”acut
-of
frat
efort
heal
l
ocat
ionof
capi
talt
oinv
est
ment
sofpr
oject
s.I
tist
her
ateofr
etur
nonapr
ojectt
hatwi
l
lleav
e
unchangedt
hemar
ketpr
iceoft
hest
ock.

Accor
dingt
oSol
omonEzr
a,“
Costofcapi
tali
sthemi
nimum r
equi
redr
ateof
ear
ningort
hecut
-of
frat
eofcapi
tal
expendi
tur
es”
.

Comput
ati
onofWei
ght
edAv
erageCostofCapi
tal

Wei
ght
edav
eragecostofcapi
tali
stheav
eragecostoft
hecost
sofv
ari
ous
sour
cesofFi
nanci
ng.Wei
ght
edav
eragecostofcapi
tali
sal
soknownascomposi
te
costofcapi
tal
,ov
eral
lcostofcapi
talorav
eragecostofcapi
tal
.Oncet
hespeci
fi
ccost
ofi
ndi
vi
dualsour
cesoff
inancei
sdet
ermi
ned,wecancomput
ethewei
ght
edav
erage
costofcapi
talbyput
ti
ngwei
ght
stot
hespeci
fi
ccost
sofcapi
tali
npr
opor
ti
onoft
he
v
ari
oussour
cesoff
undst
othet
otal
.Thewei
ght
smaybegi
venei
therbyusi
ngt
hebook
v
alueoft
hesour
ceormar
ketv
alueoft
hesour
ce.Themar
ketv
aluewei
ght
ssuf
ferf
rom
t
hef
oll
owi
ngl
i
mit
ati
ons:I
tisv
erydi
ff
icul
ttodet
ermi
net
hemar
ketv
aluesbecauseof
f
requentf
luct
uat
ions.Wi
tht
heuseofmar
ketv
aluewei
ght
s,equi
tycapi
talget
sgr
eat
er
i
mpor
tance.

Measur
ementofCostofCapi
tal

Thet
erm costofcapi
tali
sanov
eral
lcost
.Thi
sist
hecombi
nat
ioncostoft
he
speci
fi
ccostassoci
atedwi
thspeci
fi
csour
ceoff
inanci
ng.Thecomput
ati
onofcost
capi
talt
her
efor
e,i
nvol
vest
wost
eps:Thecomput
ati
onoft
hedi
ff
erentel
ement
soft
he
costi
nter
m oft
hecostoft
hedi
ff
erentsour
ceoff
inance.Thecal
cul
ati
onoft
heov
eral
l
costbycombi
ningt
hespeci
fi
ccosti
ntoacomposi
tecost
.

Fr
om t
hev
iewpoi
ntofcapi
talbudget
ingdeci
sionst
hel
ong-
ter
m sour
cesoff
und
ar
erel
evantast
heconst
it
utet
hemaj
orsour
ceoff
inanci
ngoff
ixedcost
.Incal
cul
ati
ng
t
hecostofcapi
tal
,ther
efor
e,t
hef
ocusi
stobeont
hel
ong-
ter
mfunds.I
not
herwor
ds
t
hespeci
fi
ccosthast
obecal
cul
atedf
or:1)Longt
erm debt2)Pr
efer
enceShar
es3)
Equi
tyShar
es4)Ret
ainedear
nings

CostofPr
efer
enceCapi
tal

Af
ixedr
ateofdi
vi
dendi
spay
abl
eonpr
efer
enceshar
es.Thoughdi
vi
dendi
s
pay
abl
eatt
hedi
scr
eti
onoft
heBoar
dofdi
rect
orsandt
her
eisnol
egalbi
ndi
ngt
opay
di
vi
dend,y
eti
tdoes notmean t
hatpr
efer
ence capi
tali
s costf
ree.The costof
pr
efer
encecapi
tali
saf
unct
ionofdi
vi
dendexpect
edbyi
tsi
nvest
ors,i
.e.
,it
sst
ated
di
vi
dend.I
ncasedi
vi
dendshar
enotpai
dtopr
efer
enceshar
ehol
der
s,i
twi
l
laf
fectt
he
f
und r
aisi
ng capaci
tyoft
he f
ir
m.Hence,di
vi
dends ar
e usual
l
ypai
dregul
arl
yof
pr
efer
enceshar
esexpectwhent
her
ear
enopr
ofi
tst
opaydi
vi
dends.

CostofEqui
tyShar
eCapi
tal

Thecostofequi
tyi
sthemaxi
mum r
ateofr
etur
nthatt
hecompanymustear
nof
equi
tyf
inancedpor
ti
onofi
tsi
nvest
ment
sinor
dert
oleav
eunchangedt
hemar
ketpr
ice
ofi
tsst
ock‟
.Thecostofequi
tycapi
tali
saf
unct
ionoft
heexpect
edr
etur
nbyi
ts
i
nvest
ors.Thecostofequi
tyi
snott
heout
-of
-pocketcostofusi
ngequi
tycapi
talast
he
equi
tyshar
ehol
der
sar
enotpai
ddi
vi
dendataf
ixedr
ateev
eryy
ear
.Mor
eov
er,pay
ment
ofdi
vi
dendi
snotal
egalbi
ndi
ng.I
tmayormaynotbepai
d.Buti
sdoesnotmeant
hat
equi
tyshar
ecapi
tali
sacostf
reecapi
tal
.Shar
ehol
der
sinv
estmoneyi
nequi
tyshar
es
ont
heex
pect
ati
onofget
ti
ngdi
vi
dendandt
hecompanymustear
nthi
smi
nimum r
ate
sot
hatt
hemar
ketpr
iceoft
heshar
esr
emai
nsunchanged.Whenev
eracompanywant
s
t
orai
seaddi
ti
onalf
undsbyt
hei
ssueofnew equi
tyshar
es,t
heexpect
ati
onsoft
he
shar
ehol
der
shav
etoev
aluat
e.

LEVERAGE

Meani
ngofLev
erage

The wor
d‘l
ever
age’
,bor
rowed f
rom phy
sics,i
sfr
equent
lyused i
nfi
nanci
al
management
.Theobj
ectofappl
i
cat
ionofwhi
chi
smadet
o gai
nhi
gherf
inanci
al
benef
it
scompar
edt
othef
ixedchar
gespay
abl
e,asi
thappensi
nphy
sicsi
.e.
,gai
ning
l
argerbenef
it
sbyusi
ngl
esseramountoff
orce.

Def
ini
ti
onofLev
erage

Accor
dingt
oJ.C.VanHor
ne“
Lev
eragei
stheempl
oymentofanassetorf
unds
f
orwhi
cht
hef
ir
m pay
saf
ixedcostoff
ixedr
etur
n.”

Ty
pesofLev
erage

Lev
eragear
ethr
eet
ypes:

(
i)Oper
ati
ngl
ever
age

(
ii
)Fi
nanci
all
ever
ageand

(
ii
i)Combi
nedl
ever
age

1.Oper
ati
ngLev
erage:

Oper
ati
ng l
ever
age r
efer
stot
he use of f
ixed oper
ati
ng cost
s such as
depr
eci
ati
on,i
nsur
anceofasset
s,r
epai
rsandmai
ntenance,pr
oper
tyt
axeset
c.i
nthe
oper
ati
onsofaf
ir
m.Buti
tdoesnoti
ncl
udei
nter
eston debtcapi
tal
.Hi
ghert
he
pr
opor
ti
onoff
ixedoper
ati
ngcostascompar
edt
ovar
iabl
ecost
,hi
gheri
stheoper
ati
ng
l
ever
age,
andv
icev
ersa.

Oper
ati
ngl
ever
agemaybedef
inedast
he“
fi
rm’
sabi
l
ityt
ousef
ixedoper
ati
ng
costt
omagni
fyef
fect
sofchangesi
nsal
esoni
tsear
ningsbef
orei
nter
estandt
axes.
”

I
npr
act
ice,
afi
rm wi
l
lhav
ethr
eet
ypesofcostv
iz:

(
i)Var
iabl
ecostt
hatt
endst
ovar
yindi
rectpr
opor
ti
ont
othechangei
nthe
v
olumeofact
ivi
ty,

(
ii
)Fi
xedcost
swhi
cht
endt
oremai
nfi
xedi
rr
espect
iveofv
ari
ati
onsi
nthev
olume
ofact
ivi
tywi
thi
nar
elev
antr
angeanddur
ingadef
inedper
iodoft
ime,

(
ii
i)Semi
-var
iabl
eorSemi
-f
ixedcost
swhi
char
epar
tl
yfi
xedandpar
tl
yvar
iabl
e.
Theycanbesegr
egat
edi
ntov
ari
abl
eandf
ixedel
ement
sandi
ncl
udedi
nther
espect
ive
gr
oupofcost
s.

Oper
ati
ng l
ever
ageoccur
swhen a f
ir
m i
ncur
sfi
xed cost
swhi
ch ar
eto be
r
ecov
eredoutofsal
esr
evenuei
rr
espect
iveoft
hev
olumeofbusi
nessi
naper
iod.I
na
f
ir
m hav
ingf
ixedcost
sint
het
otalcostst
ruct
ure,
agi
venchangei
nsal
eswi
l
lresul
tina
di
spr
opor
ti
onat
echangei
ntheoper
ati
ngpr
ofi
torEBI
Toft
hef
ir
m.

I
fther
eisnof
ixedcosti
nthet
otalcostst
ruct
ure,t
hent
hef
ir
m wi
l
lnothav
ean
oper
ati
ngl
ever
age.I
nthatcase,t
heoper
ati
ngpr
ofi
torEBI
Tvar
iesi
ndi
rectpr
opor
ti
on
t
othechangesi
nsal
esv
olume.

Oper
ati
ngl
ever
agei
sassoci
atedwi
thoper
ati
ngr
iskorbusi
nessr
isk.Thehi
gher
t
hef
ixedoper
ati
ngcost
s,t
hehi
ghert
hef
ir
m’soper
ati
ngl
ever
ageandi
tsoper
ati
ngr
isk.
Oper
ati
ngr
iski
sthedegr
eeofuncer
tai
ntyt
hatt
hef
ir
m hasf
acedi
nmeet
ingi
tsf
ixed
oper
ati
ngcostwher
ether
eisv
ari
abi
l
ityofEBI
T.

I
tar
iseswhent
her
eisv
olat
il
it
yinear
ningsofaf
ir
m duet
ochangesi
ndemand,
suppl
y,economi
cenv
ironment
,busi
nesscondi
ti
onset
c.Thel
argert
hemagni
tudeof
oper
ati
ngl
ever
age,
thel
argeri
sthev
olumeofsal
esr
equi
redt
ocov
eral
lfi
xedcost
s.
Fi
nanci
alLev
erage

Fi
nanci
all
ever
age i
s pr
imar
il
yconcer
ned wi
tht
he f
inanci
alact
ivi
ti
es whi
ch
i
nvol
ver
aisi
ngoff
undsf
rom t
hesour
cesf
orwhi
chaf
ir
m hast
obearf
ixedchar
ges
suchasi
nter
estexpenses,l
oanf
eeset
c.Thesesour
cesi
ncl
udel
ong-
ter
m debt(
i.
e.,
debent
ures,
bondset
c.)andpr
efer
enceshar
ecapi
tal
.

Longt
erm debtcapi
talcar
ri
esacont
ract
ualf
ixedr
ateofi
nter
estandi
tspay
ment
i
sobl
i
gat
oryi
rr
espect
iveoft
hef
actwhet
hert
hef
ir
m ear
nsapr
ofi
tornot
.

Asdebtpr
ovi
der
shav
epr
iorcl
aim oni
ncomeandasset
sofaf
ir
m ov
erequi
ty
shar
ehol
der
s,t
hei
rrat
eofi
nter
esti
sgener
all
ylowert
hant
heexpect
edr
etur
ninequi
ty
shar
ehol
der
s.Fur
ther
,int
erestondebtcapi
tal
isat
axdeduct
ibl
eexpense.

Theset
wof
act
sleadt
othemagni
fi
cat
ionoft
her
ateofr
etur
nonequi
tyshar
e
capi
talandhenceear
ningspershar
e.Thus,
theef
fectofchangesi
noper
ati
ngpr
ofi
tsor
EBI
Tont
heear
ningspershar
eisshownbyt
hef
inanci
all
ever
age.

Accor
dingt
oGi
tmanf
inanci
all
ever
agei
s“t
heabi
l
ityofaf
ir
mtousef
ixed
f
inanci
alchar
gest
omagni
fyt
heef
fect
sofchangesi
nEBI
Tonf
ir
m’sear
ningsper
shar
e”.I
not
herwor
ds,f
inanci
all
ever
agei
nvol
vest
heuseoff
undsobt
ainedataf
ixed
costi
nthehopeofi
ncr
easi
ngt
her
etur
ntot
heequi
tyshar
ehol
der
s.

Fav
our
abl
eorposi
ti
vef
inanci
all
ever
ageoccur
swhenaf
ir
m ear
nsmor
eont
he
asset
s/i
nvest
mentpur
chased wi
tht
he f
unds,t
han t
he f
ixed costoft
hei
ruse.
Unf
avor
abl
eornegat
ivel
ever
ageoccur
swhent
hef
ir
m doesnotear
nasmuchast
he
f
undscost
.

Thusshar
ehol
der
sgai
nwher
ethef
ir
m ear
nsahi
gherr
ateofr
etur
nandpay
sa
l
owerr
ateofr
etur
ntot
hesuppl
i
erofl
ong-
ter
mfunds.Thedi
ff
erencebet
weent
he
ear
ningsf
rom t
heasset
sandt
hef
ixedcostont
heuseoff
undsgoest
otheequi
ty
shar
ehol
der
s.Fi
nanci
all
ever
agei
sal
so,
ther
efor
e,cal
l
edas‘
tr
adi
ngonequi
ty’
.

Fi
nanci
all
ever
agei
sassoci
atedwi
thf
inanci
alr
isk.Fi
nanci
alr
iskr
efer
stor
iskof
t
hef
ir
m notbei
ngabl
etocov
eri
tsf
ixedf
inanci
alcost
sduet
ovar
iat
ioni
nEBI
T.Wi
tht
he
i
ncr
easei
nfi
nanci
alchar
ges,t
hef
ir
m i
sal
so r
equi
red t
orai
set
hel
evelofEBI
T
necessar
ytomeetf
inanci
alchar
ges.I
fthef
ir
m cannotcov
ert
hesef
inanci
alpay
ment
s
i
tcanbet
echni
cal
l
yfor
cedi
ntol
i
qui
dat
ion.

Combi
nedLev
erage

Oper
ati
ngl
ever
ageshowst
heoper
ati
ngr
iskandi
smeasur
edbyt
heper
cent
age
changei
nEBI
Tduet
oper
cent
agechangei
nsal
es.Thef
inanci
all
ever
ageshowst
he
f
inanci
alr
iskandi
smeasur
edbyt
heper
cent
agechangei
nEPSduet
oper
cent
age
changei
nEBI
T.

Bot
hoper
ati
ngandf
inanci
all
ever
agesar
ecl
osel
yconcer
nedwi
thascer
tai
ning
t
hef
ir
m’sabi
l
ityt
ocov
erf
ixedcost
sorf
ixedr
ateofi
nter
estobl
i
gat
ion,i
fwecombi
ne
t
hem,t
her
esul
tist
otall
ever
ageandt
her
iskassoci
atedwi
thcombi
nedl
ever
agei
s
known ast
otalr
isk.I
tmeasur
est
he ef
fectofa per
cent
age change i
n sal
eson
per
cent
agechangei
nEPS.

UNI
T-I
V

Capi
talSt
ruct
ure

Capi
talst
ruct
urer
efer
stot
heki
ndsofsecur
it
iesandt
hepr
opor
ti
onat
eamount
s
t
hatmakeupcapi
tal
i
zat
ion.I
tist
hemi
xofdi
ff
erentsour
cesofl
ong-
ter
m sour
cessuch
asequi
tyshar
es,
pref
erenceshar
es,
debent
ures,
long-
ter
mloansandr
etai
nedear
nings.
Thet
erm capi
talst
ruct
urer
efer
stot
her
elat
ionshi
pbet
weent
hev
ari
ousl
ong-
ter
m
sour
cesf
inanci
ngsuchasequi
tycapi
tal
,pr
efer
enceshar
ecapi
talanddebtcapi
tal
.
Deci
ding t
he sui
tabl
e capi
talst
ruct
urei
sthe i
mpor
tantdeci
sion oft
he f
inanci
al
managementbecausei
tiscl
osel
yrel
atedt
othev
alueoft
hef
ir
m.Capi
talst
ruct
urei
s
t
heper
manentf
inanci
ngoft
hecompanyr
epr
esent
edpr
imar
il
ybyl
ong-
ter
m debtand
equi
ty.

Def
ini
ti
onofCapi
talSt
ruct
ure

Accor
dingt
othedef
ini
ti
onofGer
est
enbeg,“
Capi
talSt
ruct
ureofacompany
r
efer
stot
hecomposi
ti
onormakeupofi
tscapi
tal
i
zat
ionandi
tincl
udesal
llong-
ter
m
capi
talr
esour
ces”
.Accor
dingt
othedef
ini
ti
onofJamesC.VanHor
ne,“
Themi
xofa
f
ir
m’s per
manentl
ong-
ter
m f
inanci
ng r
epr
esent
ed by debt
,pr
efer
red st
ock,and
common st
ock equi
ty”
.Accor
ding t
othe def
ini
ti
on of Per
sona Chandr
a,“
The
composi
ti
onofaf
ir
m’sf
inanci
ngconsi
stsofequi
ty,
pref
erence,
anddebt
.

Fi
nanci
alSt
ruct
ure

Thet
ermf
inanci
alst
ruct
urei
sdi
ff
erentf
rom t
hecapi
talst
ruct
ure.Fi
nanci
al
st
ruct
ureshowst
hepat
ter
ntot
alf
inanci
ng.I
tmeasur
est
heext
entt
owhi
cht
otalf
unds
ar
eav
ail
abl
etof
inancet
het
otalasset
soft
hebusi
ness.Fi
nanci
alSt
ruct
ure=Tot
al
l
i
abi
l
iti
es

Opt
imum Capi
talSt
ruct
ure

Opt
imum capi
talst
ruct
urei
sthecapi
talst
ruct
ureatwhi
cht
hewei
ght
edav
erage
costofcapi
tali
smi
nimum andt
her
ebyt
hev
alueoft
hef
ir
mismaxi
mum.Opt
imum
capi
talst
ruct
uremaybedef
inedast
hecapi
talst
ruct
ureorcombi
nat
ionofdebtand
equi
tyt
hatl
eadst
othemaxi
mum v
alueoft
hef
ir
m.

Fact
orsDet
ermi
ningCapi
talSt
ruct
ure

Thef
oll
owi
ngf
act
orsar
econsi
der
edwhi
l
edeci
dingt
hecapi
talst
ruct
ureoft
he
f
ir
m.Lev
erageI
tist
hebasi
candi
mpor
tantf
act
or,whi
chaf
fectt
hecapi
talst
ruct
ure.I
t
usest
hef
ixedcostf
inanci
ngsuchasdebt
,equi
tyandpr
efer
enceshar
ecapi
tal
.Iti
s
cl
osel
yrel
atedt
otheov
eral
lcostofcapi
tal
.CostofCapi
talCostofcapi
talconst
it
utes
t
hemaj
orpar
tfordeci
dingt
hecapi
talst
ruct
ureofaf
ir
m.Nor
mal
l
ylong-t
ermf
inance
suchasequi
tyanddebtconsi
stoff
ixedcostwhi
l
emobi
l
izat
ion.Whent
hecostof
capi
tali
ncr
eases,
val
ueoft
hef
ir
m wi
l
lal
sodecr
ease.Hencet
hef
ir
m mustt
akecar
eful
st
epst
oreducet
hecostofcapi
tal
.

(
a)Nat
ure oft
he busi
ness:Use off
ixed i
nter
est
/di
vi
dend bear
ing f
inance
dependsupont
henat
ureoft
hebusi
ness.I
fthebusi
nessconsi
stsofl
ongper
iodof
oper
ati
on,
itwi
l
lappl
yforequi
tyt
handebt
,andi
twi
l
lreducet
hecostofcapi
tal
.
 (
b)Si
zeoft
hecompany
:Ital
soaf
fect
sthecapi
talst
ruct
ureofaf
ir
m.I
fthef
ir
m
bel
ongst
olar
gescal
e,i
tcanmanaget
hef
inanci
alr
equi
rement
swi
tht
hehel
pofi
nter
nal
sour
ces.Buti
fiti
ssmal
lsi
ze,t
heywi
l
lgof
orext
ernalf
inance.I
tconsi
stsofhi
ghcost
ofcapi
tal
.(

c)Legalr
equi
rement
s:Legalr
equi
rement
sar
eal
sooneoft
heconsi
der
ati
ons
whi
l
edi
vi
dingt
hecapi
talst
ruct
ureofaf
ir
m.Forexampl
e,banki
ngcompani
esar
e
r
est
ri
ctedt
orai
sef
undsf
rom somesour
ces.

(
d)Requi
rementofi
nvest
ors:I
nor
dert
ocol
l
ectf
undsf
rom di
ff
erentt
ypeof
i
nvest
ors,i
twi
l
lbe appr
opr
iat
efort
he compani
es t
oissue di
ff
erentsour
ces of
secur
it
ies.Gov
ernmentpol
i
cyPr
omot
ercont
ri
but
ioni
sfi
xedbyt
hecompanyAct
.It
r
est
ri
ctst
omobi
l
izel
arge,l
ongt
ermf
undsf
rom ext
ernalsour
ces.Hencet
hecompany
mustconsi
dergov
ernmentpol
i
cyr
egar
dingt
hecapi
tal
str
uct
ure.

Capi
talSt
ruct
ureTheor
ies

Capi
talst
ruct
urei
sthemaj
orpar
toft
hef
ir
m’sf
inanci
aldeci
sionwhi
chaf
fect
s
t
hev
alueoft
hef
ir
m andi
tleadst
ochangeEBI
Tandmar
ketv
alueoft
heshar
es.Ther
e
i
sar
elat
ionshi
pamongt
hecapi
talst
ruct
ure,costofcapi
talandv
alueoft
hef
ir
m.The
ai
m ofef
fect
ivecapi
talst
ruct
urei
stomaxi
mizet
hev
alueoft
hef
ir
m andt
oreducet
he
costofcapi
tal
.

Ther
e ar
etwo maj
ort
heor
ies expl
aini
ng t
he r
elat
ionshi
p bet
ween capi
tal
st
ruct
ure,
costofcapi
tal
andv
alueoft
hef
ir
m.

Tr
adi
ti
onalAppr
oachI
tist
hemi
xofNetI
ncomeappr
oachandNetOper
ati
ng
I
ncomeappr
oach.Hence,i
tisal
socal
l
edasi
nter
medi
ateappr
oach.Accor
dingt
othe
t
radi
ti
onalappr
oach,
mixofdebtandequi
tycapi
talcani
ncr
easet
hev
alueoft
hef
ir
m by
r
educi
ngov
eral
lcostofcapi
talupt
ocer
tai
nlev
elofdebt
.Tr
adi
ti
onalappr
oachst
ates
t
hatt
heKodecr
easesonl
ywi
thi
nther
esponsi
blel
i
mitoff
inanci
all
ever
ageandwhen
r
eachi
ngt
hemi
nimum l
evel
,i
tst
art
sincr
easi
ngwi
thf
inanci
all
ever
age.

Assumpt
ions:Capi
talst
ruct
uret
heor
iesar
ebasedoncer
tai
nassumpt
iont
oanal
ysi
s
i
nasi
ngl
eandconv
eni
entmanner
:
•Ther
ear
eonl
ytwosour
cesoff
undsusedbyaf
ir
m;debtandshar
es.

•Thef
ir
m pay
s100%ofi
tsear
ningasdi
vi
dend.

•Thet
otal
asset
sar
egi
venanddonotchange.

•Thet
otal
financer
emai
nsconst
ant
.

•Theoper
ati
ngpr
ofi
ts(
EBI
T)ar
enotexpect
edt
ogr
ow.

•Thebusi
nessr
iskr
emai
nsconst
ant
.

•Thef
ir
m hasaper
pet
ual
li
fe.

•Thei
nvest
orsbehav
erat
ional
l
y

NetI
ncome(
NI)Appr
oach:

Neti
ncomeappr
oachsuggest
edbyt
heDur
and.Accor
dingt
othi
sappr
oach,t
he
capi
talst
ruct
uredeci
sioni
srel
evantt
othev
aluat
ionoft
hef
ir
m.I
not
herwor
ds,a
changei
nthecapi
talst
ruct
urel
eadst
oacor
respondi
ngchangei
ntheov
eral
lcostof
capi
talaswel
last
het
otalv
alueoft
hef
ir
m.Accor
dingt
othi
sappr
oach,
usemor
edebt
f
inancet
oreducet
heov
eral
lcostofcapi
talandi
ncr
easet
hev
alueoff
ir
m.Neti
ncome
appr
oachi
sbasedont
hef
oll
owi
ngt
hreei
mpor
tantassumpt
ions:1.Ther
ear
eno
cor
por
atet
axes.2.Thecostdebti
slesst
hant
hecostofequi
ty.3.Theuseofdebtdoes
notchanget
her
iskper
cept
ionoft
hei
nvest
or.

NetOper
ati
ngI
ncome(
NOI
)Appr
oach:

Anot
hermoder
ntheor
yofcapi
talst
ruct
ure,
suggest
edbyDur
and.Thi
sisj
ustt
he
opposi
tet
otheNetI
ncomeappr
oach.Accor
dingt
othi
sappr
oach,Capi
talSt
ruct
ure
deci
sioni
sir
rel
evantt
othev
aluat
ionoft
hef
ir
m.Themar
ketv
alueoft
hef
ir
misnotat
al
laf
fect
edbyt
hecapi
talst
ruct
urechanges.Accor
dingt
othi
sappr
oach,t
hechangei
n
capi
talst
ruct
urewi
l
lnotl
eadt
oanychangei
nthet
otalv
alueoft
hef
ir
m andmar
ket
pr
iceofshar
esaswel
last
heov
eral
lcostofcapi
tal
.56Fi
nanci
alManagementNI
appr
oachi
sbasedont
hef
oll
owi
ngi
mpor
tantassumpt
ions;Theov
eral
lcostofcapi
tal
r
emai
nsconst
ant
;Ther
ear
enocor
por
atet
axes;
Themar
ketcapi
tal
i
zest
hev
alueoft
he
f
ir
m asawhol
e;

Modi
gli
aniandMi
ll
erAppr
oach:

Modi
gli
aniandMi
l
lerappr
oachst
atest
hatt
hef
inanci
ngdeci
sionofaf
ir
m does
notaf
fectt
hemar
ketv
alueofaf
ir
minaper
fectcapi
talmar
ket
.Inot
herwor
dsMM
appr
oachmai
ntai
nst
hatt
heav
eragecostofcapi
taldoesnotchangewi
thchangei
nthe
debtwei
ght
ed equi
tymi
xorcapi
talst
ruct
ures oft
he f
ir
m.Modi
gli
aniand Mi
l
ler
appr
oachi
sbasedont
hef
oll
owi
ngi
mpor
tantassumpt
ions:•Ther
eisaper
fectcapi
tal
mar
ket
.•Ther
ear
enor
etai
nedear
nings.•Ther
ear
enocor
por
atet
axes.•Thei
nvest
ors
actr
ati
onal
l
y.•Thedi
vi
dendpay
outr
ati
ois100%.•Thebusi
nessconsi
stsoft
hesame
l
evel
ofbusi
nessr
isk.

Meani
ngofDi
vi
dend

Di
vi
dendr
efer
stot
hebusi
nessconcer
nsnetpr
ofi
tsdi
str
ibut
edamongt
he
shar
ehol
der
s.I
tmayal
sobet
ermedast
hepar
toft
hepr
ofi
tofabusi
nessconcer
n,
whi
chi
sdi
str
ibut
edamongi
tsshar
ehol
der
s.Accor
dingt
otheI
nst
it
uteofChar
ter
ed
Account
antofI
ndi
a,di
vi
dendi
sdef
inedas“
adi
str
ibut
iont
oshar
ehol
der
soutofpr
ofi
ts
orr
eser
vesav
ail
abl
efort
hispur
pose”
.

Ty
pesofDi
vi
dend/
For
m ofDi
vi
dend

(
a)Cashdi
vi
dend

Acashdi
vi
dendi
sausualmet
hodofpay
ingdi
vi
dends.Pay
mentofdi
vi
dendi
s
cashr
esul
tsi
nther
educt
ionoutf
low off
undsandr
educest
henetwor
thoft
he
company
.Theshar
ehol
der
sgetanoppor
tuni
tyt
oinv
estt
hecashi
nanymanner
,they
desi
re.Hence,
theor
dinar
yshar
ehol
der
spr
efert
orecei
vedi
vi
dendsi
ncash.I
ncaseof
compani
eshav
ingcashdi
vi
dends,t
hef
ir
m musthav
eadequat
eli
qui
dresour
ces,so
t
hati
tsl
i
qui
dit
yposi
ti
oni
snotadv
ersel
yaf
fect
edonaccountofcashdi
vi
dend.

(
b)Scr
ip(
or)Bonddi
vi
dend

Ascr
ipdi
vi
dendpr
omi
sest
opayt
heshar
ehol
der
sataf
utur
especi
fi
cdat
e.I
n
caseacompanydoesnothav
esuf
fi
cientf
undst
opaydi
vi
dendsi
ncash,i
tmayi
ssue
not
esorbondsf
oramount
sduet
otheshar
ehol
der
s.Theobj
ect
iveofscr
ipdi
vi
dendsi
s
t
opost
ponet
hei
mmedi
atepay
mentofcash.Ascr
ipdi
vi
dendbear
sint
erestandi
s
accept
edascol
l
ater
alsecur
it
y.

(
c)Pr
oper
tyDi
vi
dend

Pr
oper
tydi
vi
dendsar
epai
dint
hef
orm ofsomeasset
sot
hert
hancash.They
ar
edi
str
ibut
edunderexcept
ional
cir
cumst
ancesandar
enotpopul
ari
nIndi
a.

(
d)St
ockDi
vi
dend

St
ocksdi
vi
dendmeanst
hei
ssueandt
hebonusshar
est
otheexi
sti
ngshar
e
hol
der
s.I
facompanydoesnothav
eli
qui
dresour
ces,i
tisbet
tert
odecl
arest
ock
di
vi
dends.St
ockdi
vi
dendamount
stocapi
tal
i
zat
ionofear
ningsanddi
str
ibut
ionof
pr
ofi
tsamongt
heexi
sti
ngshar
ehol
der
swi
thoutaf
fect
ingt
hecashposi
ti
onoft
hef
ir
m.

BonusShar
e

Acompanycanpaybonust
oit
sshar
ehol
der
sei
theri
ncashori
nthef
orm of
shar
es.Manyat
imesacompanyneednoti
naposi
ti
ont
opaybonusi
ncash,
inspi
teof
suf
fi
cientpr
ofi
ts,becauseofunsat
isf
act
orycashposi
ti
onorbecauseofi
tsadv
erse
ef
fect
sont
hewor
kingcapi
tal
oft
hecompany
.

Fact
orsDet
ermi
ningDi
vi
dendPol
icy

1.Pr
ofi
tabl
ePosi
ti
onoft
heFi
rm

Di
vi
denddeci
siondependsont
hepr
ofi
tabl
eposi
ti
onoft
hebusi
nessconcer
n.
Whent
hef
ir
m ear
nsmor
epr
ofi
t,t
heycandi
str
ibut
emor
edi
vi
dendst
otheshar
ehol
der
s.

2.Uncer
tai
ntyofFut
ure

I
ncomeFut
urei
ncomei
sav
eryi
mpor
tantf
act
or,whi
chaf
fect
sthedi
vi
dend
pol
i
cy.Whent
heshar
ehol
derneedsr
egul
ari
ncome,t
hef
ir
m shoul
dmai
ntai
nregul
ar
di
vi
dendpol
i
cy.

3.Cont
ract
ualconst
rai
nts
 Of
ten,t
hef
ir
m’sabi
l
ityt
o paycash di
vi
dendsi
sconst
rai
ned byr
est
ri
cti
ve
pr
ovi
sionsi
nal
oanagr
eement
.Gener
all
y,t
heseconst
rai
ntspr
ohi
bitt
hepay
mentof
cashdi
vi
dendsunt
ilacer
tai
nlev
elofear
ningshav
ebeenachi
eved,ort
heymayl
i
mit
di
vi
dendst
oacer
tai
namountoraper
cent
ageofear
nings.Const
rai
ntsondi
vi
dends
hel
ptopr
otectcr
edi
tor
sfr
om l
ossesduet
othef
ir
m’si
nsol
vency
.Thev
iol
ati
onofa
cont
ract
ualconst
rai
nti
sgener
all
ygr
oundsf
orademandofi
mmedi
atepay
mentbyt
he
f
undssuppl
i
er.

4.I
nter
nalconst
rai
nts

Thef
ir
m’sabi
l
ityt
opaycashdi
vi
dendsi
sgener
all
yconst
rai
nedbyt
heamountof
excesscashav
ail
abl
erat
hert
hant
hel
evelofr
etai
nedear
ningsagai
nstwhi
cht
ochar
ge
t
hem.Al
thoughi
tispossi
blef
oraf
ir
mtobor
row f
undst
opaydi
vi
dends,l
ender
sar
e
gener
all
yrel
uct
antt
omakesuchl
oansbecauset
heypr
oducenot
angi
bleoroper
ati
ng
benef
it
sthatwi
l
lhel
pthef
ir
mrepayt
hel
oan.Al
thought
hef
ir
m mayhav
ehi
ghear
nings,
i
tsabi
l
ityt
opaydi
vi
dendsmaybeconst
rai
nedbyal
owl
evelofl
i
qui
dasset
s.(
Cashand
mar
ket
abl
esecur
it
ies)Wewi
l
ltaket
hepr
evi
ousexampl
etoexpl
aint
hispoi
nt.I
nour
exampl
e,t
hef
ir
m canpayRs.
1,40,
000i
ndi
vi
dends.Supposet
hatt
hef
ir
m hast
otal
l
i
qui
dasset
sofRs.
50,000(
Rs.
20,000cash+mar
ket
abl
esecur
it
ieswor
thRs.
30,000)
andRs.
35,000oft
hisi
sneededf
oroper
ati
ons,t
hemaxi
mum cashdi
vi
dendt
hef
ir
m
canpayi
s15,
000(
Rs.
50,
000–Rs.
35,
000)

5.Gr
owt
hpr
ospect
s

Thef
ir
m’sf
inanci
alr
equi
rement
sar
edi
rect
lyr
elat
edt
otheant
ici
pat
eddegr
eeof
assetexpansi
on.I
fthef
ir
misi
nagr
owt
hst
age,i
tmayneedal
lit
sfundst
ofi
nance
capi
talexpendi
tur
es.Fi
rmsexhi
bit
ingl
i
ttl
eornogr
owt
hmaynev
erneedr
epl
aceor
r
enew asset
s.Agr
owt
hfi
rmi
sli
kel
ytohav
etodependheav
il
yoni
nter
nalf
inanci
ng
t
hroughr
etai
nedear
ningsi
nst
eadofdi
str
ibut
ingcur
renti
ncomeasdi
vi
dends.

6.Ownerconsi
der
ati
ons

I
nest
abl
i
shi
ngadi
vi
dendpol
i
cy,
thef
ir
m’spr
imar
yconcer
nnor
mal
l
ywoul
dbet
o
maxi
mizeshar
ehol
der
’sweal
th.Onesuchconsi
der
ati
oni
sthent
axst
atusofaf
ir
m’s
owner
s.Supposet
hati
faf
ir
m hasal
argeper
cent
ageofweal
thyshar
ehol
der
swhoar
e
i
nahi
ght
axbr
acket
,itmaydeci
det
opayoutal
owerper
cent
ageofi
tsear
ningst
oal
l
ow
t
heowner
stodel
ayt
hepay
ment
soft
axesunt
ilt
heysel
lthest
ock.Ofcour
se,
whent
he
equi
tyshar
eissol
d,t
hepr
oceedsar
einexcessoft
heor
igi
nalpur
chasepr
ice,t
he
capi
talgai
nwi
l
lbet
axed,possi
bleatamor
efav
orabl
erat
ethant
heoneappl
i
edt
o
or
dinar
yincome.Lower
-i
ncomeshar
ehol
der
s,howev
erwhoneeddi
vi
dendi
ncomewi
l
l
pr
eferahi
gherpay
outofear
nings.Asofnow,t
hedi
vi
dendi
ncomei
snott
axedi
nthe
handsoft
heshar
ehol
der
sinI
ndi
a.I
nst
ead,f
orpay
ingoutsuchdi
vi
dendst
oit
sshar
e
hol
der
s,t
hecompanybear
sthedi
vi
denddi
str
ibut
iont
ax.

7.Mar
ketConsi
der
ati
ons

Ther
isk-
ret
urnconceptal
soappl
i
est
othef
ir
m’sdi
vi
dendpol
i
cy.Af
ir
m wher
e
t
hedi
vi
dendsf
luct
uat
efr
om per
iodt
oper
iodwi
l
lbev
iewedasr
isky
,andi
nvest
orswi
l
l
r
equi
reahi
ghr
ateofr
etur
n,whi
chwi
l
lincr
easet
hef
ir
m’scostofcapi
tal
.So,
thef
ir
m’s
di
vi
dendpol
i
cyal
sodependsont
hemar
ket
’spr
obabl
eresponset
ocer
tai
nty
pesof
pol
i
cies.Shar
ehol
der
sar
ebel
i
evedt
oval
ueaf
ixedori
ncr
easi
ngl
evelofdi
vi
dendsas
opposedt
oaf
luct
uat
ingpat
ter
nofdi
vi
dends.

8.LegalConst
rai
nts

TheCompani
esAct1956hasputsev
eralr
est
ri
cti
onsr
egar
dingpay
ment
sand
decl
arat
ion ofdi
vi
dends.Si
mil
arl
y,I
ncome Tax Act
,1961 al
so l
ays down cer
tai
n
r
est
ri
cti
onsonpay
mentofdi
vi
dends.

9.Li
qui
dit
yPosi
ti
on

Li
qui
dit
yposi
ti
onoft
hef
ir
msl
eadst
oeasypay
ment
sofdi
vi
dend.I
fthef
ir
ms
hav
ehi
ghl
i
qui
dit
y,t
hef
ir
mscanpr
ovi
decashdi
vi
dendot
her
wise,t
heyhav
etopay
st
ockdi
vi
dend.

10.Sour
cesofFi
nance

I
fthef
ir
m hasf
inancesour
ces,
itwi
l
lbeeasyt
omobi
l
izel
argef
inance.Thef
ir
m
shal
lnotgof
orr
etai
nedear
nings.
11.Gr
owt
hRat
eoft
heFi
rm

Hi
ghgr
owt
hrat
eimpl
i
est
hatt
hef
ir
m candi
str
ibut
emor
edi
vi
dendst
oit
s
shar
ehol
der
s.

12.TaxPol
icy

Taxpol
i
cyoft
hegov
ernmental
soaf
fect
sthedi
vi
dendpol
i
cyoft
hef
ir
m.When
t
hegov
ernmentgi
vest
axi
ncent
ives,
thecompanypay
smor
edi
vi
dends.

Ty
pesofDi
vi
dendPol
icy

Di
vi
dendpol
i
cydependsupont
henat
ureoft
hef
ir
m,t
ypeofshar
ehol
derand
pr
ofi
tabl
eposi
ti
on.Ont
hebasi
soft
hedi
vi
denddecl
arat
ionbyt
hef
ir
m,t
hedi
vi
dend
pol
i
cymaybecl
assi
fi
edundert
hef
oll
owi
ngt
ypes:

•Regul
ardi
vi
dendpol
i
cy

•St
abl
edi
vi
dendpol
i
cy

•I
rr
egul
ardi
vi
dendpol
i
cy

•Nodi
vi
dendpol
i
cy.

Regul
arDi
vi
dendPol
icy

Di
vi
dendpay
abl
eatt
heusual
rat
eiscal
l
edasr
egul
ardi
vi
dendpol
i
cy.Thi
sty
pe
ofpol
i
cyi
ssui
tabl
etot
hesmal
li
nvest
ors,
ret
ir
edper
sonsandot
her
s.St
abl
eDi
vi
dend
Pol
i
cySt
abl
edi
vi
dendpol
i
cymeanspay
mentofcer
tai
nmi
nimum amountofdi
vi
dend
r
egul
arl
y.

Thi
sdi
vi
dendpol
i
cyconsi
stsoft
hef
oll
owi
ngt
hreei
mpor
tantf
orms:
Const
ant
di
vi
dendpershar
eConst
antpay
outr
ati
oSt
abl
erupeedi
vi
dendpl
usext
radi
vi
dend.

I
rr
egul
arDi
vi
dendPol
icy

Whent
hecompani
esar
efaci
ngconst
rai
ntsofear
ningsandunsuccessf
ul
busi
nessoper
ati
on,
theymayf
oll
owi
rr
egul
ardi
vi
dendpol
i
cy.I
tisoneoft
het
empor
ary
ar
rangement
stomeett
hef
inanci
alpr
obl
ems.Theset
ypesar
ehav
ingadequat
epr
ofi
t.
Forot
her
snodi
vi
dendi
sdi
str
ibut
ed.

NoDi
vi
dendPol
icy

Somet
imest
hecompanymayf
oll
ownodi
vi
dendpol
i
cybecauseofi
ts
unf
avor
abl
ewor
kingcapi
tal
posi
ti
onoft
heamountr
equi
redf
orf
utur
egr
owt
hoft
he
concer
ns.

UNI
T-V

Def
ini
ti
on

I
nthewor
dsofShubi
n,“
Wor
kingcapi
tal
ist
heamountoff
undsnecessar
yto
cov
ert
hecostofoper
ati
ngt
heent
erpr
ise”
.

Accor
dingt
oGenest
enber
g,“
Cir
cul
ati
ngcapi
tal
meanscur
rentasset
sofa
companyt
hatar
echangedi
ntheor
dinar
ycour
seofbusi
nessf
rom onef
ormt
oanot
her
,
asf
orexampl
e,f
rom casht
oinv
ent
ori
es,
inv
ent
ori
est
orecei
vabl
es,
recei
vabl
esi
nto
cash”
.

Concept
sofWor
kingCapi
tal

Ther
e ar
etwo concept
s ofwor
king capi
tal
:(A)
Bal
ance SheetConcept(
B)
Oper
ati
ngCy
cleorCi
rcul
arFl
ow Concept(
A)Bal
anceSheetConcept
:Ther
ear
etwo
i
nter
pret
ati
onsofwor
kingcapi
talundert
hebal
ancesheetconcept
:(i
)Gr
ossWor
king
Capi
tal(
ii
)NetWor
kingcapi
talI
nthebr
oadsense,
thet
erm wor
kingcapi
talr
efer
stot
he
gr
osswor
kingcapi
talandr
epr
esent
stheamountoff
undsi
nvest
edi
ncur
rentasset
s.
Thus,t
hegr
osswor
kingcapi
tali
sthecapi
tali
nvest
edi
ntot
alcur
rentasset
soft
he
ent
erpr
ise;
cur
rentasset
sar
ethoseasset
swhi
chi
ntheor
dinar
ycour
seofbusi
nesscan
beconv
ert
edi
ntocashwi
thi
nashor
tper
iodofnor
mal
l
yoneaccount
ingy
ear
.

I
nanar
rowsense,
thet
erm wor
kingcapi
talr
efer
stot
henewwor
kingcapi
tal
.Net
wor
kingcapi
tal
ist
heexcessofcur
rentasset
sov
ercur
rentl
i
abi
l
iti
esorsay
:

NetWor
kingCapi
tal=Cur
rentAsset
s–Cur
rentLi
abi
l
iti
es.NetWor
kingCapi
tal
maybeposi
ti
veornegat
ive.Whent
hecur
rentasset
sexceedt
hecur
rentl
i
abi
l
iti
est
he
wor
kingcapi
tali
sposi
ti
veandt
henegat
ivewor
kingcapi
talr
esul
tswhent
hecur
rent
l
i
abi
l
iti
esar
emor
ethant
hecur
rentasset
s.Cur
rentl
i
abi
l
iti
esar
ethosel
i
abi
l
iti
eswhi
ch
ar
eint
endedt
obepai
dint
heor
dinar
ycour
seofbusi
nesswi
thi
nashor
tper
iodof
nor
mal
l
yoneaccount
ingy
earoutoft
hecur
rentasset
sort
hei
ncomeoft
hebusi
ness.

Oper
ati
ngCy
cleorCi
rcul
arFl
ow ConceptAsdi
scussedear
li
er,wor
kingcapi
tal
r
efer
stot
hatpar
toff
ir
m’scapi
talwhi
chi
srequi
redf
orf
inanci
ngshor
t-
ter
m orcur
rent
asset
ssuch ascash,mar
ket
abl
esecur
it
ies,debt
orsand i
nvent
ori
es.Funds,t
hus,
i
nvest
edi
ncur
rentasset
ssuchascash,
mar
ket
abl
esecur
it
ies,
debt
orsandi
nvent
ori
es.
Funds,
thus,
inv
est
edagai
ninexchangef
orot
hercur
rentasset
s.

Thegr
ossoper
ati
ngcy
cleofaf
ir
misequalt
othel
engt
hoft
hei
nvent
ori
esand
r
ecei
vabl
esconv
ersi
onper
iods.

Gr
ossOper
ati
ngCy
cle=RMCP+WI
PCP+RCP

Thus,
Wher
e,RMCP=RawMat
eri
alConv
ersi
onPer
iodWI
PCP=Wor
k-i
n-Pr
ocess
Conv
ersi
on Per
iod FGCP = Fi
nished GoodsConv
ersi
on Per
iod RCP = Recei
vabl
es
Conv
ersi
onPer
iod.

Char
act
eri
sti
csofWor
kingCapi
tal

1.Shor
t–t
erm Requi
rement
s

Wor
king capi
tali
sut
il
ized t
o pur
chasecur
rentasset
swhi
ch can beeasi
l
y
conv
ert
edi
ntocashi
nshor
tper
iodoft
ime.Thel
engt
hofpr
oduct
ionpr
ocessdeci
des
t
hedur
ati
onofwor
kingcapi
tal
;i
tist
het
imeper
iodbet
weensal
eandcashr
ecei
pts.

2.Ci
rcul
arMov
ement

Wor
kingcapi
tali
scont
inuousl
ytr
ansf
ormedi
ntocashbuti
tagai
ntur
nsi
nto
wor
kingcapi
tal
.Thi
spr
ocessi
soncont
inuousbasi
s.Whencashi
sut
il
izedt
opur
chase
cur
rentasset
sandwi
tht
hehel
pofcur
rentasset
sgoodsar
epr
oducedandsol
dthen
t
her
efor
ewor
kingcapi
tal
isal
sot
ermedasci
rcul
ati
ngcapi
tal
.
3.Per
manence

Wor
kingcapi
tali
sashor
t-
ter
m capi
talbuti
nor
dert
ocont
inuet
hepr
oduct
ion
pr
ocessi
tisal
way
srequi
redbyt
hef
ir
m.Hencewor
kingcapi
tali
sal
sot
ermedas
per
manenceorr
egul
arwor
kingcapi
tal
.

4.I
nst
abi
li
ty

Thoughwor
kingcapi
tali
srequi
redper
manent
lyi
naf
ir
m butt
heamountof
wor
king capi
talr
equi
red f
requent
lychangeswi
tht
he changesi
n pr
oduct
ion l
evel
,
changesi
npur
chase,sal
epol
i
cy,pr
icel
evelanddemandl
evel
.Theamountofwor
king
capi
tal
thatchangesduet
ochangesi
not
herf
act
orsi
scal
l
edv
ari
abl
ewor
kingcapi
tal
.

5.Li
qui
dit
y

Wor
kingcapi
talcanbeeasi
l
yconv
ert
edi
ntocash,hencei
tismor
eli
qui
d.Fi
rms
whi
chmai
ntai
nadequat
eamountorwor
kingcapi
talf
indseasyt
oconv
erti
tint
ocashi
n
t
imewhencashi
srequi
red.

6.LessRi
sky

Wor
kingcapi
tali
sthei
nvest
menti
ncur
rentasset
swhi
chi
sforashor
tper
iodof
t
ime.Hencei
tinv
olv
esl
essr
isk.Wor
kingcapi
taldoesnoti
nvol
veanyr
iskr
elat
edt
o
t
echnol
ogi
cal
changes.I
tinv
olv
esav
eryl
essamountofphy
sical
riskonl
y.

7.Speci
alAccount
ingSy
stem notRequi
red

Aswor
kingcapi
tali
sforshor
t-
ter
m usual
l
yforoney
ear
.Hence,
ther
eisnoneed
t
oadoptspeci
alaccount
ingsy
stem f
ori
t.

For
ecast
/Est
imat
eofWor
kingCapi
talRequi
rement
s

“
Wor
kingcapi
tali
sthel
i
fe-
bloodandcont
rol
l
ingner
vecent
reofabusi
ness”
.No
busi
nesscanbesuccessf
ull
yrunwi
thoutanadequat
eamountofwor
kingcapi
tal
.To
av
oidt
he shor
tage ofwor
king capi
talatonce,an est
imat
e ofwor
king capi
tal
r
equi
rement
sshoul
dbemadei
nadv
ancesot
hatar
rangement
scanbemadet
opr
ocur
e
adequat
ewor
kingcapi
tal
.Met
hodsofEst
imat
ingWor
kingCapi
talRequi
rement
sThe
f
oll
owi
ngmet
hodar
eusual
l
yfol
l
owedi
nfor
ecast
ingwor
kingcapi
talr
equi
rement
sofa
f
ir
m 1.Per
cent
ageofSal
esMet
hod2.Regr
essi
onAnal
ysi
sMet
hod3.CashFor
ecast
ing
Met
hod4.Oper
ati
ngCy
cleMet
hod5.Pr
oject
edBal
anceSheetMet
hod.

Wor
kingCapi
talPol
icy

Wor
king capi
talpol
i
cycan al
so beknown aswor
king capi
talmanagement
.
Wor
kingcapi
talmanagementr
efer
stoast
rat
egywhi
chmai
nlyf
ocusonmai
ntai
ning
adequat
elev
elofcur
rentasset
sandcur
rentl
i
abi
l
iti
esi
naf
ir
m,sot
hatappr
opr
iat
elev
el
ofwor
kingcapi
tal
canbemai
ntai
ned.

Ther
ati
ohel
pst
oexami
net
hef
oll
owi
ngal
ter
nat
ivewor
kingcapi
tal
pol
i
cies:

1.
Conser
vat
ivePol
ici
es

Assumi
ngaconst
antl
eveloff
ixedasset
s,ahi
ghercur
rentasset
stof
ixedasset
s
r
ati
o,r
efer
stoconser
vat
ivepol
i
cies.I
tindi
cat
est
hef
ir
m’ssoundl
i
qui
dit
yposi
ti
onand
l
owerr
iskt
omeeti
tscur
rentobl
i
gat
ionsandi
nvest
ment
s.Thi
spol
i
cyi
sal
sot
ermedas
f
lexi
blepol
i
cy.I
tal
soi
ndi
cat
est
hatt
hecur
rentasset
sar
eef
fi
cient
lyut
il
izedatev
ery
l
evel
sorout
put
.Conser
vat
ivePol
i
cyI
ndi
cat
es(
i)Soundl
i
qui
dit
y(i
i
)Lowerr
isk(
ii
i)
Cur
rentasset
sar
eef
fi
cient
lyut
il
izedi
npr
oduct
ion(
iv)Nobot
tl
enecksi
npr
oduct
ion,
becauseoft
hemai
net
enanceofhugest
ock(
v)Pr
omptpay
mentofaccount
spay
abl
e,
becauseofhugel
i
qui
dcashi
nhand.

2.Moder
atePol
ici
es

Moder
atepol
i
cyi
sot
her
wiset
ermedasav
eragecur
rentasset
spol
i
cy.Thi
srat
io
occur
sbet
weenhi
gherandl
owerr
ati
oofcur
rentasset
stof
ixedasset
srat
io.I
not
her
wor
ds,t
hecur
rentasset
spol
i
cyofmostf
ir
msmayf
allbet
weent
heconser
vat
ive
pol
i
ciesandaggr
essi
vepol
i
cies.Thi
sindi
cat
esmoder
ater
iskandav
eragel
i
qui
dit
y
posi
ti
onofaf
ir
m.Moder
atePol
i
cyI
ndi
cat
es:(
i)Moder
ater
isk(
ii
)Av
eragel
i
qui
dit
y
posi
ti
on(
ii
i)Cur
rentasset
sar
eusedi
npr
oduct
ion(
iv)Mai
ntenanceofst
ockofr
aw
mat
eri
als,wor
k-i
n-pr
ogr
essandf
ini
shedgoodsar
eatanav
eragel
evel
.3.Agr
essi
ve
Pol
i
cies:
Lowerl
evel
ofcur
rentasset
stof
ixedasset
srat
ior
epr
esent
saggr
essi
vepol
i
cy.
Thi
saggr
essi
vepol
i
cyi
ndi
cat
eshi
gherr
iskandpoorl
i
qui
dit
yposi
ti
onofaf
ir
m.I
tal
so
i
ndi
cat
est
hatt
hecur
rentasset
sar
einef
fi
cient
lyut
il
izedatal
llev
elsofout
put
.Thi
s
pol
i
cyi
sal
sot
ermedasr
est
ri
cti
vepol
i
cy.Aggr
essi
vePol
i
cyI
ndi
cat
es(
i)Poorl
i
qui
dit
y
posi
ti
on(
ii
)Hi
gherr
isk(
ii
i)Cur
rentasset
sar
eut
il
izedatl
owesti
nal
ll
evel
sofout
put(
iv)
Mai
ntenanceofsmal
lst
ockl
evel
s(v
)Decl
i
ningsi
zeofsal
esbecauseofr
arecr
edi
t
sal
esf
aci
l
iti
es(
vi)St
oppageandbot
tl
enecksi
npr
oduct
ion,duet
olackofst
ock(
vii
)
Sl
oweraccount
spay
abl
epay
ment
s,becauseofl
owcashbal
ancei
nhand.