Module -5

Capital

• Capital is the life blood of a business enterprise.

• Capital is a universal lubricant which keeps enterprise dynamic.
• Capital in its meaning covers all the elements (e.g. money, Land,
Building, machinery, materials etc.) a businessman needs to
start an enterprise.
• Capital is the measure of the amount of resources of
enterprise.
• Capital develops products, keeps workers and machines at
work, encourages management to make progress and create
value.
 The forms, classification or types of capital

There are two categories mainly:

 Fixed capital
 Working Capital

Fixed Capital:

• It refers to durable capital goods which are used in production again and
again till they wear out.
• Machinery, tools, means of transport, factory building, etc are fixed capital.
Fixed capital does not mean fixed in location.
• Since the money invested in such capital goods is fixed for a long period.
• Assets of this type are used over and over again for a number of years and
are commonly termed s fixed capital.
Working capital :

Once fixed assets e.g building, equipment , machinery etc. have been purchased the
enterprise needs funds to meet its day to day needs and expenditure such as
• Purchase of raw materials
• Payment of employee wages and salaries
• Advertisements and selling expenses
• Equipment and plant maintenance costs
• To provide credit facilities to the customers.
• To meet the short term obligations of a business enterprise.
• Transportation and shipping expenses.
• To incur day to day expenses and overheads costs such as fuel, power etc.

Working capital or variable capital is referred to the single use capital goods like raw
materials. They are used directly and only once in production. They get converted into
finished goods. Money spend on them is fully recovered when goods made out of them are
sold in the market.
 Types of working capital

There are four types of working capital and they

are as follows:-
– Gross Working Capital
– Net Working Capital
– Permanent Capital
– Temporary Working Capital
 Gross Working Capital

Total or gross working capital is that working capital which is used for all the current
assets. Total value of current assets will equal to gross working capital.

 Net Working Capital

Net working capital is the excess of current assets over current liabilities. Net working
capital = Total current assets – Total Current Liabilities.

• Current assets typically include categories such as cash in hand, cash at bank, short-
term investment, prepaid expenses, Sundry debtors and inventory.

• Current liabilities typically include categories such as accrued expenses, accounts

payable, long term debt.
 Permanent Capital

Permanent working capital is that amount of capital which must be in cash or

current assets for continuing the activities of business. It also shows the
minimum amount of all current assets that is required at all times to ensure a
minimum level of uninterrupted business operations.

 Temporary Working capital

Sometime, it may possible that we have to pay fixed liabilities , at that time we
need working capital which is more than Permanent working capital then this
excess amount will be temporary working capital. In normal working of business,
we don’t need such capital.
 Factors affecting Working Capital

The working capital requirements of a business depends upon a

number of ‘factors which in brief are as under.
 Nature of business
 Length of period of manufacture
 Size of the business
 Terms of purchase and sale
 Price level changes
 Rate of turnover
 Size of labour force
 Seasonal variations in business
 Converting working assets into cash.
 Risk
• Every business involves some risk and most people do not
like being involved in any risky enterprise.
• Risk refers to a decision making situation where there are
different possible outcomes and the probabilities of these
outcomes can be measured in some way.
• Risk involves choice with multiple outcomes where the
probability of each outcome is known or can be estimated.
• A manager investing in new product development adoption
of new technology or new market entry faces various risks.
• There are various types of risk that relates to investment in
projects.
 Types of Risks
Risks can be broadly classifies into two groups that is:-
• Systematic risk
• Unsystematic risk

Systematic risk
• It arises due to macroeconomic factors of business such as
social, political or economic factors, it includes,
 Market risk
 Inflation risk
 Interest rate risk
Unsystematic risk

• It arises due to the fluctuations in returns of a companys security due to

microeconomic factors that is factors existing in the organization.
• The factors that cause systematic risk relates to a particular industry such
as labour problems. It includes;

 Business risk:
Internal business risk: Firms limiting environment
External business risk: Business cycle, demographic factors, political and
monetary policies
 Credit risk
 Liquidity risk.
 Decision making
• Decision making is a process by which a course of
action is consciously chosen from available alternatives
for the purpose of achieving desired results.
• Usually, there are three different conditions under
which decisions are made, which are explained below.

 Conditions under certainty

 Conditions under risk
 Conditions under uncertainty
 Conditions under certainty:
Conditions under certainty are in which the decision maker has full and needed
information to make a decision . The manager knows exactly what the outcome will be, as
he/she has enough clarity about the situation and knows the resources, time available for
decision making, the nature of the problem. In most situations, the solutions are already
available from the past experiences and are appropriate for the problem at hand.
 Conditions under risk:
Conditions under risk provide probabilities regarding expected results for decision
making alternatives, it is due to the nature of the future conditions that are not always
know in advance and the managers face this condition more often in reality compared to
conditions under certainty. Although some good information may be available it is not
enough to answer all questions about the outcomes.
 Conditions under uncertainty:
Conditions under uncertainty provide no or incomplete information, many unknown and
possibilities to predict expected results for decision making alternatives. The manager
could not even assign subjective probabilities to the likely outcomes of alternatives. The
manager himself cannot predict with confidence what the outcomes of his action to be.
Business decisions under certainty
• Decision making under certainty implies that
we are certain of the future state of nature.
• One common technique for decision making
under certainty is linear programming.
• In this method, a desired benefit such as profit
can be expressed as a mathematical functions
( the value model or objective functions) of
several variables.
 Business decisions under risk
• When making a decision under the condition of risk,
the manager does not know the outcome of each
alternative in advance, but can assign a probability to
each outcome.
• Decisions under conditions of risk are perhaps most
common. The role of the manager would be to either
eliminate risk or reduce the size of the risk within a
project and would a risk assessment to be undertaken
which would identify the project variables and the
level of risk to be attached to each project variables.
 Methods for taking investment decisions
under risk
Sensitivity analysis
 Identifying all variables that affect the NPV or IRR of the project
 Establishing a mathematical relationship between the
independent and dependent variable
 Studying and analysing the impact of the change in the variables.
Decision tree analysis
It is one of the most effective methods of assessing risks in a project.
In this method, a decision tree is drawn for analysing the risks
associated in a project.
It is a schematic representation of the alternatives available to a
decision maker and their possible consequences.
 Business decisions under uncertainty

• Uncertainty refers to a decision making

situation where there are different possible
outcomes and the probabilities of these
outcomes cannot be meaningful measured,
sometimes because all possible outcomes
cannot be foreseen or specified.
 Sources of uncertainty
There are two sources of uncertainty:

 Uncertainty with complete ignorance:

Refers to those situations in which no assumptions can be made
about the probabilities of alternative outcomes under different states
of nature.

 Uncertainty with partial ignorance:

Refers to those situations in which the decision maker is able to
assign subjective probabilities to possible outcomes. These subjective
probabilities may be based on personal knowledge, intuition or
experience.
 Different approaches of uncertainty

• Maxi-max solution: optimistic decision maker

• Maxi-min solution: pessimist decision maker
• Mini-max solution: between optimism &
pessimism
 Cost benefit analysis
• It is mainly used for economic evaluation of public projects
which are mostly funded by government organisations.
• In addition this method can also used for economic
evaluation of alternatives for private projects.

• The main objective of this method is used to find out the

desirability of public projects as far as the expected benefits
on the capital investment are concerned.
• As the name indicates, this method involves the calculation
of ratio of benefits to the costs involved in a project.