Financial Management

FINANCIAL MANAGEMENT
I WILL START DIGGING FROM THIS SIDE OF THE

MOUNTAIN. YOU START DIGGING FROM THE
OTHER SIDE . WHEN WE MEET IN THE MIDDLE ,
WE WILL HAVE MADE A TUNNEL . AND IF WE DO
NOT MEET , WE WILL HAVE MADE TWO TUNNEL
!
September 17, 2023 Dr. Namrata Prakash 1

FINANCIAL DECISION RECTANGLE
INVESTMENT FINANCING
DECISION DECISION
DIVIDEND WORKING
DECISION CAP.DECISION
September 17, 2023 2

KEY ISSUES IN FINANCIAL DECISION MAKING
• INVESTMENT DECISION :
 What business to be in ?
 What growth rate is appropriate ?
 What assets to acquire ?
 FINANCING DECISION
 What mix of debt and equity to be used ?
 Can we change the value of the firm by changing the capital mix ?
 Is there an optimal debt-equity mix ?

DEFINITION ,NATURE AND SCOPE OF
FINANCIAL MANAGEMENT
• Financial management is all about managing the financial resources in the

most optimal manner towards desired organizational objectives .
• Financial Management includes – anticipating financial needs , acquiring
financial resources and allocating funds in business ( three A’s of Financial
Management )
• The scope of Financial Management extends to four key decisions areas :-
 Investment decisions
 Financing decisions
 Dividend decisions
 Working capital decisions

KEY ISSUES IN FINANCIAL DECISION MAKING
• DIVEDEND DECISIONS :
 How much of the profit should be retained in the business and how much
to be distributed as dividend ?
 Can we change the value of the firm by changing the amount of dividend ?
 What should be the mode of dividend payment ?
 WORKING CAPITAL DECISIONS :
 What level of inventory of goods is ideal ?
 What level of credit should be given to the customers ?
 What level of cash should be maintained ?
 How can the blockage of funds in the current assets be minimized without
compromising profits ?

RELATIONSHIP BETWEEN FINANCIAL ACCOUNTING
MANAGEMENT ACCOUNTING AND FINANCIAL MANAGEMENT
Financial
Recording and Management
Reporting of
information
Relating to diff.
Finance functions Financial
Financialdecisions
decisions
Analyzed
Analyzedtotofacilitate
facilitate
Performance Future
Future decision
decision making
Of the firm making
As per
Financial Information
statement Tools and
Techniques
To facilitate Management
Financial
Financial decisions accounting
accounting
September 17, 2023 PROF. N.N.PANDEY 6

Organization chart of finance function
Finance director / CFO
FINANCIAL Internal Treasurer

CONTROLLER auditor
Manager Management Manager Manager Cash Corporate Foreign

Accounts Accountant Credit Taxation Manager Fund Exchange
Salaries manager Manager
Financial Cost Credit Assessment Banking
Accounting Assessment Of Arrangements Obtaining Buying
Accounts Funds Selling
Statutory Management Setting Duties/taxes Cash
Accounting Credit limits Payment Forecasting Interest Foreign
Accounts Rate Currency
Debtors Budgeting Monitoring Of taxes Monitoring
Credit Claiming & control exposure Currency
Ledger Management Exposure
Creditors Chasing Refunds Working
Overdue Tax Capital control Export Mangmt.
ledger Finance
accounts Planning Investing
Compliance Surplus Project
With tax funds finance
Laws

OBJECTIVES OF A FIRM
PRIMARY SECONDARY
PROFIT MAXIMISATION SALES MAXIMISATION

WEALTH MAXIMISATION GROWTH MAXIMISATION
ROI MAXIMISATION
SOCIAL OBJECTIVES
VALUE MAXIMISATION

FIRM’S CASH FLOW AND VALUE MAXIMISATION
Short term funds Long terms funds

Used to Used to
Acquire temporary
Working capital Acquire fixed
Assets &
Permanent W.C
Generate net cash
Inflows from operations
Service debt Dividend Retained earnings

obligation distribution Available for
reinvestment
Firm’s wealth maximization
Value maximization of equity

Shareholder through increase
In stock market price of share

INVESTMENT FINANCING DIVIDEND
DECISIONS DECISIONS DECISIONS
RETURN TRADE-OFF RISK
MARKET VALUE OF FIRM
FIGURE SHOWING RISK – RETURN TRADE-OFF

FINANCIAL SYSTEM
FINANCIAL FINANCIAL FINANCIAL FINANCIAL

INSTITUTIONS MARKETS INSTRUMENTS SERVICES
MONEY MARKET SHARES MERCHANT

FINANCIAL DEBENTURES BANKING
INSTITUTIONS CAPITAL MARKET COMMERCIAL PROJECT
COMMERCIAL PAPERS CONSULTANCY
BANKS FOREIGN EXCHANGE CERTIFICATE UNDERWRITING
INDUSTRIAL MARKET OF DEPOSITES
BANKS PUBLIC
PROVIDENT DEPOSITES
FUNDS MUTUAL FUND
MUTUAL FUNDS UNITS
NBFCs INSURANCE
INSURANCE POLICIES
COMPANIES GOVERNMENT
BONDS

FLOW OF FUNDS THROUGH THE FINANCIAL SYSTEM
SAVERS / LENDERS
 HOUSE HOLDERS SHARES/BONDS
 BUSINESS FIRMS
DEPOSITS/POLICIES  GOVERNMENT
 FOREIGNERS
FUNDS SHARES/BONDS
FUNDS
FUNDS
FINANCIAL INSTITUTIONS FINANCIAL MARKETS
P.P
 BANKS MODE  MONEY MARKET
SHARES/BONDS
 PROVIDENT FUNDS  CAPITAL MARKET
 INSURANCE COMPANIES
MUTUAL FUNDS FUNDS
 NBFCs
FUNDS INVESTORS/BORROWERS
 HOUSE HOLDERS
FUNDS
BUSINESS FIRMS
 GOVERNMENT
FUNDS FOREIGNERS
SHARES/BONDS
TIME VALUE OF MONEY
• Time value of money is probably one of most important

concepts in finance that form the basis of decision making in
almost all areas of finance .
• The application range from personal finance areas to
corporate finance such as capital budgeting , derivatives and
risk management .
• Time value of money states that not only, is the amount of
money is important but when is it received or paid is equally
important .
• Time value of money explains that money can be employed
productively to generate positive returns.

EXAMPLE
A project needs an initial investment of Rs. 1,00,000/- . It is

Expected to give a return of Rs. 20,000/- p.a. at the end of
Each year for 6 years. The project thus involves a cash outflow
Of Rs.1,00,000/- in the ‘ Zero year ’ and cash inflow of
Rs.20,000/-
Per year for 6 years . In order to decide , whether to accept or
Reject the project , it is necessary , that the present value of cash
Inflows received annually for 6 years is ascertained and compared
With the initial investment of Rs. 1,00,000/- . The firm will
Accept the project only when the present value of the cash inflows
At the desired rate of interest is greater than the initial investment
Of Rs. 1,00,000/-

VALUATION CONCEPTS OR TECHNIQUES
• Time value of money implies (a ) that a person will have to pay in future more
, for a rupee received today and (b) a person may accept less today , for a
rupee to be received in the future .
• The above statement relate to two different concept (a) compound value
concept and (b ) Discounting or present value concept.
• COMPOUND VALUE CONCEPT :
In this concept , the interest earned on the initial principal amount
Becomes a part of the principal at the end of a compounding period .
EX:1: Rs. 1,000/- invested at 10% compounded annually for three years
Calculate the compounded value after 3 years .

SOLUTION
Amount at the end of 1st year( 1000x110/100 ) = 1100

Amount at the end of 2nd year( 1100x110/100) = 1210
Amount at the end of 3rd year ( 1210x110/100) = 1331
The compounding process can be continued for an in definite
Period of time .
If we use equation : A = P ( 1 + i ) n
WHERE , A = amount at the end of period n i.e. future value
P = principal at the beginning of the period i.e. present value
i = interest rate
n = number of years
Or 1000 ( 1 + .10 ) 3 = 1000 x ( 1.10 ) 3 = 1000 x 1.331 = 1331
USE COMPOUND VALUE TABLE

MULTIPLE COMPOUNDING PERIODS
Interest can be compounded even more than once a year . In

That case formula will be :
A = P( 1 + i/m ) mxn
WHERE , A = Amount after a period
P = Amount in the beginning of the period
i = interest rate
m = number of times per year compounding is made
n = number of years for which compounding is to
be done

FUTURE VALUE OF SERIES OF CASH FLOWS
• So far we have considered only the future value of a single payment made
at time zero . The transaction in real life are not limited to one . An
investor investing money in installment may wish to know the value of his
savings after ‘n’ years .
• EXAMPLE : 2 : Mr. Manish invests Rs. 500/- , 1000 , 1500 , 2000 and 2500
at the end of each year . Calculate the compound value at the end of 5
years , compounded annually when the interest charged is 5% .

SOLUTION
Rs. 500 put at the end of first year, compounded for

4 years = 500 ( 1 + .05 ) 4 = 608
Similarly others = 1000 ( 1 + .05 ) 3 = 1158
1500 ( 1 + .05 ) 2 = 1654
2000 ( 1 + .05 ) 1 = 2100
2500 ( 1 + .05 ) 0 = 2500
AMOUNT AT THE END OF THE 5 YEARS = 8020

COMPOUNDED SUM OF AN ANNUITY
• An annuity is a stream of equal annual cash flows . Annuities involve calculations

based upon the regular periodic contribution or receipt of a fixed sum of money .
• Formula : Sn = IF X A
HERE , Sn = the compounded sum of annuity
IF = interest factor for the sum of the annuity
of Rs. 1
A = Annuity value
EXAMPLE : 3 : Find the compound value of annuity when three equal
yearly payments of Rs. 2000/- are deposited into an
account , that yields 7% compound interest .

SOLUTION
THE ANNUITY TABLE gives the compound value as

3.215 , when Rs. 1 is paid every year for 3 years
At 7% .
Hence : Sn = IF X A
= 3.215 X 2000
= 6,430

DISCOUNTING OR PRESENT VALUE CONCEPT
• In present value concept , we estimate the present worth of a future

payment or installment or series of payment adjusted for the time value
of money .
• Given a positive rate of interest , the present value of the future rupee will
always be lower. The technique for finding the present value is termed as
“ DISCOUNTING”.
• FORMULA : PV = A / ( 1 + i ) n
Where , PV = present value
i = interest rate
A = amount at the end of the period ‘n’
n = number of years

EXAMPLE - 4
If Mr. X , depositor expects to get Rs.100 after one year , at the

Rate of 10 % , the amount he will have to forego at present can
Be calculated as follows :
PV = A / (1 + i ) n
= 100 / ( 1 + .10 )
= Rs 90.90

PRESENT VALUE OF A SERIES OF CASH FLOWS
EX : 5 : Given the time value of money as 10 % ( i.e. the discounting

Factor ) , you are required to find out the PV of the future cash inflows
That will be received over the next 4 years : yr.1 – 1000 , yr.2 – 2000
Yr.3 – 3000 , yr.4 – 4000 .
ANS.
YEAR CASH FLOWS PRESENT VALUE PRESENT
FACTOR AT 10% VALUE
1 1000 0.909 909
2 2000 0.826 1652
3 3000 0. 751 2253
4 4000 0.683 2732
PRESENT VALUE OF SERIES OF CASH FLOWS 7546

PRESENT VALUE OF AN ANNUITY
• To find out the present value of annuity either , we can find the present
value of each cash flow or use the annuity table. The annuity table gives
the present value of an annuity of Rs.1 for interest rate ‘r’ over number of
years ‘n’ .
• EXAMPLE :6 :
Calculate the present value of annuity of Rs. 500 received
annually for 4 years , when the discounting factor is 10% .

SOLUTION
YEAR CASH FLOWS PRESENT VALUE PRESENT VALUE

FACTOR AT 10 %
1 500 0.909 454.50
2 500 0.827 413.50
3 500 0.751 375.50
4 500 0.683 341.50
TOTAL 3.170 1585.00
This basically means to add up the present value factor i.e.
Column-3 and multiply with Rs. 500/- .
i.e. 3.170 x 500 = Rs. 1585 /- .

PRESENT VALUE OF A PERPETUAL ANNUITY
• A person may like to find out the present value of his investment , if he
wants a constant return year after year . This is called a perpetual annuity.
• The present value of a perpetual annuity can be ascertained by simply
dividing ‘A’ by interest rate or discount rate ‘i’
that is A/i .
Ex : 7 : Mr Bharat , Principal , wishes to institute a scholarship of
Rs. 5000/- for an outstanding student every year. He wants to
Know the present value of an investment which would yield
Rs. 5000/- in perpetuity , discounted at 10%.
ANS. P = A/i = 5000/.10 = Rs 50000/-.

EXAMPLE - 8
A finance firm has announced a scheme called ‘ Lakhpati in 10

years’ has promised to pay Rs.1,00.000/- after 10 years for
Every Rs.20,000/- deposited today. The advertisement states
that the firm pays Rs. 80,000/- as interest at Rs.8,000/- every
Year and therefore offers a 40% annual return. Do you agree
With the claim made in the scheme ? Explain , what would be
The maturity value if the finance firm really had to offer 40%
Return annually.

SOLUTION - 8
The claim made by the finance company is wrong.

The real rate of return offered by the finance company is :
20000 x ( 1 + r )10 = 1,00,000

( 1 + r )10 = 5
Using the table given in the last of book for a period of 10 years and
Looking for value of 5 , we find the future value factors of 4.807 and
5.234 at 17% and 18% respectively.
Say , 17.5% approx.
If the firm really had to offer 40% return , then the amount will be :
20000 x ( 1.4 )10 = 20000 x 28.925 = 5,78,500 .

CAPITAL BUDGETING
• Capital budgeting is the process to identify, analyze and select investment

projects, whose returns ( cash flows ) are expected to extend beyond one
year.
• It involves making of an economic analysis to determine the profit
potential of each investment proposal.
• Launching of new products , renovations of existing plant , replacement of
machineries , buying a technology, initiating research & development
programmes etc. are some of the good example of capital budgeting
decision.
• The lack of capital budgeting proposals in any enterprise is a signal that
the firm is languishing over a period of time .

FEATURE OF CAPITAL BUDGETING DECISION
• Non-reversible
• Large initial outlays followed by small periodic inflows
• Information gap and inexperience
• Strategic and risky nature
• Inflexibility
• Capital budget process
PROJECT PROJECT PROJECT PROJECT

GENERATION EVALUATION SELECTION EXECUTION

Capital Budgeting Process
1.Identification of potential investment
opportunities.
2. Assembling of investment proposals.
3.Decision making
4.Preparation of capital budget and
appropriations.
5.Implementation.
6.Performance review.
TECHNIQUES OF EVALUATION OF CAPITAL BUDGETING
DECISIONS|INVESTMENT CRITERIA
Traditional Modern
or or
Non-discounted Discounted cash
Cash flow flow
Pay Accounting/ IRR PI

NPV
Back Average Method Method
Method
period Rate of return

PAY BACK PERIOD
• Pay back period is one of the most popular and widely recognized techniques of
evaluating investment proposals.
• Pay back period may be defined as that period required to recover the original
cash outflow invested in a project .
• Pay back period = Initial investment ( cash outlay ) / Annual cash
flows after tax
ACCEPT – REJECT RULE
Accept : CALCULATED PBP < Standard PBP
Reject : CALCULATED PBP > Standard PBP
Considered : CALCULATED PBP = Standard PBP

EXAMPLES – 1 & 2
• A project requires an initial investment of Rs. 1,20,000/- and yields annual cash
inflow of Rs. 12.000/- for 12 years. Find the pay back period. ANS. 1,20,000 /
12,000 = 10 YEARS
• A project requires an initial investment of Rs. 20,000/- and the annual cash inflows
for 5 years is Rs. 6,000/- , 8000/- , 5000/- and 4,000/- respectively . Find the pay
back period.
ANS. YEAR CASH INFLOWS CUMULATIVE
1 6000 6,000
2 8000 14,000
3 5000 19,000
4 4000 23,000
PAY BACK PERIOD = 3 YEARS + 1000/4000 = 3.25 YEARS

CALCULATION OF CASH FLOWS AFTER TAXES
( CFAT )
Sales revenue xxxxxxx

Less. Variable cost xxxxxxx
Contribution xxxxxxx
Less. Fixed cost xxxxxxxx
Earning before depreciation and taxes (EBDT) XXXXXX
LESS. Depreciation xxxx
Earnings before taxes ( EBT ) XXXX
LESS. Taxes xxxxx
Earnings after taxes ( EAT ) XXXXX
ADD. Depreciation xxxxxx
Cash flows after tax ( CFAT ) XXXXX

EXAMPLE – 3
A company is considering expanding it’s production . It can either go for

an automatic machine costing Rs. 2,24,000/- with an estimated life of
5 years or an ordinary machine costing Rs. 60,000/- having an
estimated life of 8 years . The annual sales and costs are estimated
As follows : AUTOMATIC ORDINARY
MACHINE (Rs) MACHINE(Rs)
Sales 1,50,000 1,50,000
Material costs 50,000 50,000
Labour costs 12,000 60,000
Variable overheads 24,000 20,000
Calculate the payback period and advice the management . Assume
A tax rate of 50%.

SOLUTION
CALCULATION OF CFAT
PARTICULARS AUTOMATIC ORDINARY

MACHINE(Rs) MACHINE(Rs)
Sales 1,50,000 1,50,000
LESS: COSTS
( materials+ lab our+ v.oh) 86,000 1,30,000
EBDT 64,000 20,000
LESS: Depreciation 44, 800 7500
EBT 19,200 12,500
LESS. Taxes ( 50% ) 9600 6250
EAT 9600 6250
ADD. Depreciation 44, 800 7500
CFAT 54,400 13,750

SOLUTION…..CONTD….
Pay back period = initial investment / annual cash inflows

PBP of Automatic machine = 2,24,000 / 54,400 = 4.11 years
PBP of ordinary machine = 60,000 / 13,750 = 4. 36 years
Advice : The pay back period in case of automatic machine is shorter
hence automatic machine is preferable .
Working notes:
Depreciation = (original investment – scrap value) / life period
Automatic machine = ( 2,24,000 – 0 ) / 5 = Rs. 44,800
Ordinary machine = ( 60,000 – 0 ) / 8 = Rs. 7,500

ACCOUNTING RATE OF RETURN / AVERAGE RATE OF RETURN
( ARR )
• ARR method uses accounting information as revealed by financial statements , to

measure the profitability of the investment proposals. It is also known as RETURN
OF INVESTMENT ( ROI ) .
• ARR can be calculated in two ways .
• ( A ) ACCOUNTING RATE OF RETURN =

AVERAGE EAT OR PAT / ORIGINAL INVESTMENT X 100
HERE , OI = Original investment + additional new working capital +

installation charges + transportation charges

( B ) AVERAGE RATE OF RETURN
AVERAGE RATE OF RETURN =

AVERAGE EAT / AVERAGE INVESTMENT X 100
AI = (original investment – scrap ) /2 + additional new working capital
+ scrap value
NOTE : If question is not specific , about accounting or average rate of

return say ARR , then calculate average rate of return.
ACCEPT – REJECT RULE :
ACCEPT : CAL. ARR > Predetermined ARR or CUT– OFF rate
REJECT : CAL. ARR < Predetermined ARR or cut – off rate .
CONSIDERED : CAL. ARR = Predetermined ARR or cut-off rate .

EXAMPLE - 4
The working result of two machine are given below : ---
MACHINE – X MACHINE- Y
Cost 45,000 45,000
Sales per year 1,00,000 80,000
Total expenditure per year 36,000 30,000
( Excluding depreciation )
Expected life 2 years 3 years
Which of the two should be preferred ? Apply ARR technique.

SOLUTION - 4
MACHINE – X MACHINE – Y
Sales 1,00,000 80,000
Less . Expenditure per year 36,000 30,000
------------ ----------------
64,000 50,000
Less. Depreciation 22,500 15,000
Net profit 41,500 35,000
Average income 41,500 35,000
Average investment 22,500 22,500
ARR= av.income/av.inv x100 184% 156%
MACHINE – X HAS HIGHER ARR HENCE MACHINE – X SHOULD BE
PREFERRED.

EXAMPLE – 5
A machine is available for purchase at a cost of Rs. 80,000/- .

We expect it to have a life of 5 years and to have a scrap value
Of RS 10,000/- at the end of the five year period. We have
Estimated that it will generate additional profits over it’s life as
Follows :
YEAR 1 2 3 4 5
AMOUNT 20,000 40,000 30,000 15,000 5,000
These estimates are of profits before depreciation. You are

Required to calculate the accounting rate of return as well
Average rate of return.

SOLUTION - 5
Total profit before depreciation over the life of machine = 1,10,000

So , Average profit p.a. = 1,10,000 / 5 = 22,000
Total depreciation over the life of machine(80,000-10,000)= 70,000
So, Average depreciation p.a. = 70,000/5 = 14,000
So, average annual profit after depn.(22,000- 14,000) = 8,000
Original investment required = 80,000

Accounting rate of return = 8000/80,000 x 100 = 10 %
Average investment = ( 80,000 – 10000)/2 + 10,000 = 45,000

Average rate of return = 8,000/45,000 x 100 = 17.78 %

NET PRESENT VALUE ( NPV ) METHOD
• The net present value method is one of the discounted cash flow method.
• NPV can be defined as present value of benefits minus present value of cost .
• It is the process of calculating present value of cash inflows using cost of capital as
an appropriate rate of discount and subs tract present value of cash outflows from
the present value of cash inflows and find the net present value ( NPV ) , which
may be positive or negative.
• Accept-Reject rule :
Accept : NPV > ZERO
REJECT : NPV < ZERO
CONSIDER : NPV = ZERO

EXAMPLE - 6
A choice is to be made between the two competing proposals which

Require an equal investment of Rs. 50,000/- and are expected to
Generate net cash flows as under : -
YEARS 1 2 3 4 5 6
PROJECT
A 25,000 15,000 10,000 NIL 12,000 6,000
B 10,000 12,000 18,000 25,000 8,000 4,000
COST OF CAPITAL IS 10 % .
PVF AT
10 % 0.909 0.826 0.751 0. 683 0. 621 0. 564

SOLUTION - 6
YEAR PVF @ 10% PROJECT – A PROJECT- B

cash inflow PV cash inflow PV
1 0.909 25,000 22,725 10,000 9090
2 0.826 15,000 12,390 12,000 9912
3 0.751 10,000 7,510 18,000 13,518
4 0.683 NIL NIL 25,000 17,075
5 0.621 12,000 7452 8,000 4968
6 0.564 6,000 3384 4,000 2256
TOTAL PRESENT VALUE 53,461 56819
LESS : INITIAL INVESTMENT 50,000 50,000
NPV 3,461 6,819
Since, project B has the highest NPV , It should be selected .

CASELETS - 1
Light Rollers Ltd ( LRL ) is considering a project to produce rubber

Rollers with an initial investment of RS.400 LAKH. The project would
Last for 8 years after which 10% of the initial investment may be
Realized. LRL has a policy of charging depreciation on SLM basis.
After taking costing of the product a profit before tax of Rs. 52 lakh
Is expected for next 8 years. Though the normal rates of tax is 35% LRL
Would pay only 28% taxes due to tax incentives available . Assume
That no tax is payable on the salvage value realized .
If the cost of capital of LRL is 12%, what is the NPV of the project and
What shall be the decision with respect to it’s acceptance ?
Would your decision change if suddenly the tax benefit is withdrawn and
LRL is subjected to normal rate of tax of 40 % .

SOLUTION – 7
COMPUTATION OF CASH FLOW AND NPV
WITH 28% TAX WITH 40% TAX

PROFIT BEFORE TAX 52.00 52.00
TAXES ( 28% / 40 % ) 14.56 20.80
PROFIT AFTER TAX 37.44 31.20
ADD.DEPRECIATION 45.00 45.00
CASH FLOW AFTER TAX 82.44 76.20
PRESENT VALUE OF OPRETIONAL CASH FLOWS 409.53 378.53
SALVAGE VALUE REALISED AT 8 YEAR
TH
40.00 40.00
PRESENT VALUE OF THE SALVAGE VALUE 16.16 16.16
TOATAL PRESENT VALUE OF CASH INFLOWS 425.69 394.69
LESS. INITIAL COST 400.00 400.00
NPV 25.69 ( 5.31 )
CONCLUSION : THE PROJECT IS VIABLE AT 28% BUT NOT AT 40% TAX RATE
(A) PRESENT VALUE OF ANNUITY FOR 8 YEARS AT 12% = 4.9676
(B) PRESENT VALUE OF RS. 1 AFTER 8 YEARS AT 12% = 0.4039
( C ) DEPRECIATION = COST – SALVAGE/LIFE = 400 – 40/ 8 = 45 LAKH

INTERNAL RATE OF RETURN ( IRR )
• IRR is that rate at which the sum of discounted cash inflow equals the sum
of discounted cash outflow .
• It is the rate at which the net present value ( NPV ) is zero.
• Computation of IRR is based on the cash flows after taxes. IRR is
mathematically represented as ‘ r ’ . It can be found by trial and error
method.
• Generally, IRR may lie between two discounting factors , in that case we
use the following formula for calculation of IRR:
A + ( C – O ) /( C – D) X ( B- A )
HERE, A = DISCOUNTED FACTOR OF LOW TRIAL/ B= DISCOUNTED FACTOR OF HIGHTRIAL
C = PRESENT VALUE OF CASH INFLOW IN THE LOW TRIAL / D = PRESENT VALUE
OF CASH INFLOW IN THE HIGH TRIAL / O = ORIGINAL OR INITIAL OUTLAY.

INTERNAL RATE OF RETURN ( IRR )
ACCEPT – REJECT RULE :

ACCEPT : IRR > COST OF CAPITAL
REJECT : IRR < COST OF CAPITAL
CONSIDER : IRR = COST OF CAPITAL
EX : 8 : A project costs an initial investment of Rs.40,000/- and is

Expected to generate annual cash inflows of Rs. 16,000/- for 4 years.
Calculate IRR.
ANS. Fake pay back period=initial investment/ average annual cash flow
= 40,000 / 16,000 = 2.5
Referring to the PV of an annuity of one rupee table, we find that the
Fake PBP of 2.5 lies in between 21% (2.540 ) and 22% ( 2.494 ) in the
Line of 4 years .

SOLUTION -8 CONTD……
CALCULATION OF PV OF CASH INFLOWS :

PV of cash inflows at 21 % = 16000 x 2.540 = 40,640
PV of cash inflows at 22 % = 16,000 x 2.494 = 39,904
CALCULATION OF IRR = A+ ( C – O ) /( C – D )X ( B – A )
= 21 + ( 40,640 – 40,000 ) / ( 40,640 – 39,904 ) X ( 22 – 21 )
= 21 + 640 / 736 X 1
= 21 + 0.87
= 21.87 %

EXAMPLE - 9
A company is considering an investment proposal of Rs. 50,000/-

To install new milling controls . The facility has a life expectancy
Of 5 years with nil salvage value . The company’s tax rate is 55%
And no investment tax credit is allowed . The firm uses straight
Line depreciation. The estimated cash flow before depreciation and tax
From the proposed investment proposal is as follows :
YEAR : 1 2 3 4 5
CFBDT ( RS ) 10,000 11,000 14,000 15,000 25,000
Calculate INTERNAL RATE OF RETURN .

SOLUTION – 9
CALCULATION OF CASH FLOW AFTER TAX(CFAT)
YEAR CFBT DEPN.EBT TAXES EAT CFAT

1 10,000 10,000 NIL NIL NIL 10,000
2 11,000 10,0001,000 550 450 10,450
3 14,000 10,0004,000 2,200 1800 11,800
4 15,000 10,0005,000 2,750 2,250 12,250
5 25,000 10,00015,000 8,250 6,750 16,750
TOTAL 61,250
AVERAGE CASH FLOW 12,250
Depreciation = 50,000/ 5 = 10,000/- .
Calculation of fake payback period = OI / ACF
= 50,000 / 12,250 = 4.0816

PROFITABILITY INDEX ( PI ) OR DISCOUNTED
BENEFIT COST RATIO ( DBCR )
• It is the ratio of the present value of cash inflows , at the required rate of return ,
to the initial cash outflow of the investment proposal.
• It is similar to NPV method .
• PI = PV OF CASH INFLOWS / INITIAL CASH OUTLAY
• ACCEPT – REJECT RULE :
ACCEPT : PI > 1 REJECT : PI < 1 CONSIDERED : PI = 1
EXAMPLE – 10 :
The initial cash outlay of a project is Rs. 50,000/- and it generates cash
Inflows of Rs. 10,000/- , 20,000/- , 30,000/- , and Rs. 10,000/- .
Assume 10 % rate of discount . Find PI .

SOLUTION - 9
If we look at PV OF annuity table close to the payback period of 4.0816 against

5 years . The relevant factor is 4.22 against 6 % and 3.99 at 8 % .
STATEMENT SHOWING PRESENT VALUE AT 6% & 8%
YEAR CFAT PVF AT 6% PV AT 6% PVF AT 8% PV AT 8%
1 10,000 .943 9,430 .926 9,260
2 10,450 .890 9,300 .857 8,956
3 11,800 .840 9,912 .794 9,369
4 12,250 .823 10,082 .763 9,347
5 16,750 .747 12,512 . 681 11,407
TOTAL 51,236 48,339
IRR = A + C-O/C-D X B-A
= 6 +( 51,236 – 50,000 ) / (51,236 – 48,339) X ( 8-6)
= 6 + (1236/2897) X 2
= 6.85 %

SOLUTION – 10
COMPUTATION OF PI
YEAR CASH INFLOW P.V.F. PRESENT VALUE

@ 10% OF CASH INFLOW
1 10,000 0.909 9090
2 20,000 0.826 16,520
3 30,000 0.751 22,530
4 10,000 0.683 6,830
TOTAL 54,970
PI = 54,970/ 50,000 = 1.0994
WE WILL ACCEPT THE PROJECT AS PI IS GREATER THAN 1 .

EXAMPLE - 11
Swaraj Ltd, plans to undertake a project for placing a new product in

the market . The company’s cut-off rate is 12 % . It was estimated that
The project would cost Rs.40,00,000/- in plant and machinery in
Addition to working capital of Rs 10,00,000/-, which will be recovered
In full when the project’s 5 year life is over . The scrap value of plant
And machinery at the end of 5 years was estimated at Rs. 5,00,000/-.
After providing for depreciation on straight line basis , profit after tax
Were estimated as follows :
YEAR : 1 2 3 4 5
PAT : 3,00,000 8,00,000 13,00,000 5,00,000 4,00,000
FIND OUT THE PROFITABILITY INDEX ( PI ) OF THE PROJECT.

SOLUTION – 11
Depreciation =( 40,00,000 – 5,00,000 ) /5 = 7,00,000

Depreciation should be added to all the years PAT to get CFAT.
CALCULATION OF CFAT
YEAR EAT ( RS.) DEPRECIATION CFAT
1 3,00,000 7,00,000 10,00,000
2 8,00,000 7,00,000 15,00,000
3 13,00,000 7,00,000 20,00,000
4 5,00,000 7,00,000 12,00,000
5 4,00,000 7,00,000 11,00,000

SOLUTION – 11
CALCULATION OF PV OF CASH INFLOWS
YAER CASH INFLOW D.F. AT 12% PRESENT VALUE

1 10,00,000 0.893 8,93,000
2 15,00,000 0.797 11, 95,500
3 20,00,000 0.712 14,24,000
4 12,00,000 0.636 7,63,200
5 11,00,000 0.567 6,23,700
PRESENT VALUE OF CASH INFLOWS 48,99,400
ADD. PV OF WORKING CAPITAL( 10,00,000X 0.567) 5,67,000
PV OF SCRAP VALUE ( 5,00,000 X 0.567 ) 2,83,500
PV OF TOTAL CASH INFLOWS 57, 49,900
PI = 57,49,900 / 50,00,000 = 1.15
PROJECT SHOULD BE ACCEPTED AS PI IS MORE THAN 1 .

CLASS TEST
A firm is considering to install a large sampling machine. Two machines

currently being marketed will do the job satisfactorily. Machine A costs
Rs. 50,000/- and will require cash running expenses of Rs. 15,000/- per
year. It has a useful life of 6 years and is expected to yield Rs. 2,000/-
salvage value at the end of its useful life. Machine B costs Rs. 65,000/-
but cash running expenses are expected to be Rs. 12,000/-. This machine
is expected to have a useful life of 10 years with salvage value of Rs.
5,000/-. Assume both the machines would be depreciated on straight line
basis for tax purposes.
If the corporate tax rate is 35 % and cost of capital is 10%, which machine
should be bought by the company?

CAPITAL RATIONING
• Capital Rationing means the allocation of the limited funds available for
financing the capital projects to only some of the profitable projects in
such a manner that the long term returns are maximized.
• When there is capital rationing, a firm will not be able to undertake all the
profitable investment proposals and reject the other profitable
investment proposals.
• Two important steps involved in Capital Rationing are :
( a ) ranking of the different investment proposal
( b ) selection of some of the profitable investment proposals

EXAMPLE - 12
A firm has the following investment opportunities :

PROPOSAL INITIAL OUTLAYS PI
1 3,00,000 1.20
2 1,50,000 1.15
3 2,50,000 1.10
4 2,00,000 1.05
The available fund amount is Rs. 4,00,000/- . Which proposals

The firm should accept ?

SOLUTION - 12
First we will rank the proposals in descending order , in our question it is already
In that order , so we will calculate the net present value of the proposals :
PROPOSAL RANK NET PRESENT VALUE OF THE PROPOSAL
1 I 3,00,000 X ( 1.2 – 1 ) = 60,000
2 II 1,50,000 X ( 1.15 – 1 ) = 22,500
3 III 2,50,000 X ( 1.10 – 1 ) = 25,000
4 IV 2,00,000 X ( 1.05 – 1 ) = 10,000
FORMULA : NPV = INITIAL OUTLAY X ( PI – 1 )
After the ascertainment of the NPV of each proposal , we will select that
Combination which will yield the highest total NPV .
PROPOSAL 1 involving a capital outlay of Rs. 3,00,000/- and yielding a net
Present value of Rs.60,000/- is the highest , hence it should be selected.

CAPITAL STRUCTURE
• Capital structure is that part of financial structure , which represents long

term sources .
• The term capital structure refers to the mix of long term sources of funds
such as equity share capital, reserves and surplus , debentures , long term
debt and preference share capital.
• In taking financing decisions , the financial manager’s job is to come out
with an optimum capital structure .
• Optimum capital structure is that capital structure , where , the market
value per share is maximum and the cost of capital is minimum .
•

DETERMINANTS OF CAPITAL STRUCTURE
• Tax benefit of debt

• Flexibility
• Control
• Industry leverage ratio
• Seasonal variations
• Degree of competition
• Industry life cycle
• Company characteristics
• Timing of public issue
• Legal requirements

HOW TO DETERMINE APPROPRIATE CAPITAL STRUCTURE BY EBIT – EPS
APPROACH ?
CASELETS - 2
VS International Ltd. has a capital structure ( all equity ) comprising of

Rs.5,00,000/- each share of Rs.10. The firm wants to raise an additional
Rs. 2,50,000/- for expansion project. The firm has the following four
Alternatives financial plans I , II , III and IV . If the firm is able to earn
An operating profit at Rs. 80,000/- after additional investment and 50%
Tax rate . Calculate EPS for all four alternatives and select the
Preferable financial plan , which are :
(I) Raise the entire amount in the form of equity capital.
(II) Raise 50% as equity capital and 50% as 10% debt capital.
(III) Raise the entire amount at 12% debentures .
(IV) Raise 50% equity capital and 50% preference share capital at 10% .

SOLUTION – 1
CALCULATION OF EPS
PARTICULARS PLAN – I PLAN – II PLAN – III PLAN – IV

EBIT 80,000 80,000 80,000 80,000
LESS. INTEREST --- 12,500 30,000 ---
EBT 80,000 67,500 50,000 80,000
LESS. TAX AT 50% 40,000 33,750 25,000 40,000
EAT 40,000 33,750 25,000 40,000
LESS.PREF.DVND ---- ---- ---- 12,500
EARNINGS AVAILABLE
TO SHAREHOLDERS 40,000 33,750 25,000 27,500
NOS. OF SHARES O/S 75,000 62,500 50,000 62,500
EPS 0.53 0.54 0.50 0.44
PREFERABLE PLAN WILL BE II , BECAUSE IT HAS HIGHEST EPS.

CASELETS - 3
ABC LTD , has currently an equity share capital of Rs 25 lakh ,

Consisting of 25,000 shares of Rs 100 each. The management is
Planning to raise another 20 lakhs to finance a major programme of
Expansion through one of the four possible financial plans .
(I) Entirely through ordinary shares.
(II) Rs 10 lakhs through ordinary shares and Rs 10 lakhs through long term
borrowing at 8% interest p.a.
(III) Rs.5 lakhs through ordinary shares and Rs.15 lakhs through long term
borrowing at 9% interest p.a.
(IV) Rs. 10 lakhs through ordinary shares and Rs. 10 lakh through preference
shares with 5% dividend.
The company expected EBIT will be Rs. 8 lakh. Assuming a corporate
tax rate of 46% , determine the EPS in each alternatives and comment
Which alternative is best and why ?

SOLUTION – 2
CALCULATION OF EPS
PARTICULARS PLAN – I PALN – II PLAN – IIII PLAN – IV

EBIT 8,00,000 8,00,000 8,00,000 8,00,000
LESS.INTEREST --- 80,000 1,35,000 ----
EBT 8,00,000 7,20,000 6,65,000 8,00,000
LESS.TAX @ 46% 3,68,000 3,31,200 3,05,900 3,68,000
EAT 4,32,000 3,88,800 3,59,100 4,32,000
LESS. PREF.DVDND ---- --- ---- 50,000
EARNINGS AVAILABLE
TO EQUITY SHARE 4,32,000 3,88,800 3,59,100 3,82,000
Nos. of o/s eq.share 45,000 35,000 30,000 35,000
EPS 9.6 11.12 11.97 10.91
ANS. The above calculation indicates that plan – III is the best since EPS is
highest under this plan .
NOTE : O/S EQ.SH. = P – I : 25,000+20,000 = 45,000 , P-II: 25,000+10,000=
35,000 : P – III : 25,000 + 5,000 = 30,000 : P – IV : 25,000 + 10,000 =35000

LEVERAGES
• A firm can raise it’s required finance either from equity or debt or both .
• While constructing capital structure , a firm can use fixed cost bearing
securities for maximization of share holders wealth .
• From Financial Management point of view , the term leverage is
commonly used to describe the firm’s ability to use fixed cost assets or
sources of funds to magnify the returns to it’s owners.
• There are two types of leverages :
I. Operating leverage
II. Financial leverage

OPERATING LEVERAGE
• Operating leverage exists when changes in revenue ( sales ) produce greater

change in the operating profit . The degree of operating leverage ( DOL ) is
computed by dividing the marginal contribution by the operating profit . In the
form of equation :------
OL = CONTRIBUTION / EBIT
Or OL = SALES – V.C. / SALES – V.C. – FIXED OPERATING COST
Or DOL = % CHANGE IN EBIT / % CHANGE IN sales
EX – 3: Find OL if a firm sells 10,000 units @ Rs. 5/- per unit ,
variable cost is Rs. 3/- per unit and fixed operating cost is
Rs. 10,000/-.
ANS. OL = 50,000 – 30,000 / 50,000 – 30,000 – 10,000
= 20,000/ 10,000 = 2/1

OPERATING LEVERAGE
• Now , suppose sales volume increase by 20% to 12,000 units the

operating profit will rise to Rs. 60,000 – 36,000 – 10,000 = Rs 14,000/- .
• This shows that with a DOL of 2/1 , the operating profit will rise by 40%
( from Rs. 10,000/- to Rs. 14,000/- ) with only a 20% increase in sales
volume .
• In other words , a 1% increase in sales leads to 2% increase in operating
profit .
• DOL has the same effect in opposite side also . That means , if sales drop,
by 1% the operating profit will drop by 2% .

FINANCIAL LEVERAGE
• The use of fixed charges , sources of funds such as debt and preference
share capital along with the equity share capital in capital structure is
described as financial leverage .
• The fixed charges do not vary with firm’s EBIT . They must be paid
regardless of the amount of EBIT available to the firm.
• Financial leverage indicates the effect on EBIT created by the use of fixed
charges securities in the capital structure of a firm.
• Financial leverage = EBIT or OPERATING PROFIT / EBT
OR
Degree of financial leverage ( DFL ) = % change in EPS / %
change in EBIT

EXAMPLE – 4
A firm has sales of 1,00,000 units at Rs 10/- per unit . Variable

Cost of the produced products is 60% of total sales revenue .
Fixed cost is Rs. 2,00,000/- . The firm has used a debt of Rs.
5,00,000/- at 20% interest . Calculate the operating leverage and
Financial leverage .

SOLUTION - 4
Sales revenue ( 1,00,000 x 10 ) = 10,00,000

Less. Variable cost ( 10,00,000 x .60 ) = 6,00,000
Contribution = 4,00,000
LESS . Fixed cost = 2,00,000
EBIT = 2,00,000
LESS. Interest ( 5,00,000 x 20/100 ) = 1,00,000
Earning before tax ( EBT ) = 1,00,000
OPERATING LEVERAGE = CONTRIBUTION / EBIT = 4,00,000/2,00,000

=2
FINANCIAL LEVERAGE = EBIT/ EBT = 2,00,000/ 1,00,000 = 2

EXERCISE - 5
The capital structure of XL Ltd consists of the following

securities:
10% Debentures Rs. 5,00,000
12% preference shares Rs. 1,00,000
Equity shares of Rs 100 Rs . 4,00,000
Operating profit ( EBIT ) of Rs. 1,60,000/- and the company is
In 50% tax bracket .
i) Determine the company’s EPS .
ii) Determine the percentage change in EPS associated with 30% increase and
30% decrease in EBIT.
iii) Determine financial leverage.

SOLUTION - 5
BASE CASE – I CASE – II

( 30 % INCREASE ) ( 30 % DECREASE )
EBIT 1,60,000 2,08,000 1,12,000
LESS: Interest on deb. 50,000 50,000 50,000
EBT 1,10,000 1,58,000 62,000
LESS : Tax 50 % 55,000 79,000 31,000
EAT 55,000 79,000 31,000
LESS:Pref. dvdnd @ 12% 12,000 12,000 12,000
Earnings available to -
Equity shareholders : 43,000 67,000 19,000
Nos. of o/s shares 4,000 4,000 4,000
EPS 10.75 16.75 4.75

SOLUTION – 5 CONTD-----
( ii ) % CHANGE IN EPS :
30% increase : ( 6/ 10.75 ) x 100 = 55.8 %
30% decrease : ( - 6 / 10.75 ) x 100 = - 55.8 %
( iii ) Degree of financial leverage ( DFL ) = EBIT / EBT
Base = 1,60,000 / 1,10,000 = 1 . 455

Case – I = 2,08,000 / 1,58,000 = 1.316
Case – II = 1,12,000 / 62,000 = 1.806

COMBINED LEVERAGE
• The operating leverage has it’s effect on operating risk and is measured by the
percentage change in EBIT due to percentage change in sales .
• The financing leverage has it’s effect on financial risk and is measured by the
percentage change in EPS due to the percentage change in EBIT .
• Since, both these leverages are closely related with the ascertainment of the firm’s
ability to cover fixed charges ( fixed operating costs in the case of operating
leverage and fixed financial costs in the case of financial leverage ) , the sum of
both , gives us the total leverage or combined leverage and the risk associated
with the combined leverage is known as total risk .
• The degree of combined leverage may be defined as the percentage change in EPS
due to the percentage change in sales .
• Symbolically , Degree of combined leverage ( DCL ) = DOL X DFL

CASELETS - 4
A firm’s sales , variable costs and fixed cost amount to Rs. 75,00,000/-
42,00,000/- and Rs. 6,00,000/- respectively . It has borrowed
Rs. 45,00,000/- at 9% and it’s equity capital totals Rs. 55,00,000/- .
(i) What is the firm’s ROI ?
(ii) Does it have favorable financial leverage ?
(iii) If the firm belongs to an industry whose asset turnover is 3 , does it have a
high or low asset turnover ?
(iv) What are the operating , financial and combined leverages of firm ?
(v) If the sales drop to Rs. 50,00,000/-, what will the new EBIT be ?
(vi) At what level will the EBT of the firm equal to zero ?

SOLUTION - 6
( i ) ROI = EBIT / INVESTMENT

EBIT = SALES – VC – FC = 75 LAKH - 42 LAKH – 6 LAKH = 27 LAKH
ROI = 27 LAKH / 100 LAKH = 27 %
( ii ) yes , the firm has favorable financial leverage as it’s ROI is higher
than the interest on debt .
(iii ) Assets turnover = sales / total assets = 75 LAKH / 100 LAKH = 0.75 , it is lower than
the industry average .
( iv ) DOL = S – V / EBIT = 75 – 42 / 27 = 1.22

DFL = EBIT / EBIT – INTEREST = 27 / 27 – 4.05 = 1.18
DCL = DOL X DFL = 1.22 X 1.18 = 1.44

SOLUTION – 6 CONTND…….
( v ) EBIT at sales level of Rs, 50 LAKH :

Sales revenue 50,00,000
LESS : Variable cost 28,00,000
LESS : Fixed cost 6,00,000
EBIT = 16,00,000
(vi ) Zero EBT implies break even sales = FC / PV RATIO
P/ V RATIO = CONTRIBUTION / SALES X 100 = 33 LAKHS / 75 LAKHS X 100
= 44 %
Break even sales = 6 LAKH + 4.05 LAKH / 0.44 = Rs . 22,84,091/-
CONFIRMATION TABLE
Sales revenue 22,84,091
LESS: Variable cost ( 22,84,091 x .56 ) 12,79,091
LESS : Fixed cost ( operating ) 6,00,000
LESS: Interest ( additional fixed cost ) 4,05,000
EBT ZERO

EXERCISE – 7
The share capital of a company is Rs.8,00,000/- with shares of

Face value of Rs. 10/- . It has a debt capital of Rs. 5,00,000/- at
12% interest rate. The sales of firm are 2,50,000 units p.a. at a
Selling price of Rs. 5 per unit and the variable cost per unit is
Rs. 3 . The fixed costs amount to Rs. 1,00,000 and the company
Pays tax @ 50% . If the sales increase by 20%, find out :
( i ) the EPS at two level
( ii ) the degree of operating leverage at two levels.
(ii ) the degree of financial leverage at two levels .

SOLUTION - 7
OLD LEVEL NEW LEVEL

A . Sales ( @ 5 per unit ) 12,50,000 15,00,000
B . Variable cost (@ 3 per unit ) 7,50,000 9,00,000
C . Contribution ( A – B ) 5,00,000 6,00,000
D . Fixed Cost 1,00, 000 1,00,000
E. Operating Profit ( EBIT ) = ( C – D ) 4,00,000 5,00,000
F . Interest @ 12% 60,000 60,000
G . EBT ( E – F ) 3,40,000 4,40,000
H . Tax @ 50% 1,70,000 2,20,000
I . EAT ( G – H ) 1,70,000 2,20,000
EPS ( EAT / NOS. OF SHARES ) 1,70,000 / 80,000 2,20,000 / 80,000

= 2.125 2.75
DOL ( CONTRIBUTION / EBIT ) 5,00,000 / 4,00,000 6,00,000 / 5,00,000
= 1.25 1.2
DFL ( EBIT / EBT ) 4,00,000 / 3,40,000 5,00,000 / 4,40,000
= 1.176 1.136

EXERCISE - 8
The degree of Operating Leverage ( DOL ) is 1.2 and sales

Revenue is Rs. 144 lakh of a company . The annual interest
Burden is Rs. 10 lakh and preference dividend payable is
Rs. 4.2 lakh . The total variable costs to sales ratio is 60 % .
Find out the fixed expenses of the company .

SOLUTION – 8
Variable costs to sales ratio = .60

OR , Contribution = 1 - .60 = .40
= 144 x .40 = 57.6
DOL = Contribution / EBIT = C / C – F

1.2 = 57.6 / 57.6 – F
OR 69.12 – 1.2 F = 57.6
OR 1.2 F = 11.52
OR F = 9.6
OR FIXED EXPENSES = 9.6 LAKHS

CASELETS – 5
Ruchi Corporation is considering a project costing Rs. 800 lakhs.

The project offers expected earnings of Rs. 100 lakhs under
Normal condition . These earnings can change by (+/ - ) 50%
Under condition of expansion and recession . Ruchi Corporation
Has two alternate financing plans : raise 100% equity financing
Through issue of 10 lakhs shares of value Rs. 80/- each or avail
A loan of Rs. 400 lakhs – equivalent to 50% of the project cost
At interest of 12.5% , while issuing 5 lakhs shares at Rs.80/-
Each. ( a ) What is the DFL of the company under both the
Financing plans ( b ) Project expected earnings to shareholders under
Expansion and recession. Ignore tax factor. ( c ) what
Interpretation do you assign to the values of DFL .

SOLUTION - 9
( a ) Calculation of DFL : ( FIGURES IN LAKH )

100% Equity 50% Equity
EBIT ( Rs. ) 100 100
Interest - 50
EBT 100 50
Nos. of Shares 10 5
EPS ( RS. ) 10 10
DFL ( EBIT/EBT ) 1 2

( B ) EXPECTED EARNINGS
100% EQUITY 50%EQUITY

expansion recession expansion recession
EBIT 150 50 150 50
INTEREST -- --- 50 50
EBT 150 50 100 ---
NOS. OF
SHARES 10 10 5 5
EPS 15 5 20 0

SOLUTION - C
With 100% equity financing , DFL is 1 indicating equivalent changes

In EPS with EBIT . A 50% rise or fall in sales will lead to a 50% rise
Or fall in EPS. Hence, expected EPS is Rs. 15 and Rs. 5 under condition
Of expansion and recession .
Financing with 50% debt have a large DFL of 2 . The change in EPS
IS expected to be twice as much as that of sales. A 50% rise or fall
In sales will cause a 100% rise or fall in EPS .

COST OF CAPITAL
• The cost of capital is that minimum rate of return , which a firm must and
is expected to earn on it’s investments so as to maintain the market value
of it’s shares.
• The cost of capital has different meaning for individual investors and a
business organization. For an investors it may be the sacrifice made by
him. For a business organization, it is the minimum required rate of return
to justify the use of capital.
• It is also known as Weighted cost of capital (WACC) and expressed in
terms of percentage.
• The concept of COC is useful in taking following decisions :
(a) Designing optimal capital structure (b) Capital Budgeting
And ( c ) Financial performance appraisal of top management.

COMPUTATION OF SPECIFIC COST OF CAPITAL
COST OF EQUITY
• The company may resort to different financial sources viz. equity share ,
preference share , debentures , retained earnings etc.
• Firms may obtain equity capital in two ways ( a ) retention of earnings and
( b ) issue of additional equity shares to the public .
• The cost of equity or the returns required by the equity shareholders is
same in both cases, since in both cases, the shareholders are providing
funds to the firm to finance their investment proposals.
• But issue of additional equity shares to the public involves a floatation
cost ,whereas , there is no floatation cost for retained earnings.

COST OF RETAINED EARNINGS ( K re )
• Retained earnings are those part of amount earnings that are retained by the firm
invests in capital budgeting proposals instead of paying them as dividends to
shareholders.
• Some analysts consider retained earnings as cost free , but it is not so , it involves
opportunity cost .
• The opportunity cost of retained earnings is the rate of return that the
shareholders forgoes by not putting his or her fund elsewhere, because the
management has retained the funds .
• This opportunity cost can be well computed with the following formula :-
K re = K e X ( 1 - T i ) / ( 1 – Tb ) x 100

COST OF RETAINED EARNINGS
where ,
K e = cost of equity capital ( D / NP or E / NP + g )
Ti = Marginal tax rate applicable to the individuals concerned
Tb = cost of purchase of new securities
D = Expected dividend per share
E = Earnings per share
NP = Net proceeds of equity share / market price
g = Growth rate in %

EXAMPLE – 1
A company paid a dividend of Rs. 2 per share , market price

Per share is Rs. 20/- , income tax rate is 60 % and brokerage
Is expected to be 2% . Compute the cost of retained earnings.
ANS. K re = D/NP X 1 – Ti / 1 – Tb x 100
= 2/20 x 1 – 0.6 / 1 – 0.02 x 100
= 0.10 x 0.409 x100 = 4.1 %

EXAMPLE – 2
BPL Company’s equity share is currently being sold at Rs. 350.75

And it is currently paying a dividend of Rs. 5.25 per share. The
Dividend is expected to grow at 15% per annum for one year.
Income tax rate is 40% and brokerage is 2% . Calculate cost
Of retained earnings.

SOLUTION - 2
K re = [ ( D / NP + g ) X ( 1 – Ti ) / ( 1 – Tb ) ] x 100
= [( 5.25 / 350.75 + 0.15 ) x (1 – 0.40 ) / (1 – 0.02) ] x100
= ( 0.165 x 0.613 ) x 100
= 10.2 %

COST OF ISSUE OF EQUITY SHARES ( K e )
There are four important approaches available to calculate the

cost of equity capital , they are :
( I )DIVIDENDS CAPITALISATION APPROACH ( D / MP approach)
 According to this approach , the cost of equity capital is calculated on the
basis of a required rate of return in terms of future dividends to be paid
on the shares.
 Accordingly, K e is defined as the discount rate that equates the present
value of all expected future dividends per share along with the net
proceeds of the sale with the current market price of a share .
 This method assumes that investor give prime importance to dividend and
risk in the firm remains unchanged and it does not consider the growth in
dividend.

FORMULA OF COST OF EQUITY
K e = D / CMP or NP
HERE , D = DIVIDEND PER SHARE
CMP = CURRENT MARKET PRICE PER SHARE
NP = NET PROCEEDS PER SHARE
EXAMPLE : 3 : XYZ Ltd is currently earning Rs. 1,00,000/- , it’s current share
Market price is Rs. 100/- , outstanding equity shares is 10,000 . The company
Decides to raise an additional capital of Rs. 2,50,000/- through issue of equity
Shares to the public. It is expected to pay 10% as floatation cost . Equity
Capital is issued at a discount rate of 10 % per share . The company is interested
To pay a dividend of Rs. 8/- per share . Calculate the cost of equity.

SOLUTION - 3
K e = D / NP X 100
= 8 / ( 100 – 10 – 10 ) X 100
= 8 / 80 X 100
= 10 %

( ii ) EARNINGS CAPITALISATION APPROACH
• According to this approach , the cost of equity ( K e ) is the discount rate that
equates the present value of expected future earnings per share with the net
proceeds or current market price of a share .
• The advocate of this approach establish a relationship between earnings and
market price of a share .
• The formula is : K e = E / CMP or NP , here , E = earnings per share CMP = current
market price per share , NP = net proceeds per share.
• This approach acknowledges that all earnings of the company , after payment to
preference shareholders , legally belong to equity shareholders whether they are
paid as dividend or retained for investments .

EXERCISE – 4
Well Do Company Ltd. is currently earning 15% operating profit

on it’s share capital of Rs. 20 lacs ( F V of Rs. 200/- per share )
It is interested to go for expansion for which the company
requires an additional share capital of Rs 10 lacs. Company is
raising this amount by the issue of equity shares at 10%
Premium and the expected floatation cost is 5%. Calculate the
Cost of equity .

SOLUTION – 4
K e = E / NP X 100 = 30 / ( 200 + 20 – 10 ) X 100 = 14.3 %
NOTE : 1 : Calculation of EPS :

Operating profit = 20,00,000 x 0.15 = 3,00,000
Nos. of equity shares = 20,00,000/200 = 10,000 shares
EPS = 3,00,000 / 10,000 = Rs. 30/-
2 : Net Proceeds ( NP ) :
Face value ( FV ) + Premium – Floatation cost
= 200 + 20 – 10
= 210

( iii ) DIVIDEND CAPITALISATION PLUS GROWTH RATE APPROACH
• Computation of cost of equity capital based on a fixed dividend rate may not appropriate ,
because the future dividend may grow .
• The growth in dividends may be constant perpetually or may vary over a period of time.
• This generally treated as best method .
• K e under constant growth rate perpetually :
= D / NP or CMP + g
Here , D = dividends per share
NP = Net proceeds per share
CMP = Current Market price per share
g = growth rate ( % )

EXAMPLE – 5
Equity shares of a paper manufacturing company is currently

selling for Rs. 100/- . It wants to finance it’s capital expenditure
of Rs. 1 Lakh either by retaining earnings or selling new shares .
If company seeks to sell shares, the issue price will be Rs.95/-.
The expected dividend next year is Rs. 4.75 and it is expected
To grow at 6% perpetually.
Calculate cost of equity capital ( internal and external )

SOLUTION - 5
K e = D / MP + g
= 4.75 / 100 + 0.06
= 0.048 + 0.06
= 10.8 % ( INTERNAL )
Cost of external equity ( issue of shares )

= 4.75 / 95 + 0.06
= 0.05 + 0.06
= 11 %

COST OF CAPITAL UNDER VARIABLE GROWTH RATE
g r = D 0( 1 + r ) n = Dn
Here , g r = growth rate in dividends
D 0 = first year dividend payment
( 1 + r ) n = present value factor for nth year
D n = last year dividend payment
EXAMPLE : 6 : From the following dividends record of a company ,

Compute the expected growth rate in dividends .
YEAR : 1996 97 98 99 2000 01 02 03
DIVIDEND
PER SHARE 21 22 23 24 25 26 27 28

SOLUTION – 6
gr=D0(1+r)n= Dn
= 21 ( 1 + r ) 7 = 28
= ( 1 + r ) 7 = 28 / 21 = 1.34
During 7 years the dividends has increased by Rs. 7 /- giving a
Compound factor of 1.34 .
The growth rate is 4 % since the sum of Rs. 1 /- would
Accumulate to Rs. 1.34 in 7 years at 4% interest .
REFER COMPOUND SUM TABLE

EXAMPLE - 7
Mr. A an investor , purchase an equity share of a growing

Company for Rs. 210 /- . He expects the company to pay
Dividends of Rs. 10.50 , Rs. 11.025 and Rs. 11.575 in 1st
Year , 2nd year and 3rd year respectively and he expects to
Sell the shares at a price of Rs. 243.10 at the end of 3 years.
( a ) Determine the growth rate in dividends .

( b ) Calculate the current dividend yield .

SOLUTION - 7
(a) 10.5 ( 1 + r ) 2 = 11.575

or ( 1 + r ) 2 = 11.575 / 10.5 = 1.103
or g r = 5 %
( b ) Dividend yield = 10.5 / 210 x 100 = 5%

( iv ) CAPITAL ASSETS PRICING MODEL
( CAPM ) APPROACH
• Capital asset pricing model ( CAPM ) was developed by William Sharpe .

• From the cost of capital point of view, CAPM explains the relationship between the required
rate of return or the cost of equity capital and the relevant risk of the firm as reflected in it’s
index of relevant risk that is beta ( β ) .
• Beta factor ( β ) : The measure of the volatility of the return on a instrument ( say share )
relative to the market . If a share price were to rise or fall at double the market index , it
would have a beta factor of 2 . Conversely , if the share price moved at half the market
index , the beta factor would be 0.5 .
• Formula is : K e = R f + ( R mf - R f ) β
Here , R f = rate of return required on a risk free security
R mf = rate of return required on the on the market portfolio
of assets i.e. average rate of return on all assets .

Risk
• Systematic risk or Market risk
• Un-systematic risk OR Unique risk
• Unsystematic risk is a risk specific to a company or industry,
while systematic risk is the risk tied to the broader market.
Systematic risk is attributed to broad market factors and is the
investment portfolio risk that is not based on individual investments.

September 17, 2023
EXAMPLE - 8
The capital Ltd , wishes to calculate it’s cost of equity capital

using CAPM approach. Company analysts found, that it’s risk
free rate of return equals 12% , beta equals 1.7 and the
Return on market portfolio equals 14.5 % .
ANS. K e = R f + ( R mf – R f ) β
= 12 + ( 14.5 – 12 ) 1.7
= 12 + 4.25
= 16.25 %

EXAMPLE – 9
An investor supplied you the following information and requested you

To calculate ;
( a ) Expected rate of returns on market portfolio .
( b ) Expected returns on cost of each security using CAPM .
INVESTMENT INITIAL PRICE DIVIDEND YEAR END BETA
MARKET PRICE
Paper 20 2 55 0.7
Steel 30 2 65 0.8
Chemical 40 2 140 0.6
Govt. of India
Bonds 1,000 140 1005 0.99
Risk free returns is 10 % .

SOLUTION – 9
( A ) Calculation of expected return on market portfolio
investment
Investment Dividend Capital Gain Total returns Total investment
Paper 2 35 ( 55 – 20 ) 37 20
Steel 2 35 ( 65 – 30 ) 37 30
Chemicals 2 100 ( 140 – 40 ) 102 40
GOI BONDS 140 5 ( 1005 – 1000 ) 145 1,000
TOTAL 321 1090
Expected Return ( R mf ) = Total Return / Total Investment x 100

= 321 / 1090 x 100 = 29.44 %

SOLUTION – B
K e = R f + ( R mf - R f ) β
Paper = 10 + ( 29.44 – 10 ) 0.7 = 10 + 13.61 = 23.61%
Steel = 10 + ( 29.44 – 10 ) 0.8 = 10 + 15.55 = 25.55 %
Chemicals = 10 + ( 29.44 – 10 ) 0.6 = 10 + 11.66 = 21.66%
GOI BONDS = 10 + ( 29.44 – 10 ) 0.99 = 10 + 19.25 = 29.25 %

COST OF PREFERENCE SHARES
( I ) Cost of irredeemable preference share / perpetual preference share
K p ( without tax ) = D / CMP or NP

K p ( with tax ) = D ( 1 + Dt ) / CMP or NP
Here , D = dividend per preference share
CMP = Market price per share
NP = net proceeds
Dt = tax on preference dividend
EX : 10 : HHC LTD issues 12 % perpetual preference shares of face
value of Rs. 200/- each . Compute cost of preference share
without tax as well as with 10 % dividend tax .
ANS : K p ( without tax ) = 24 / 200 x 100 = 12 %
K p ( with tax ) = 24 ( 1 + 0.10 ) / 200 x 100
= 13.2 %

EXAMPLE - 11
Ram & co. is planning to issue 14 % perpetual preference shares

With face value of Rs 100/- each . Floatation cost are estimated
At 4 % on sales price . Compute cost of preference shares if
They are issued :
i. At par value
ii. At 10% premium
iii. At 5 % discount
Assume in all cases 5% dividend tax .

SOLUTION - 11
i. Issued at par value :

K p = 14 ( 1 + 0.05 ) / 100 – 4 x 100
= 15.4 %
ii. Issued at 10% premium :
K p = 14 ( 1 + 0.05 ) / ( 100 + 10 – 4.4 ) x 100
= 13.92 %
iii. Issued at 5% discount :
K p = 14 ( 1 + 0.05 ) / ( 100 – 5 – 3.8 ) x 100
= 16.12 %

COST OF REDEEMABLE PREFERENCE SHARES
• Cost of redeemable preference shares is the discount rate that equates the present value of
cash inflows ( sales proceeds ) with the present value of cash outflow i.e. dividend + principal
repayment .
• Formula is :
K P = D + ( f + d + P r - P i ) / Nm
-----------------------------------
( RV + NP ) / 2
HERE , D = dividend per share / f = floatation cost
d = discount on issue of preference share ( Rs. )
P r = premium on redemption of preference share ( Rs )
P i = premium on issue of preference shares ( Rs.)
N m = Term of preference shares
RV = Redeemable value of preference shares
NP = Net
September 17,proceeds
2023 realised 123
EXAMPLE – 12
• A company issues Rs 1,00,000 , 10% preference shares of Rs.100/- each

redeemable after 10 years at face value . Cost of issue is 10 % . Calculate
the cost of preference share .
• ANS : K p = 10 + ( 10 + 0 + 0 – 0 ) / 10
----------------------------------
( 100 + 90 ) / 2
= 11.58 %

COST OF DEBENTURES/DEBT/PERPETUAL DEBT
COST OF IRREDEEMABLE DEBT / PERPETUAL DEBT :
FORMULA :
( I ) Pre – tax cost : (II) Post – tax cost :
Kdi = I / P or NP X 100 Kdi = I ( 1 – t ) / P or NP X100
HERE , I = interest
P = principal amount or face value
NP = net sales proceeds
t = tax rate

EXAMPLE - 13
• XYZ Company Ltd. decides to float perpetual 12% , debentures of Rs. 100/-
each . The tax rate is 50% . Calculate cost of debenture .
• SOLUTION :
• Pre tax cost = 12 /100 x 100 = 12 %
• Post tax cost = 12 ( 1 – 0.5 ) / 100 x 100 = 6 %
EXAMPLE – 14 :
Rama & co. has 15% irredeemable debentures of Rs. 100/- each
For Rs. 10,00,000/- . The tax rate is 35% . Determine cost of
Debenture( pre tax and post tax both ) assuming it is issued at
(i) Par value ( ii ) 10% premium and ( iii ) 10% discount .

SOLUTION - 14
ISSUED AT PRE TAX POST TAX

(i) Par value 15/100x100 15 ( 1 - .35 )/100x100
= 15% = 9.8 %
(ii )10% premium: 15/110 x 100 15 ( 1 – 0.35 )/110x100

= 13.7% = 8.9 %
(iii ) 10% discount 15/90 x 100 15 ( 1 – 0.35 )/90 x 100

= 16.67% = 10.9 %

COST OF REDEEMABLE DEBENTURES / DEBT
Kd = I ( 1 – t ) + ( f + D + Pr – Pi ) / Nm
------------------------------------------------------------------ x 100
( RV + NP ) / 2
HERE , I = interest , t = tax rate , f = floatation cost , D = discount
Pr = premium on redemption , Pi = premium on issue
RV = redeemable value , NP = net proceeds
Nm = maturity period of debt
EXAMPLE : 15 : BE company issues Rs. 100 / - par value of debentures
Carrying 15% interest . The debentures are repayable after 7 years at
Face value . The cost of issue is 3% and tax rate is 45%. Calculate cost
Of debentures .
ANS. Kd = 15( 1- 0.45) +(3+0+0-0)/7 / (100+97 ) /2 x 100
= 8.81 %

CALCULATION COST OF CAPITAL ( KO) OR WEIGHTED AVERAGE
COST OF CAPITAL (WACC)
EXAMPLE : 16 : A firm has the following capital structure :

SOURCES OF FUNDS RS. AFTER TAX COST ( % )
Debt 30,00,000 4
Preference shares 10,00,000 8
Equity shares 20,00,000 11
Retained earnings 40,00,000 10
TOTAL 1,00,00,000
SOLUTION :
SOURCE WEIGHTS COST ( % ) WEIGHTED COST
Debt 0.30 0.04 0.012
Pref.share 0.10 0.08 0.008
Eq.share 0.20 0.11 0.022
Retained Er. 0.40 0.10 0.040
TOTAL 1.00 0.082
COST OF CAPITAL ( Ko ) = total weighted cost x 100 = 0.082x100 = 8.2%
WEIGHT SAY DEBT = DEBT CAPITAL /TOTAL CAPITAL = 30,00,000/1,00,00,000=0.30

MANAGEMENT OF PROFITS/DIVIDEND POLICY
• Dividends are periodic payments by a firm to it’s shareholders as rewards for their
investment .
• ‘Dividend policy’ refers to the decision on how much of earnings or what
proportion of earnings must be distributed so as to enhance the value of firm.
• Whether or not the dividend decisions can contribute to the value of the firm is a
debatable issue.
• Walter and Gordon believes that the dividend policy impacts the value of the firm
whereas Miller & Modigliani ( MM ) believes in the opposite philosophy of
irrelevance of dividend policy in determination of the value of the firm.
• We will discuss both the philosophies.

WALTER’S MODEL
• Prof. Walter argues that the choice of dividend pay-out ratio almost always affects
the value of the firm.
• He very scholarly studied the significance of the relationship between internal rate
of return ( r ) and cost of capital ( k ) in determining optimum dividend policy
which maximizes the wealth of shareholders
• MODEL : P = D + r / k ( E – D ) / K
• Here , p = market price per share , D = dividend per share, E = earning per share , r
= rate of return , k = cost of capital
• According to Walter , the optimum pay out ratio is 0% when r > k or 100 % when r
< k . For r = k , there is no optimum pay out ratio.

EXAMPLE – 1
Given the following information about Sunrise Industries Ltd ,

Show the effect of the dividend policy on the market price per
Share , using Walter’s model calculate with divdend payout ratio of 100%,
50% and 0%.
EPS = 8
COST OF CAPITAL ( K ) = 12%
Assumed rate of return ( r ) :
( a ) 15%
( b ) 10%
( c ) 12%

SOLUTION – 1
To show the effect of different dividend policies on the shareholders of the firm
For 15% ,10% and 12% , let us consider 0% , 25% , and 100% Pay out ratios.
( I ) when R > k ( 15 > 12 ) :

At 0% pay out ratio ( dividend = 0 )
p=D+R/K(E–D)/K
= 0 + .15 / .12 ( 8 – 0 ) / .12 = 83.33
At 25% pay out ratio ( dividend = 2 )
p = 2 + 0.15 / 0.12 ( 8 – 2 ) / .12 = 79.16
At 100 % pay out ratio ( dividend = 8 )
p = 8 + 0.15 / 0.12 ( 8 – 8 ) / 0.12 = 66.67
THERFORE , when r > k , price per share will be maximum at 0% pay out ratio .
Price per share decreases as and when pay out ratio is increased .

SOLUTION - 1
II . When r < k ( 10% < 12% )
At 0% pay out ratio:

p = 0 + 0.10 / 0.12 ( 8 – 0 ) / 0.12 = 55.55
At 25% pay out ratio :
p = 2 + 0.10 / 0.12 ( 8 – 2 ) / 0.12 = 58.33
p = 8 + 0.10 / 0.12 ( 8 – 8 ) / 0.12 = 66.66
Therefore, when r < k , price per share will be maximum at 100%

Pay out ratio. Price per share increases as and when pay out ratio is
Increased.

SOLUTION - 1
III. When r = k ( 12% = 12% )

p = 0 + 0.12 / 0.12 ( 8 – 0 ) / 0.12 = 66.66
p = 2 + 0.12 / 0.12 ( 8 – 2 ) / 0.12 = 66.66
P = 8 + 0.12 / 0.12 ( 8 – 8 ) / 0.12 = 66.66
Therefore , when r = k , price per share remains the same at
All pay out ratios . So, there is no optimum pay out ratio .

MILLER AND MODIGLIANI ( MM ) THEORY
• According to MM , the dividend policy of a firm is irrelevant , as it does not affect the wealth
of shareholders .
• This model which is based on certain assumptions , sidelined the importance of the dividend
policy and it’s effect thereof on the share price of the firm .
• According to this theory, the value of a firm depends solely on it’s earnings power resulting
from the investment policy and not influenced by the manner in which it’s earnings are split
between dividends and retained earnings.
• The model is : p o = 1 / 1 + r ( D1 + p1 )
Here, p0 = current market price of the share
D1 = expected dividend in the next period
p1 = expected market price in in period 1 ( ex – dividend price)
r = expected return

EXAMPLE – 2
Expanding corporation is providing 25% returns to it’s

Shareholders. The current market price of it’s share is Rs. 80/-
with 1.25 crore shares outstanding.
The firm is expected to earn Rs. 4 crore in the year , while it’s
Investment requirements of the period is Rs. 6 crore. It has been
Distributing dividend at 75 % of the earnings.
In view of it’s expansion requirement , it is exploring the
Proposition of skipping the dividend altogether for the year while
Mobilizing the remaining funds by issue of fresh shares .
Examine the value of the firm when the firm ( a ) continues with
the current dividend policy of 75% pay out and ( b ) decides to
Skip the dividend for the year.

SOLUTION- 2
The current position of the firm is as below :

Expected return ( r ) = 25 %
Current market price ( p0 ) = Rs. 80/-
Nos. of shares = 1.25 crores
Investment required ( I ) = Rs. 6 crores
Earnings available ( E1 ) = Rs. 4 crores
Planned dividend ( D1 ) = Rs. 3 crores
( a ) Value when dividend is declared :
Dividend per share = D1 / 1.25 crores = Rs. 2.40
The relationship of returns and the share price is :
P 0 = 1 / 1 + r ( D1 + P1 )
or P1 = ( 1 + r ) x P0 – D1
or P1 = ( 1 + 0.25 ) X 80 – 2.4 = Rs. 97.60 = Expected market
price

SOLUTION - 2
Capital to be mobilized = I – ( E1 – D1) = 6 – ( 4 – 3 ) = 5 Crores

Number of new shares to be issued = 5 crores/97.60 = 0.05123 crore
Total number of shares after issue = 1.25 crores + 0.05123 crore
= 1.30123 crores
The current market capitalization = 1.25 crores x 80 = 100 crores
Market value of shares after the issue for existing shareholders:
= 1.25 crores x 97.6 = 122 crores
Dividend received by existing shareholders : 3 crores
Total cash flow for existing shareholders at the end of period 1=125 crs.
Market value of shares after the issue : 1.30123 x 97.60 = 127 crores
Value for the new shareholders = 5 crores
Value for existing shareholders = 122 crores

SOLUTION – 2
( B ) VALUE WHEN DIVIDEND IS NOT DECLARED :

Expected market price : p1 = ( 1 + 0.25 ) x 80 – 0 = Rs. 100/-
Capital to be mobilized = I – ( E1 - D1 ) = 6 – ( 4 -0 ) = Rs. 2 crores
Number of new shares to be issued = .02 crores
Total number of shares = 1.25 + .02 = 1.27 crores
Market value of shares after the issue for existing shareholders :
= 1.25 x 100 = 125 crores
Dividend received by existing shareholders = nil
Market value of shares after the issue = 1.27 x 100 = 127 crores
Value for new shareholders = 2 crores
Value for existing shareholders = 125 crores
CONCLUSION : THE VALUE FOR EXISTING SHAREHOLDERS REMAINS

SAME AT RS. 125 CRORES IN TERMS OF MARKET PRICE AND DIVIDEND.

FACTORS INFLUENCING DIVIDEND POLICY
• Nature of business
• Age of company
• Liquidity position of the company
• Equity shareholders preference for current income
• Requirement of institutional investors
• Legal rules
• Financial needs of the company
• Easy access to the capital market
• Control objectives
• Dividend policy of competitors

WORKING CAPITAL MANAGEMENT
• Working capital (WC ) refers to short term funds to meet operating

expenses.
• According to Ramamoorty , “ it refers to the funds, which a company must
possess to finance it’s day to day operation.”
• It is concerned with the management of the current assets and current
liabilities .
• Broadly there are two concepts of WC ( a ) Gross working capital and ( b )
Net working capital.
• On the basis of time WC can be of two kinds :
( a ) Permanent working capital
( b ) Temporary working capital

PERMANENT AND TEMPORARY WORKING CAPITAL
• PWC is the minimum investment kept in the form of inventory of raw materials ,
work – in – progress , finished goods , stores and spares and book debts to
facilitate smooth operation in a firm.
• A firm is required to maintain an additional current assets temporarily over and
above permanent working capital to satisfy cyclical demands . That additional
working capital is called TWC.
• It can better illustrated with the following graph :
TWC
Working PWC
capital
TIME

ASPECTS OF WORKING CAPITAL MANAGEMENT
Management of working capital involves the following four

Aspects :
i. Determining the total funds required to meet the current operations of
the firm ( i.e. determination of the level of current assets )
ii. To decide the structure of current assets ( i.e. the proportion of long
term and short term capital to finance current assets )
iii. To evolve suitable policies, procedures and reporting systems for
controlling the individual components of current assets ( mainly cash ,
receivables and inventory )
iv. To determine the various sources of working capital.

OBJECTIVES OF WORKING CAPITAL MANAGEMENT
• To ensure optimum investments in current assets
• To strike a balance between the twin objectives of liquidity and

profitability
• To ensure adequate flow of funds for current operations.
• To speed up the flow of funds or to minimize the stagnation of funds.

OPERATING CYCLE
• The continuing flow from cash to suppliers to inventory to accounts receivable and
back into cash , is what is called THE OPERATING CYCLE.
DEBTORS
CREDIT SALES
CASH SALES
CASH SALES
OPERATING CYCLE
RAW MATERIALS FINISHED GOODS

WORK-IN-PROGRESS

EXAMPLE – 1
From the following information , you are required to estimate the

Net working capital : COST PER UNIT(RS)
Raw materials 200
Direct lab our 100
overhead 250
TOTAL 550
Estimated data for the forthcoming period is given as under :
Raw materials in stock average 6 weeks
W.I.P (assume 50% completion stage with
full material consumption ) 2 weeks
Finished goods in stock 4 weeks
Credit allowed by suppliers 4 weeks
Credit allowed to debtors 6 weeks
Cash at bank expected to be Rs. 75,000/-
Selling price Rs. 800/- per unit
Output 52,000 units
Assume that production is sustained at an even pace during 52 weeks of the year.
All sales are on credit basis .

SOLUTION - 1
Nature of Assets / Liabilities basis of calculation amount

A. Current Assets
i. Raw materials stock 52,000 x 200 x 6/52 12,00,000
ii. Work in progress :
( a ) Raw materials 52,000 x 200 x 2/52 4,00,000
( b ) Direct lab our & OH
( 50% completion ) 52,000 x 175 x 2/52 3,50,000
iii. Finished goods stock 52,000 x 550 x 4/52 22,00,000
iv. Debtors 52,000 x 550 x 6 / 52 33,00,000
v. Cash at bank 75,000
TOTAL 75,25,000
B. Current liabilities
Creditors 52,000 x 200 x 4/52 8,00,000
NET WORKING CAPITAL A–B 67,25,000

EXAMPLE – 2
X & CO. is desirous to purchase a business and has consulted you . You are asked to advise
Them regarding the average amount of working capital required in the first year. You are
Given the following estimates : AMOUNT FOR THE YEAR
( I ) average amount blocked for stocks : ( Rs )
stock of finished goods 5,000
stock of stores , materials etc 8,000
( ii ) average credit given :
inland sales 6 weeks credit 3,12,000
export sales 1 & ½ weeks credit 78,000
( iii ) average time lag in payment of wages and other :
Wages 1 & ½ weeks 2,60,000
stock & materials 1 & ½ months 48,000
rent , royalties etc. 6 months 10,000
clerical staff ½ months 62,400
manager ½ months 4,800
miscellaneous expenses 1 & ½ months 48,000
( iv ) payment in advance :
sundry expenses ( paid quarterly in advance ) 8,000
SOLUTION – 2
STATEMENT SHOWING WORKING CAPITAL FOR X & CO
( A ) Current assets :
( I ) stock of finished goods 5,000
( ii ) stock of stores , materials etc 8,000
( iii ) debtors :
( a ) Inland : 3,12,000 x 6 / 52 weeks 36,000
( b ) export : 78,000 x 1.5 / 52 weeks 2250
( Iv) advance payment of s. expenses : 8000 x 3 months/ 12 months 2,000
TOTAL INVESTMENT IN CURRENT ASSETS 53,250
( B ) CURRENT LIABILITIES :
i. Wages : 2,60,000 x 1.5 / 52 weeks 7,500
ii. Stocks , materials : 48,000 x 1.5 / 12 months 6,000
iii. Rent , royalties : 10,000 x 6 /12 months 5,000
iv. Clerical staff : 62,400 x 0.5 / 12 months 2,600
v. Manager : 4,800 x 0.5 / 12 months 200
vi. Misc. expenses : 48,000 x 1.5 / 12 months 6,000
TOTAL ESTIMATES OF CURRENT LIABILITIES 27,300
NET WORKING CAPITAL ( A – B ) 25,950

DETERMINANTS OF WORKING CAPITAL
• General nature of business

• Production cycle
• Business cycle
• Production policy
• Credit policy
• Growth and expansion
• Availability of raw material
• Level of taxes
• Dividend policy
• Price level changes

RECEIVABLE MANAGEMENT
• Accounts receivable or simply receivables represents the value of unpaid

customer’s invoices.
• Due to the magnitude of funds blocked in the receivables, they affect both
the top line and bottom-line.
• Management and control of receivables assumes great significance in
business world.
• Credit policy influences the sales, investment level , bad debts and
collection costs.
• Firms should follow optimum credit policy that lies between lenient and
stringent credit policy. Optimum credit policy involves a balance between
costs and benefits.

EXAMPLE - 1
Dream well company’s annual sales are Rs. 5,00,000/- , cost of

Capital is 15% and the company is in 40% tax bracket. Company
Categorized it’s customers into four categories viz. C 1 , C 2 , C 3
And C 4 ( C 1 customers have the highest credit standing and
Those in C 4 have lowest credit standing ). At present , company
Has provided unlimited credit to categories C 1 and C 2 ,
Whereas limited credit facility to C 3 and no credit facility to
C 4 customers. Due to present credit policy the company
Foregoing sales to the extent of Rs. 50,000/- to the customer in
C 3 and Rs.40,000/- in C 4. Now, company is considering to relax
The credit in C 3 and C 4 category.

EXAMPLE – 1
As a result , sales are expected to increase by Rs. 75,000/- but

It involves 12% bad debts loss. The estimated contribution
Margin is 25% and average collection period is 50 days.
Determine the change in net profit and advise whether the
Company should consider the relaxation of credit or not ?

SOLUTION – 1
CALCULATION OF CHANGE IN NET PROFIT
Increased sales 75,000

Less : variable cost ( 75,000 x 0.75 ) 56,250
contribution 18,750
Less : bad debts ( 12 % of 75,000 ) 9,000
earnings before tax ( EBT ) 9,750
Less : tax @ 40% 3,900
earnings after tax ( EAT ) 5,850
Less : opportunity cost ( see note ) 1156
change in net profit 4694
The firm can relax it’s credit standards since the change is
positive.
NOTE : Opportunity cost :
Increased in sales/365 x average collection period x ratio of V.C. to sales
X cost of capital = 75,000/365 x 50 x 0.75 x 0.15 = 1156

EXAMPLE - 2
The present annual sales of Infoway company is Rs. 30 lakhs.

The company classifies it’s customers into three categories viz.
1 , 2 & 3. At present , it provides unlimited credit to category -1
Limited credit to customers in category – 2 and no credit to
Category – 3 customers. Due to the present credit policy, the
Company foregoing sales to the extent of Rs. 5 lakhs to the
Customers in category-2 and Rs. 8 lakhs to 3 rd category. Now ,
The company is considering the adoption of more liberal credit
Policy, in which the customers in category -2 would be provided
Unlimited credit facility and customers in 3 rd category would be Provided
limited credit facility. Such relaxation would increase The sales by Rs. 9 Lakhs
on which bad debts losses would be 5%. The variable cost to sales ratio is 70%
the average collection Period is 50 days, cost of capital is 15% , and tax rate is
40%.determine The change in net profits and suggest whether the proposed
change is desirable?
SOLUTION – 2
CALCULATION OF CHANGE IN NET PROFIT
Increased sales 9,00,000

Less : Variable cost ( 9,00,000 x .70 ) 6,30,000
contribution 2,70,000
Less : Bad debts ( 9,00,000 x .05 ) 45,000
earnings before tax ( EBT ) 2,25,000
Less : tax @ 40% 90,000
earnings after tax ( EAT ) 1,35,000
Less : opportunity cost ( see note ) 12,945
Increased in net profit 1,22,055
NOTE : Calculation of opportunity cost :
Increased in sales / 365 x average collection period x ratio of VC to
Sales x cost of capital = 9,00,000 / 365 x 50 x 0.7 x 0.15 = 12,945/-

CASH MANAGEMENT
CASE STUDY
“ Managing the liquid resources of firms like ours is a tough

Choice” , said Mr. Gupta , the chief of treasury operations of
Apex Ltd, at an induction and orientation programme for
Management trainees in the firm’s finance department .
Looking at the perplexed faces of his audience, Mr. Gupta sensed
The need to elaborate the significance of cash management.
“ Extra cash improves liquidity, but cuts profitability , and so ,
One has to strike a balance all the time. There is always a
Profitability – liquidity tangle to be resolved. Unlike other areas
Of financial decision making , cash management can not be
Compartmentalized into short term and long term. Cash has no

CASE STUDY ……. CONTD…
co lour or creed, and the job of treasury manager is to ensure

That adequate cash is available for both long-term and short –
Term commitments.
Today’s treasurers need rapid and reliable information so that
Risk and exposure can be accurately monitored for improved
Decision making. Efficient cash management processes are
Needed to execute payment , collect receivables , and manage
Liquidity. Good cash management is simple. It involves :
 Knowing when, where , and how your cash needs will occur;
 Knowing the best sources for meeting additional cash needs;
 Being prepared to meet these needs when they occur, by keeping good
relationships with banker and other creditors.

CASE STUDY ….. CONTD…..
The starting point for good cash flow management is developing a cash flow
projection. Smart business owners know how to Develop both short-term ( weekly ,
monthly ) cash flow Projections to help them to manage daily cash and long term
( annual , 3 – 5 year ) cash flow projections to help them Develop the necessary capital
strategy to meet their business Needs. They also prepare and use historical cash flow
statements To understand how they used money in the past. I wish you all the very best
at this juncture of your career and suggest that you remember all your life the five basic
tenets of cash Management :
1. Bill promptly
2. Follow up aggressively
3. Pay slowly
4. Project accurately
5. Invest discretely

MOTIVES FOR HOLDING CASH
• THE TRANSACTION MOTIVE

• THE PRECAUTIONARY MOTIVE
• THE SPECULATIVE MOTIVE

EXAMPLE – 1
The following details of estimates are obtained in respect of the retail business
Of Fancy Ltd for the months of January to March , 2008 .
( I ) ESTIMATED WORKING CAPITAL AS ON 1ST JANUARY, 2008 :
Cash & bank balance : 10,900 , debtors : 51,400 : creditors : 42,200
Out standing expenses : 4,000 : dividend due : 9,700 : tax due : 6,400
Stock : 26,000/- .
( II ) BUDGETED PROFIT STATEMENT FOR 3 MONTHS :
JANUARY FEBRUARY MARCH
Sales ( credit ) 42,000 36,000 34,000
LESS : Cost of sales 32,700 28,100 26,600
Gross profit 9,300 7,900 7,400
LESS: selling & admin. Expenses 6,300 5,400 5,100
NET PROFIT BEFORE TAX 3,000 2,500 2,300

EXAMPLE – 1 ….. CONTD….
( III ) BUDGETED BALANCE AT THE END OF EACH MONTH :

Stock 24,000 22,000 20,000
debtors 52,000 50,000 47,000
creditors 40,000 39,000 38,000
outstanding expenses 4,000 4,000 4,000
dividend due 9,700 -- ----
tax due 6,400 6,400 6,400
Depreciation amounting to Rs. 1,700/- has been included in the
Budgeted expenditure of each month. You are required to prepare a
Month wise cash budget for the three months on receipt and payment
Basis.

SOLUTION – 1
CASH BUDGET FOR THREE MONTHS

( A ) RECEIPTS
Opening cash & bank bal. 10,900 12,800 10,300
Add. Receipt from debtors 41,400 38,000 37,000
( see note : 1 )
TOTAL 52,300 50,800 47,300
( B ) PAYMENTS :
To creditors & expenses 39,500 30,800 29,000
( see note : 2 )
To dividend ---- 9,700 -----
CLOSING CASH & BANK
BALANCE ( A - B ) 12,800 10,300 18,300

NOTE – 1
RECEPT FROM DEBTORS :

Opening balance 51,400 52,000 50,000

Add. Credit sales 42,000 36,000 34,000
Total 93,400 88,000 84,000
Less : closing balance 52,000 50,000 47,000
RECEIPT FROM DEBTORS 41,400 38,000 37,000

NOTE – 2
PAYMENT TO CREDITORS & EXPENSES
Opening balance : JANUARY FEBRUARY MARCH

Creditors 42,200 40,000 39,000
Expenses 4,000 4,000 4,000
TOATAL 46,200 44,000 43,000
ADD: cost of sales (note:3) 31,000 26,400 24,900
ADD: S & D expenses 6,300 5,400 5,100
TOTAL – A 83,500 75,800 73,000
LESS: Closing balance
creditors 40,000 39,000 38,000
expenses 4,000 4,000 4,000
TOTAL – B 44,000 43,000 42,000
PAYMENT DURING THE
MONTH ( A – B ) 39,500 32,800 31,000

NOTE - 3

Cost of sales 32,700 28,100 26,600
( GIVEN )
LESS: Depreciation 1,700 1,700 1,700
( NON-CASH ITEM )
CASH COST OF SALES 31,000 26,400 24,900

EXERCISE - 2
V industries ( new company ) requested to prepare a cash budget for the period
Of 6 months from January to June , 2008. They have provided the following
Information :-- ( Rs. In Lakhs )
JAN FEB MARCH APRIL MAY JUNE
Sales 80.00 100.00 120.00 120.00 120.00 120.00
Purchase 2.00 3.00 4.00 4.00 4.00 2.00
Wages 12.00 14.00 16.00 16.00 16.00 12.00
Manufacturing exps. 26.00 27.00 28.00 28.00 28.00 26.00
Administration exps. 4.00 4.00 4.00 4.00 4.00 4.00
Distribution expenses 4.00 6.00 8.00 8.00 8.00 4.00
ADDITIONAL INFORMATIONS :
i. Receipt of interest Rs. 2 lakhs in the month of JAN & MAY.
ii. Receipt of dividend Rs. 3 Lakhs in the month of March & June .

EXERCISE – 2
ADDITIONAL INFORMATION
• Sale of securities in the month of June for 3 crores.

• Payment of interest during January for Rs. 50,000/-
• Payment of loan in the month of June 2.5 crores
• Interim dividend payment of Rs. 10 Lakhs in April.
• Installation of machine in the month of June for Rs. 42 Lakhs.
ASSUMPTIONS : 10% of each month’s sale for cash , Customers are

Allowed a credit period of one month , creditors are allowing a credit
Of 2 months ; wages are paid on the 1st day of next month .

SOLUTION – 2
CASH BUDGET ( RS. IN LAKHS )
JAN FEB MARCH APRIL MAY JUNE

Opening balance - (-)24.5 8.5 57.5 108.5 170.5
ADD: RECEIPTS
Cash sales(10%
Of sales ) 8.00 10.00 12.00 12.00 12.00 12.00
Collection from
Customers - 72.00 90.00 108.00 108.00 108.00
Interest received 2.00 --- --- --- 2.00 ---
Dividend received --- ---- 3.00 ---- ---- 3.00
Sale of securities --- --- --- ---- --- 300.00
TOTAL RECEIPTS 10.00 57.5 113.5 177.5 230.5 593.5

SOLUTION – 2
CASH BUDGET ( RS. IN LAKHS )
PAYMENTS : JAN FEB MARCH APRIL MAY JUNE

Purchase -- -- 2.00 3.00 4.00 4.00
Wages -- 12.00 14.00 16.00 16.00 16.00
Manufac. Expenses 26.00 27.00 28.00 28.00 28.00 26.00
Admin. Expenses 4.00 4.00 4.00 4.00 4.00 4.00
Distri. Expenses 4.00 6.00 8.00 8.00 8.00 4.00
Interest paid 0.50 -- -- -- --- ---
Loan paid -- -- -- -- --- 250.00
Interim dividend -- -- -- 10.00 -- --
Installation payments -- -- -- --- -- 42.00
TOTAL PAYMENTS 34.50 49.00 56.00 69.00 60.00 346.00
CLOSING BALANCE (-)24.50 8.50 57.50 108.50 170.50 247.50
( TR – TP )

COMPUTATION OF OPTIMUM CASH BALANCE
• A firm has to maintain sufficient liquidity by holding minimum cash

balance.
• Sufficient liquidity means the availability of cash to pay the firm
obligations in time.
• Generally, the minimum cash balance is equal to the cash needed for
transaction plus safety cash that can be maintained based on firm’s past
experiences.
• Maintenance of cash balance provides sufficient liquidity but involve
opportunity cost ( loss of interest ) whereas less cash balance affects
liquidity.
• In conclusion, we can say every firm has to maintain optimum cash
balance.

• According to Baumol, Optimal cash balance is that cash balance where the
firm’s opportunity cost equals to transaction costs and the total costs are
minimum.
TOTAL COST
M.P OPPORTUNITY COST
COST M.P = MINIMUM POINT
TRANSACTION COST
LEVEL OF CASH BALANCE

OPTIMAL LEVEL
Baumol’s model :
C= √2AT/I
HERE , C = Optimum level of cash balance
A = Annual cash payments estimated
T = Cost per transaction of purchase or sale of
marketable securities
I = Interest on marketable securities per annum i.e.
carrying cost per rupee of cash

EXAMPLE – 3
ABC Ltd has estimated that use of Rs. 24 lakhs of cash during the next
Budgeted year. It intends to hold cash in a commercial bank which pay
Interest @ 10% p.a. For each withdrawal , the company incur
Expenditure of Rs. 150/-. What is the optimal size for each withdrawal.
SOLUTION:
C = √ 2 A T / I = √ 2 X 24,00,000 X 150 / 0.10
= Rs. 84,853 say Rs. 85,000/-
Each time the firm will withdraw Rs. 85,000/- from the bank deposit.
After spending all the amount of Rs. 85,000/- , again the company will
Withdraw a similar amount and so on.

INVENTORY MANAGEMENT
INVENTORY
FINISHED STORES
RAW WORK
PRODUCTS &
MATERIALS IN PROGRESS
SPARES

September 17, 2023
OBJECTIVES
• Ensure a continuous supply of Raw Materials and supplies to facilitate

uninterrupted production.
• Maintain sufficient stocks of raw materials in periods of short supply and
anticipate price change.
• Maintain sufficient finished goods inventory for smooth sales operation , and
efficient customer service .
• Minimize the carrying costs and time.
• Control investment in inventories and keep it at an optimum level.
• Elimination of duplication in ordering by centralization of purchases.
• Provide data for short – term and long – term planning and control of inventories.

COSTS OF HOLDING INVENTORY
• There are three costs involved in the management of inventories :

( I ) ORDERING COSTS :
 Ordering costs are those costs that are associated with the acquisition of raw materials.
 In other words, the costs that are spend, from placing an order for raw-materials to the
receipt of raw-materials.
 They include :
a) Cost of requisitioning the items ( raw materials )
b) Cost of preparation of purchase order i.e. drafting, typing, dispatch , postage etc.
c) Cost of transportation of goods.
d) Cost of receiving and verifying the goods.
e) Cost of un loading of goods
f) Storage and stocking charges

ORDERING COSTS…….CONTD..
In case of items manufactured in house the ordering costs would

Comprise the following costs :
a) Requisitioning costs
b) Set up cost
c) Cost of receiving and verifying the items
d) Cost of placing and arranging/stacking of the items in the store etc.
Ordering costs are fixed as per order placed irrespective of the
Amount of the order but ordering costs increases in proportion to
The number of orders placed. If the firm maintains small
Inventory levels, then the number of orders will increase,
Thereby, ordering costs will increase and vice-versa.

( ii ) INVENTORY CARRYING COSTS
Inventory carrying costs are those costs , which are associated

In carrying or maintaining inventory. This includes :
a) Capital cost ( interest on capital locked in the inventories)
b) Storage cost ( insurance, maintenance of building , utilities serving costs
)
c) Insurance ( on inventory against fire and theft )
d) Obsolescence cost and deterioration
e) Taxes
Carrying costs usually constitute around 25% of the value of
Inventories held.

( iii ) SHORTAGE COSTS OR COSTS OF STOCK –
OUT
Shortage costs are those costs that arise due to stock out ,
Either shortage of raw materials or finished goods.
( a ) shortage of inventories of raw materials affect the firm in
following ways :
 The firm may have to pay some higher prices , connected with immediate
( cash ) procurements.
 The firm may have to compulsorily resort to some different production
schedules , which may not be as efficient and economical.
( b ) shortage of finished goods may result in the dissatisfaction
of the customers and resultant lead to loss of revenue.

TECHNIQUES OF INVENTORY MANAGEMENT
( I ) ABC ANALYSIS
 This is the one of the widely used technique to identify various items of inventory
for the purpose of inventory control
 According to this technique , the task of inventory management is proper
classification of all inventory items in to three categories viz. A , B and C . The ideal
categorization is shown below :
CATEGORY NUMBER OF ITEMS( % ) ITEM VALUE ( %)
A 15 70
B 30 20
C 55 10
TOTAL 100 100
The above table clearly shows that Category ‘ A ’ items require greatest
Attention, Category ‘ B ’ reasonable attention , whereas , Category ‘C’
Least attention.

(ii ) ECONOMIC ORDER QUANTITY ( EOQ )
• Once categorization of inventory items is completed, then the next

question is how much inventory should be bought in one order ? To this
problem the answer is Economic order quantity
• Economic order quantity ( EOQ ) refers to that level of inventory at which
the total ordering and carrying costs are minimum.
• FORMULA :
EOQ = √ 2 A O / C C
Here , A = Annual usage
O = Ordering cost per order
C C = Carrying cost per unit ( annual )

EXAMPLE – 1
A company purchases a component of a product at the rate of

Rs. 50/- per unit . The annual consumption of that component is
25,000 units . If the ordering cost is Rs. 230/- per order and
Carrying cost is 20% 0f inventory value , what would be EOQ.
SOLUTION :
Annual usage = 25,000 units
Ordering cost = Rs. 230/-
Carrying cost = 20% of Rs. 50/- = Rs. 10/-
EOQ = √ 2 X 25,000 X 230 / 10 = 1072 units

EXAMPLE – 2
XYZ Company buys 75,000 glass bottles per year. Price of each
Bottle is Rs. 0.90 . Cost of purchase is Rs. 100/- per order . Cost
Of holding one bottle per year is Rs. 0.20. bank interest is 15%
Including a charge for taxes and insurances.
EXAMPLE – 3 :
A unit manufacturing electronics meters consumes 20,000 units
Of moulded steel boxes every month. The material is consumed
At an uniform rate during the month. The cost of acquiring the
Inputs is Rs.100 per unit and the carrying cost for the firm is
27.5 % on an average. The acquisition cost is likely to remain
Constant in the near future. The cost of placing an order is
Rs.50,000/- per order. Compute the optimal inventory for the year
Ahead using EOQ model.

SOLUTION - 2
Annual usage = 75,000 units

Cost of placing and receiving one order = Rs. 100/-
Cost of bottle = Rs. 0.90 per bottle
Annual carrying cost of one bottle = Rs. 0.20 per bottle.
Inventory carrying cost = 0.20 + ( 0.90 x 0.15 ) = Rs. 0.335
EOQ = √ 2 A O / C C
= √ ( 2 X 75,000 X 100 ) / O.335
= 6691.5 UNITS

SOLUTION – 3
Annual Demand ( A ) = 20000 x 12 = 2,40,000

Ordering Cost ( O ) = Rs. 50,000/-
Carrying cost ( CC ) = Rs. 27.5 ( 27.5% of acquisition cost of
Rs. 100/- )
EOQ = √ 2 X 2,40,000 X 50,000 / 27.5

= 29,542 UNITS

( iii ) ORDER POINT PROBLEM
• After determination of EOQ, problem is at what level order should be

placed?
• If the inventory level is too high, it will be unnecessary blocks the capital,
and if the level is too low , it will disturb the production by frequent stock-
out and also involve high ordering cost.
• Hence , an optimum inventory level needs to maintain, where there is no
stock out and the costs are minimum.
• The different stock levels are ( a ) minimum level ( b ) re-order level ( c )
maximum level ( d ) average stock level ,and (e ) danger level

FORMULAS
( a ) RE-ORDER LEVEL :
Maximum usage x Maximum delivery time
( b ) MINIMUM LEVEL :
Re order level – ( normal usage x average delivery time )
( c ) MAXIMUM LEVEL
Re order level + Re order quantity – ( minimum usage X
minimum delivery time )
( d ) AVERAGE STOCK LEVEL :
Minimum level + (Re order quantity / 2 )
( e ) DANGER STOCK LEVEL :
Average usage x minimum delivery time ( for emergency purchase)

EXAMPLE - 4
From the following information of VST company , compute

Re order level, minimum level , maximum level and average
Stock level. The company uses two components X and Y for
Manufacturing a product .
Normal usage --- 100 units per week , minimum usage – 50 units
Per week , maximum usage – 150 units per week .
Re order period : X : 4 to 10 weeks , Y : 2 to 8 weeks
Re order quantity : X : 600 units , Y : 900 units

SOLUTION – 4
RE ORDER LEVEL = Maximum usage x maximum delivery time

Component – X = 150 X 10 weeks = 1500 units
Component – Y = 150 X 8 weeks = 1200 units
MINIMUM LEVEL = Re order level – ( normal usage x average delivery time )
Component – X = 1500 units – ( 100 units x 7 weeks ) = 800 units
Component – Y = 1200 units – ( 100 units x 5 weeks ) = 700 units
MAXIMUM LEVEL = Re order level + Re order quantity – ( minimum usage x
minimum delivery time )
Component – X = 1500 + 600 – ( 50 units x 4 weeks ) = 1900 units
Components – y = 1200 + 900 - ( 50 units x 2 weeks ) = 2000 units
AVERAGE STOCK LEVEL = minimum level + ( Re order quantity / 2 )
Component – X = 800 units + ( 600 units / 2 ) = 1100 units
Component – Y = 700 units + ( 900 units / 2 ) = 1150 units

EXAMPLE – 5
Determine re order level , minimum level , maximum level and

Average stock level.
Normal usage : 100 units per week
Lead time : 4 to 6 weeks
Minimum usage : 50 units per week
Maximum usage : 150 units per week
Re order quantity : 600 units

SOLUTION - 5
Re order level : maximum usage x maximum delivery time

= 150 units x 6 weeks = 900 units
Minimum level : re order level – ( normal usage x av.del.time)
= 900 units – ( 100 units x 5 weeks )
= 400 units
Maximum level : re order level + re order quantity –
(minimum usage x minimum delivery time )
= 900 units + 600 units – ( 50 units x 4 weeks)
= 1300 units
Average stock level : minimum level + (re order quantity / 2 )
= 400 units + ( 600 units / 2 )
= 700 units

JUST- IN – TIME ( JIT ) INVENTORY MANAGEMENT
• JIT has been developed and implemented in Japan.

• It is not only a technique , but a grand manufacturing philosophy.
• The purpose behind the technique is to eliminate waste of all forms viz.
scrap , equipment downtime , excess lead time , over production and poor
space utilization.
• The basic principle of this philosophy is to produce at each manufacturing
stage , only the necessary products at the necessary time , in the
necessary quantity to hold the successive manufacturing stages together.

JIT ……. CONTD……
JIT inventory management is not very successful in India due to

Following reasons :
 Most of the Indian employees have low moral and poor commitment.
 They usually , do not identify himself with the company.
 Lack of motivation
 Absence or inadequate preventive maintenance
 Low inventory turnover ratio

FINANCING OF WORKING CAPITAL
Sources of short term funds have to be used exclusively for

Meeting the working capital requirements only and not for
Financing fixed assets and for meeting the margin money for
Working capital loans. The various sources of short term
Financing are as follows :
 Trade credit
 Accruals
 Deferred income
 Commercial papers
 Public deposits
 Inter corporate deposits
 Commercial banks
 factoring

VARIOUS FORMS OF CORPORATE RESTRUCTURING
• MERGER : ICICI & ICICI BANK

• ACQUISITION / TAKEOVER: CORUS BY TATA STEEL
• CONSOLIDATION : ARCELLOR MITTAL STEEL
• DIVESTITURE : L & T CEMENT DIVISION ( LATER ULTRA TECH CEMENT) TO GRASIM
• DEMERGER : INDIAN ALUMINIUM CO. LTD. INTO HINDALCO
• JOINT VENTURE : MARUTI SUZUKI
• BUY BACK OF SECURITIES: RELIANCE INDUSTRIES LTD.

TAKEOVER DEFENCE TACTICS
• CROWN JEWELS
• BLANK CHEQUE
• SHARK REPELLENTS
• POISON PILL
• PEOPLE PILL
• PACMAN
• GREEN MAIL
• WHITE KNIGHT
• GREY KNIGHT
• GOLDEN PARACHUTE
• BUY BACK


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Financial Management

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FINANCIAL MANAGEMENT

I WILL START DIGGING FROM THIS SIDE OF THE

September 17, 2023 Dr. Namrata Prakash 1

September 17, 2023 2

September 17, 2023 3

• Financial management is all about managing the financial resources in the

September 17, 2023 4

September 17, 2023 5

September 17, 2023 PROF. N.N.PANDEY 6

Finance director / CFO

FINANCIAL Internal Treasurer

Manager Management Manager Manager Cash Corporate Foreign

September 17, 2023 7

PROFIT MAXIMISATION SALES MAXIMISATION

September 17, 2023 8

Short term funds Long terms funds

Service debt Dividend Retained earnings

Firm’s wealth maximization

Value maximization of equity

September 17, 2023 9

RETURN TRADE-OFF RISK

MARKET VALUE OF FIRM

FIGURE SHOWING RISK – RETURN TRADE-OFF

September 17, 2023 10

FINANCIAL FINANCIAL FINANCIAL FINANCIAL

MONEY MARKET SHARES MERCHANT

September 17, 2023 11

• Time value of money is probably one of most important

September 17, 2023 PROF. N.N.PANDEY 13

A project needs an initial investment of Rs. 1,00,000/- . It is

September 17, 2023 14

September 17, 2023 15

Amount at the end of 1st year( 1000x110/100 ) = 1100

September 17, 2023 16

Interest can be compounded even more than once a year . In

September 17, 2023 17

September 17, 2023 18

Rs. 500 put at the end of first year, compounded for

AMOUNT AT THE END OF THE 5 YEARS = 8020

September 17, 2023 19

• An annuity is a stream of equal annual cash flows . Annuities involve calculations

September 17, 2023 PROF. N.N.PANDEY 20

THE ANNUITY TABLE gives the compound value as

September 17, 2023 21

• In present value concept , we estimate the present worth of a future

September 17, 2023 22

If Mr. X , depositor expects to get Rs.100 after one year , at the

September 17, 2023 23

EX : 5 : Given the time value of money as 10 % ( i.e. the discounting

September 17, 2023 24

September 17, 2023 25

YEAR CASH FLOWS PRESENT VALUE PRESENT VALUE

September 17, 2023 26

September 17, 2023 PROF. N.N.PANDEY 27

A finance firm has announced a scheme called ‘ Lakhpati in 10

September 17, 2023 28

The claim made by the finance company is wrong.

20000 x ( 1 + r )10 = 1,00,000

September 17, 2023 29

• Capital budgeting is the process to identify, analyze and select investment

September 17, 2023 30

PROJECT PROJECT PROJECT PROJECT

September 17, 2023 31