FM Final Important

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UNIT I
Q.
Define Financial Management and explain its nature.
Ans. Introduction : Financial management is that part of managerial process

which is concerned with the planning and controlling of firms financial
resources. It is concerned with the procurement of funds from most suitable
sources and making the most efficient use of such funds. In the earlier stages,
financial management was a branch of economics and as a separate subject it
is of recent origin. The subject is of immense importance to the managers
because among the most crucial decisions of the firm are those which relate to
finance.
Meaning of Financial Management : Financial management is a vital and an
integral part of business management. It refers to that part of managerial
activity which is concerned with planning and controlling of financial resources
of the enterprise. It deals with raising finance for the enterprise and the efficient
utilization of such finance. It includes:
Investment Decisions
Financing Decisions
Dividend Decisions
Liquidity Decisions
Capital budgeting
Budgetary Control
Definition of Financial Management :
According to Joseph L. Massie
Financial management is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for
efficient operations.
According to Wheeler
Financial Management is the activity which is concerned with the
acquisition and administration of capital funds in meeting the financial needs
and overall objectives of business enterprise.
Nature of Financial Management :
(1)
Financial Management is an essential part of Top Management : In

the modern business management the financial manager is one of the
active members of top management team and day-by-day his role is
becoming more significant in solving the complex management problems.
This is because almost all kinds of business activities such as production,
marketing etc. directly or indirectly involve the acquisition and use of
finance.
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(2)
Less Descriptive and More Analytical : Financial management is less

descriptive and more analytical. Due to the development of new statistical
and accounting techniques of financial analysis, the financial
management chooses the best alternative out of the many possible
alternatives.
(3)
Continuous Function : Financing is a continuous function. In addition

to the raising of finance, there is a continuous need for planning and
controlling the finances of an enterprise. A firm performs finance
functions continuously in the normal course of the business.
(4)
Different from Accounting Function : There are key difference between

the accounting and finance function. Accounting generates information or
data whereas in the finance function the data re analysed and used for the
purpose of decision making.
(5)
Wide Scope : There is wide scope of financial management. It is

concerned not only with the raising of finance but also with the allocation
and efficient use of such finance.
(6)
Centralised Nature : Financial management is centralized in nature. It

is neither possible nor desirable to decentralize the financial
responsibilities.
(7)
Measurement of Performance : Financial management is concerned

with the wise use of finance. It fixes certain norms and standards against
which the benefits of an investment decisions are matched.
(8)
Inseparable Relationship between Finance and other Activities :

There exists an inseparable relationship between finance on the one hand
and production, marketing and other activities on the other. All other
activities are related to finance.
(9)
Applicable to All Types of Organisations : It is applicable to all forms of

organization whether corporate or non-corporate such as sole
proprietorship and partnership firms etc.
Q.
Define Financial Management. Explain the Scope of Financial

Management.
OR
Q.
Define Finance Function and discuss its nature and scope
Ans. Meaning of Finance : Finance is defined as the provision of money at the

time when it is required. The role of finance in business enterprise needs no
emphasis. Every enterprise, whether big or small, needs finance to carry on
and expand its operations. Finance holds the key to all the business activities
and a firms success and, in fact, its survival is dependent upon how efficiently
it is able to acquire and utilize the funds.
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FINANCIAL MANAGEMENT
Meaning of Financial Management : Financial management is a vital and an

integral part of business management. It refers to that part of managerial
activity which is concerned with planning and controlling of financial resources
of the enterprise. It deals with raising finance for the enterprise and the efficient
utilization of such finance.
Scope of Financial Management : Financial management as an academic
discipline has undergone notable changes over the years, with regard to its
scope of functions. At the same time, the financial managers role also has
undergone fundamental changes over the years. Study of the changes that
have taken place over the years is known as Scope of Financial Management.
In order to have an easy understanding and better exposition to the changes, it
is necessary to divide the scope into two approaches:
(A) Traditional Approach
(B) Modern Approach
(A)
Traditional Approach : Under this approach the role of financial

management was limited to the procurement of funds on suitable terms.
The utilization of funds was considered out of the scope of financial
management. Under this approach, a study of the following three things
was made for the procurement of funds:
(1) Arrangement of funds from Financial Institutions.
(2) Arrangement of funds through financial Instruments like share, bonds
etc.
(3) Legal and accounting relationship between a business and its source
of funds.
The notable feature of the traditional approach was the assumption that
the duty of the finance manager was only to raise funds from external parties
and that he was not concerned with taking the internal financial decisions. He
was not responsible for the efficient use of funds.
Limitations of Traditional Approach : The traditional approach continued
till mid 1950s. It has now been discarded as it suffers from the following
limitations:
(i) More Emphasis on Raising of Funds : This approach places more
emphasis on procurement of funds from external sources and neglects
the issues relating to the efficient utilization of funds. Since it is
concerned with the raising of funds, it attaches more importance to the
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viewpoint of external parties who provide funds to the business and

completely ignores the internal persons who make financial decisions.
(ii) Ignores the Financial Problems of Non-Corporate Enterprises : It
places more emphasis on the problems faced by corporate enterprises
in procuring the funds. The non-corporate enterprise like sole
proprietorship and partnership firms are considered outside its scope.
(iii Ignored Routine Problems : This approach concentrates on the
financial problems on the occurrence of special events such as merger,
incorporation etc, and fails to consider the day-to-day financial
problems of a normal firm.
(iv) Ignored Working Capital Financing : This approach gives more
emphasis on the problems relating to long term financing and the
problems relating to working capital financing are considered outside
the purview of this approach.
(B)
Modern Approach : The modern approach considers the term financial

management in a broad sense. According to this approach the finance
function covers both acquisition of funds as well as their efficient
utilization. According to this approach the financial management is
concerned with the solution of three major problems relating finance:
(1) What is the total volume of funds an enterprise should commit?
(2) How should the funds required be raised?
(3) In what specific assets the enterprise should invest its funds?
Thus, in the modern approach, the financial management is responsible

for taking three decisions:
(1) The Investment Decision : Investment decision also known as Capital
Budgeting is related to the selection of long-term assets or projects in
which investments will be made by the business. Long term assets are
the assets which would yield benefits over a period of time in future.
(2) The Financing Decision : This function is related to raising of finance
from different sources. For this purpose the financial manager is to
determine the proportion of debt and equity. In other words there are
two sources of finance:
(i) Debt: Debt means long term loans and includes:
Debentures
Loan from Bank
Loan from Financial Institutions
Mortgage Loans
(ii) Equity: Equity refers to shareholders funds and includes:
Equity Share Capital

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Preference Share Capital
Reserve
Accumulated Profits
(3) The Dividend Policy Decision: The financial management has to
decide as to which portion of the profits is to be distributed as dividend
among shareholders and which portion is to be retained in the
business. For this purpose the financial management should take into
consideration the factors of dividend stability, bonus shares and cash
dividends in practice.
Q: Discuss the Chief Functions of Finance OR Financial Management.
Ans: Meaning of Financial Management : Financial management is a vital
and an integral part of business management. It refers to that part of
managerial activity which is concerned with planning and controlling of
financial resources of the enterprise. It deals with raising finance for the
enterprise and the efficient utilization of such finance.
Functions of Finance OR Financial Management : The functions of finance
are:
(1)
(2)
(3)
(4)
(5)
(6)
(7)
1.
Determining the Financial Needs

Financing Decision
Investment Decision
Working Capital Decision
Dividend Policy Decision
Financial Control
Routine Functions.
Determining the Financial Needs : The first task of the financial

management is to estimate and determine the financial requirements of
the business. For this purpose, the short term and long term needs of the
business are estimated separately. While determining the financial needs
the financial management should take into consideration the:
Nature of the Business
Possibilities for future expansion
Attitude of the management towards risk
General economic circumstances etc.
2.
Financing Decision : This function is related to raising of finance from

different sources. For this purpose the financial manager is to determine
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the proportion of debt and equity. In other words there are two sources of
finance:
(i) Debt: Debt means long term loans and includes:
Debentures
Loan from Bank
Loan from Financial Institutions
Mortgage Loans
(ii) Equity: Equity refers to shareholders funds and includes:
Reserve & Accumulated Profits

3.
Investment Decision : Investment decision also known as Capital

Budgeting is related to the selection of long-term assets or projects in
which investments will be made by the business. Long term assets are the
assets which would yield benefits over a period of time in future.
4.
Working Capital Decision : It is concerned with the management of

current assets. It is an important function of financial management.
Current assets should be managed in such a way that the investment in
current assets is neither inadequate nor unnecessary funds are locked up
in current assets.
If a firm does not have adequate working capital, that is its investment
in current assets is inadequate, it may become illiquid and as a result
may not be able to meet its current obligations.
On the other hand, if the investment in current assets is too large, the
profitability of the firm will be adversely affected because idle current
assets will not earn anything.
5.
Dividend Policy Decision : The financial management has to decide as

to which portion of the profits is to be distributed as dividend among
shareholders and which portion is to be retained in the business. For this
purpose the financial management should take into consideration the
factors of dividend stability, bonus shares and cash dividends in practice.
6.
Financial Control : The establishment and use of financial control

devices is an important function of financial management. These devices
include:
Budgetary Control
Cost Control
Ratio Analysis etc.

Process of Financial Control :
(i) Setting the standards
(ii) Measurement of Actual Performance
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(iii)Comparison of Actual Performance with standards

(iv) Finding deviations and taking remedial actions.
7.
Routine Functions : The routine functions are :
Supervision of cash receipts and payments.
Opening Bank Accounts and managing them
Safeguarding of securities, insurance policies and other valuable

documents
Maintaining records and preparation of reports
Q.
What do you mean by Organisation of Finance Function? Explain the

functions of Financial Manager.
Ans. Organisation of Finance Function : organization of finance function

means the division of functions relating to finance and to set up a sound and
efficient organization for performing the finance functions. Since the financial
decisions are very crucial for the survival as well as growth and development of
the firm. The ultimate responsibility of carrying out the finance function lies
with the top management. Hence, a department to organize and carry out the
financial activities is created under the direct control of the board of directors.
This department is headed by a financial manager.
However, the exact nature of the organization of the finance functions differs
from firm to firm depending upon many factors such as:
(i) Size of the Firm
(ii) Nature of its Business
(iii)Type of financing operations
(iv) Capabilities of firms financial officers etc.
Graphic Presentation of Organisation of Finance Function : The following
chart depicts the organization of the finance function of a large business firm:
Board of Directors
Managing Director
Production
Manager
Personnel
Manager
Financial
Manager
Marketing
Manager
Treasurer
Cash
Management
Banking
Management
Planning &
Annual
Budgeting Reports
Controller
Credit
Management
Financial
Accounting
Assets
Securities
Management Management
Cost
Accounting
Data
Processing
Internal
Audit
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Functions of Financial Manager : The financial manager is a member of top

management. He is closely associated with the formulation of financial policies
as well as financial decision making. He is expected to perform the following
functions:
(1) Financial Planning : The financial manager estimates the financial
needs of the business, determines the capital structure and prepares
financial plan.
(2) Procurement of Funds : He arranges to acquire the funds from
various sources such as shares, debentures etc.
(3) Coordination : He maintains a proper coordination among the
financial needs of different departments.
(4) Control : He establishes the standards of financial performance and
examines whether the actual performance is according to predetermined standards. He is responsible for:
Controlling the Costs
Analysing the Profits
Preparation of Reports
(5) Business Forecasting : He keeps a close watch on the various events
affecting the organization such as:
Technological Changes
Competition
Change in Govt. Policy
Change in social and business environment and studies their effect

on the firm.
(6) Other Functions: Other functions we includes:
Cash Management
Banking Relations
Credit Management
Assets Management
Securities Management
Accounting
Internal Auditing.
Functions of Treasurer :
(1)
Cash Management : It includes the managing of cash receipts and cash

payments of the business.
(2)
Banking Relations : It includes banking relations, operating

accounts, and managing deposits and withdrawals etc.
(3)
Credit Management : It includes determining the credit worthiness of

the customers and arrangement for collection of credit sales.
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(4)
Assets Management : It includes arrangement for the acquisition,

disposal and insurance of various assets.
(5)
Securities Management : It includes the investment of surplus funds of

the business.
(6)
Protecting Funds and Securities : It includes custody of funds and

securities.
Functions of Controller :
(1) Planning & Budgeting : It includes profit planning, capital
expenditure planning, budgeting, inventory control, sales forecasting
etc.
(2) Financial Accounting : He establishes a proper system of
accounting, controls it and prepares financial statements such as
profit & Loss Account and Balance Sheet etc.
(3) Cost Accounting : He establishes a cost accounting system suitable
to the business and controls it.
(4) Data Processing : It includes the collection and analysis of business
data.
(5) Internal Auditing : He manages internal audit and internal control.
(6) Annual Reports : He prepares annual reports and various other
reports needed by the top management.
(7) Information to Government : He prepares annual reports to be
submitted to the Government under various laws.
Q.
What are the goals Or Objectives of Financial Management?
Ans. Meaning of Financial Management : Financial management is a vital

and an integral part of business management. It refers to that part of
managerial activity which is concerned with planning and controlling of
financial resources of the enterprise. It deals with raising finance for the
enterprise and the efficient utilization of such finance.
Objectives of Financial Management : It is the duty of the top management
to lay down the objectives or goals which are to be achieved by the business.
The main objectives are:
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1.
Profit Maximization : According to this approach, all activities which

increase profits should be undertaken and which decrease profits should
be avoided. Profit maximization implies that the financial decision
making should be guided by only one test, which is, select those assets,
projects and decisions which are profitable and reject those which are not.
Arguments are in favour of Profit Maximization Approach :
(i) Best Criterion on Decision-Making : The goal of profit maximization
is regarded as the best criterion of decision-making as it provides a
yardstick to judge the economic performance of the enterprises.
(ii) Efficient Allocation of Resources : It leads to efficient allocation of
scare resources as they tend to be diverted to those uses which, in
terms of profitability, are the most desirable.
(iii)Optimum Utilization : Optimum utilization of available resources is
possible.
(iv) Maximum Social Welfare : It ensures maximum social welfare in the
form of maximum dividend to shareholder, timely payment to
creditors, higher wages, better quality and lower prices, more
employment opportunities to the society and maximization of capital to
the owners.
Criticism of Profit Maximization Approach:
(i) Ambiguous : One practical difficulty with this approach is that the
term profit is ambiguous. Different people take different meaning of
term profit. For example:
Profit may be short-term or long-term.
Profit may be before tax or after tax.
Profit may be total profit or rate of profit.
Profit may be return on total capital employed or total assets or

shareholders funds.
(ii) Ignores the Time Value of Money : This approach ignores the time
value of money. It does not make a distinction between profits earned
over the different years. It ignores the fact that the value of one rupee at
present is greater than the value of same rupee received after one year.
(iii)Ignores Risk Factor : This approach ignores the risk associated with
the earnings. If the two firms have the total expected earnings, but if
earnings of one firm fluctuate considerably as compared to the other, it
will be more risky. It is, thus, clear that profit maximization criterion is
inappropriate and unsuitable. It is not only ambiguous but fails to
solve the problems of time value of money and the risk. An alternative
to profit maximization, which solves these problems, is the criterion of
wealth maximization.
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2.
Wealth Maximization : It is also termed as value maximization or Net

Present worth maximization. This approach is now universally accepted
as an appropriate criterion for making financial decision as it removes all
the limitations of profit maximization approach. It is also known as net
present value (NPV) maximization approach. According to this approach
the worth of an asset is measured in terms of benefits received from its
use less the cost of its acquisition. Benefits are measured in terms of cash
flows received from its use rather than accounting profit which was the
basis of measurement of benefits in profit maximization approach.
Another important feature of this approach is that it also incorporates
the time value of money. While measuring the value of future cash flows
an allowance is made for time and risk factors by discounting or reducing
the cash flows by a certain percentage. This percentage is known as
discount rate.
The difference between the present value of future cash inflows generated
by an asset and its cost is known as net present value.
A financial asset or a project which has a positive NPV creates wealth

for shareholders and, therefore is undertaken.
On the other hand, a financial asset or a project resulting in negative

NPV should be rejected since it would reduce shareholders wealth.
If one out of various projects is to be choosen, the one with the highest
NPV is adopted.
The NPV can be calculated with the help of the following formula:
A1
A2
An
W = + + + - C
(1+K)1
(1+K)2
(1+K)n
W = Net Present Worth

A1, A2,An = Stream of Cash Flows
K = Appropriate discount rate to measure risk and time factors
C = Initial outlay to acquire an asset or pursue a course of action.
Merits of Wealth Maximization Approach :
The wealth maximization approach is superior to the profit maximization
approach because:
1. Wealth maximization approach uses cash flows instead of accounting
profits which avoids the ambiguity regarding the exact meaning of the
term profit.
2. Wealth maximization approach gives due importance to the time
value of money by reducing the future cash flows by an appropriate
discount or interest rate.
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Q.
Explain the Concept of Time value of Money.
Ans. Introduction : Time value of money means that the value of a unit of
money is different in different time periods. The value of a sum of money
received today is more than its value received after some time. Conversely, the
sum of money received in future is less valuable than it is today. In other words,
the present worth of a rupee received after some time will be less than a rupee
received today. The time value of money can also be referred to as time
preference for money.
Three reasons may be attributed to the individuals time preference for money.
Risk
Preference for consumption
Investment opportunities.
We live under risk or uncertainty. As an individual is not certain about future
cash receipts, he or she prefers receiving cash now. Most people have
subjective preference consumption over future consumption of goods and
service either because of the urgency of their present wants or because of the
risk is not being in a position to enjoy future consumption that may be caused
by illness or death, Or because of inflation.
Time Value
of Money
Compounding or
Future Value
Discounting or
Present Value
(A) Compounding or Future Value Concept : Under this method of

compounding, the future values of all cash inflows at the end of the time
horizon at a particular rate of interest are found. Interest is compounded when
the amount earned on an initial deposit becomes part of the principal at the end
of the first compounding period.
Example : If Mr. A invests Rs. 1,000 in a bank which offers him 10%
interest
compounded annually, he as Rs. 1,100 in his account at the end of the first
year. The total of the interest and principal Rs. 1,100 constitutes the principal
for the next year. He thus earns Rs, 1,210 for the second year. This becomes the
principal for the third year and so on.
(1)
Compound Value of a Single Flow (Lump Sum):- The process of

calculating future value becomes very cumbersome if they have to be
calculated over long maturity periods 10 to 20 years. A generalized
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procedure for calculating the future value of a single cash flow

compounded annually is as follows:
n
FV = PV (1+i)
Where, FV = Future value of the initial flow in n years
PV= Initial Cash flow
i= Annual rate of interest
n = No. of years for which compounding is done.
Example : Mr. x invests Rs. 1,000 at 10% is compounded annually for
three years. Calculate value after three years.
n
FV = PV (1+i)
3
FV = 1000 (1+.10)
FV = Rs. 1,331
(2)
Multi-period Compounding or Future Value : If the company will

compounding interest half-yearly (semi-annually) instead of annually
then investors will gain as he will get interest on half-yearly interest. Since
interest will be compounded half-yearly, for finding out the compound
value.
FV = PV (1+i/m)
nxm

m= No. of times compounding is done during a year.
Example : Mr. X invests Rs. 10,000 at 10% p.a. compounded semiannually. Calculate value after three years.
FV = PV (1+i/m)n x m
FV= 10,000 (1+.10/2) 3 x 2
FV = Rs. 11,025
(3)
Compounded Value of a Series of Cash Flows : We have considered

only single payment made once and its accumulation effect. An investor
may be interested in investing money in installments and wish to know the
value of its savings after n years.
n
FV = A (1+i) + A (1+i) + A (1+i) + A

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A = Amount deposit or invested.

Example : Mr. X invests Rs.500, Rs.1000, Rs.1500, Rs. 2000 and Rs.
2500 at the end of each year for 5 years. Calculate the value at the end of 5 years
compounded annually
if the rate of interest is 5% p.a.
3
FV = 500 (1+0.05) 1000 (1+0.05) + 1500 (1+0.05) + 2000 (1+0.05) +2500

FV = Rs. 8020
4+
(4)
Compound Value of an Annuity : Annuity refers to the periodic flows of

equal amounts.
FV = A {(1+i) 1}/i
n
Example : Mr. X invests Rs. 2,000 at the end of each year for 5 years into
his account, interest being 5% compounded annually. Determine the amount
of money he will have
th
at the end of the 5 year.

5
FV = 2000 {(1+.05) 1}/.05

FV = Rs. 11054
(B)
Discounting or Present Value Concept : As per this concept, rupee one

of today is more valuable than rupee one a year later. The reason for more
value of rupee today than a rupee of future is interest. Discounting is the
process of determining present values of a series of future cash flows.
Example : If Mr. X, depositor expects to get Rs. 100 after one year at the
rate of 10%, the amount he will have to forgo at present is Rs. 90.90 at present.
Thus, it is present value of Rs. 100.
(1)
Discounting or Present Value of a Single Flow (Lump Sum): We can

determine the PV of a future cash flow using the formula:
n
PV = FV (1+i)

PV= Present Value
n = No. of years
Example : Mr. X expects to have an amount of Rs. 1000 after one year
what should be the amount he has to invest today if the bank if offering 10%
interest rate?
PV = 1000 (1+.10)
PV = Rs. 909.09
(2)
Present Value of a Series of Cash Flows : In a business situation, it is

very natural that returns received by a firm are spread over a number of
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years. To estimate the present value of future series of returns, the present
value of each expected inflow will be calculated.
C1
PV = +
1
(1+i)
C2
Cn
+ +
2
n
(1+i)
(1+i)
Where PV = Sum of individual present values of each cash flow

C1, C2, Cn = Cash flows after periods 1,2n
i= Discounting Rate
Example : Given the time value of money as 10% (i.e. the discounting
factor). You are required to find out the present value of future cash inflows that
will be received over next four years.
Year
Cash Flows
1
2
3
4
1000
2000
3000
4000
1000
PV = +
1
(1+.10)
2000
3000
4000
+ +
2
3
4
(1+.10)
(1+.10)
(1+.10)
= 909 + 1652 + 2253 + 2732

= Rs. 7546
(3)
Present Value of an Annuity : An investor may have an opportunity to

receive a constant periodic amount for a certain number of years. The
present value of an annuity can be found out by using the following
formula:
A1
A2
An
PVAn = + + ---------- +
1
2
n
(1+i)
(1+i)
(1+i)
PVAn = Present value of an annuity having a duration or n periods
A = Value of single installment
I = Rate of interest
Example : Calculate the present value of annuity of Rs. 500 received

annually for four years, when discounting factor is 10%.
500
500
500
500
PVAn = + + +
1
2
3
4
(1+.10) (1+.10)
(1+.10)
(1+.10)
PVAn = 454.50 + 413.50 + 375.50 + 341.50
PVAn = Rs. 1585
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UNIT II
Q.
What do you mean by Investment Decisions? What are the

importance and difficulties of Investment Decision?
Ans. Investment Decision : The most important function of financial

management is not only the procurement of external funds for the business but
also to make efficient and wise allocation of these funds. The allocation of funds
means the investment of funds in various assets and other activities. It is also
known as Investment Decision, because a choice is to be made regarding the
assets in which funds will be invested. The assets which can be acquired fall
into two broad categories:
(i) Short-term or Current Assets.
(ii) Long-term or Fixed Assets.
Accordingly, we have to take two types of investment decisions:
(1)
Short-term investment decisions : This type of investment decisions

related to the short-term assets. These decisions are also called current
assets management or Working Capital Management.
(2)
Long-term Investment Decisions Or Capital Budgeting Decisions :

This type of investment decisions related to long-term assets. These are
widely known as capital budgeting or capital expenditure decisions.
Capital Budgeting is the technique of making decisions for investment in longterm assets. It is a process of deciding whether or not to invest the funds in a
particular asset, the benefit of which will be available over a period of time
longer than one year.
Definition of Capital Budgeting :
According to Milton H. Spencer
Capital Budgeting involves the planning of expenditures for assets, the
returns from which will be realized in future time periods.
Features of Capital Budgeting Decisions :
1.
2.
3.
4.
Funds are invested in long-term assets.

Funds are invested in present times in anticipation of future profits.
The future profits will occur to the firm over a series of years.
Capital Budgeting decisions involve a high degree of risk because
future benefits are not certain.
Importance of Capital Budgeting Decision :

1.
Such Decision affect the profitability of the Firm : Capital Budgeting

decision affect the long-term profitability of a firm. They enable a firm to
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produce finished goods which is ultimately sold for profit. Hence, a correct
investment decision can yield large profits, whereas an incorrect decision
can endanger the very survival of the firm.
2.
Long-Term Effects : The consequence of capital expenditure decisions

extend far into the future. To illustrate, if a company purchases a new
plant to manufacture a new product, the company will have to incur a
sizable amount of fixed costs, in terms of labour, supervisors salary,
insurance, rent of building etc, If, in future, the product turns out to be
unsuccessful, the company will have to bear the burden of heavy fixed
costs.
3.
Irreversible Decision : Capital Budgeting decisions, once taken, are not

easily reversible without heavy financial loss to the firm.
4.
Involvement of Large Amount of Funds : Capital Budgeting decisions

require large amount of funds and most of the firm have limited financial
resources. Hence, it is absolutely necessary to take thoughtful and correct
investment decisions.
5.
Risk : Capital investment proposals have different degrees of risk.
6.
Most difficult to make : These decisions are among the most difficult
decisions to be taken by a firm. This is, because they require an
assessment of future events which are uncertain and difficult to predict.
Difficulties :
1.
Measurement Problems : Identifying and measuring the costs and

benefits of a capital expenditure proposals tend to be difficult. This is more
so when a capital expenditure has a bearing on some other activities of the
firm.
2.
Uncertainty : A capital expenditure decision involves costs and benefits

that extend fall into the future. It is impossible to predict exactly what will
happen in the future. Hence, there is usually a great deal of uncertainty
characterizing the cost and benefits of a capital expenditure decision.
3.
Temporal Spread : The costs and benefits associated with a capital

expenditure decision are spread out over a long period of time, usually 1020 years for industrial projects and 20-50 years for infrastructural
projects.
Q.
Explain the methods OR Techniques of Capital Budgeting?
Ans. Capital Budgeting : Capital Budgeting is the technique of making

decisions for investment in long-term assets. It is a process of deciding whether
or not to invest the funds in a particular asset, the benefit of which will be
available over a period of time longer than one year.
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Methods of Capital Budgeting : There are two criterias for capital

expenditure decisions:
(A) Accounting Profit Criteria
(B) Cash Flow Criteria
Techniques of Capital Budgeting
Accounting
Profit Criteria
1.Average Rate of
Return Method
Cash Flow Criteria

1. Non-Discounting
Methods
2. Discounting
Methods
(i)Pay Back Method
(i)Net Present Value Method

(ii)Profitability Index Method
(iii)Internal Rate of Return Method
(A)
Accounting Profit Criteria : Under accounting profit criteria, there is

only one method for making capital expenditure decisions. This method is
known as Average Rate of Return Method.
(1) Average Rate of return Method (ARR): This method is also known as
Accounting Rate of Return Method. It is based on accounting
information rather than cash flows. It is calculated as follows:
Average Annual Profits after Taxes
ARR = X 100
Average Investment
Total of after tax profits of all years
Average Annual Profits after Taxes =
Number of years
Original investment + Salvage value
Average Investment =
2
Accept-Reject Criteria :
If actual ARR is higher than the predetermined rate of return

.......................Project would be accepted.
If actual ARR is lower than the predetermined rate of return

.......................Project would be rejected.
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Merits of ARR :
(i) Simple : ARR method is very simple to understand and use.
(ii) Entire life time of the project is considered : ARR method uses the
entire profits earned during the life time of the project in calculating the
projects profitability.
Demerits of ARR :
(i) It uses accounting income rather than cash flows : The principal
shortcoming of ARR approach is that it uses accounting income
instead of cash flows received from a project. Cash profits are superior
than accounting income because cash profits can be reinvested during
the life of the project itself.
(ii) Time Value of money not considered : The second principal
shortcoming of ARR approach is that it does not take into account the
time value of money. Earning of all the years during the life time of the
project is given equal weightage under this method.
(iii)Difficult to Fix a Pre-Determined Rate : It is very difficult to fix a
pre-determined rate of return with which the actual ARR is compared.
(B)
Cash Flow Criteria : Cash flow criteria is based on cash flows rather
than accounting profit. Cash flow methods are divided into two sections:
(1)
Non-Discounting Methods : Under non-discounting methods only

method is included:
(i) Pay Back Method (PB) : The payback method is the simplest method.
This method calculates the number of years required to payback the
original investment in a project. There are two methods of calculating
the Payback Period:
First Method : This method is adopted when the project generates

equal cash inflow each year. In such a case payback period is
calculated as follows:
Investment
Payback Period (PB)=
Constant Annual Cash Flow
Second Method : This method is adopted when the project

generates unequal cash inflow each year. Under this method,
payback period is calculated by adding up the cash inflows till the
time they become equal to the original investment.
Formula :
Amount required to equalise the investment
PB = Completed Year +
Amount received during the period
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If the actual payback period is less than the predetermined payback

period ...................... Project would be accepted.
If the actual payback period is more than the predetermined

payback period ...................... Project would be rejected.
Merits of Pay Back Method :
(i) Simple : The most significant merit of this method is that it is simple
to understand and easy to calculate.
(ii) Appropriate for Firms Suffering from Liquidity : This method is
very appropriate for firms suffering from shortage of cash because
emphasis in this method is on quick recovery of the original
investment.
(iii)Appropriate in case of Uncertain Conditions : This method is very
suitable where the long term outlook is extremely uncertain and risky.
(iv) Importance to Short-Term Earnings : This method is beneficial for
firms which lay more emphasis on short-term earnings rather than the
long-term growth.
(v) Superior to ARR Method : It is superior to ARR method because it is
based on cash flow analysis.
Demerits of Pay Back Method :
(i) It ignores the Cash Flows After the Pay Back Period : The major
shortcoming of this method is that it completely ignores all cash
inflows after the pay back period.
(ii) It ignores the Time Value of Money : Another deficiency of the
payback method is that it ignores the time value of money. This method
treats a rupee received in the second or third year as valuable as a
rupee received in the first year.
(iii)It does not give the Accept-Reject Decision in case of single
project : If suppose the payback period is 4 years, the method does
not provide an answer as to whether the project will be accepted or
rejected.
(iv) It ignores cost of Capital : Cost of capital is not taken into
consideration under this method.
(v) It ignores the Profitability of a Project.
(2)
Discounting Methods : Under discounting methods we include:
(I)
Net Present Value (NPV) Method : This method measures the Present
value of returns per rupee invested. Under this method, present value of
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cash outflows and cash inflows is calculated and the present value of cash
outflow is subtracted from the present value of cash inflows. The
difference is called NPV.
NPV= PV of Inflow PV of Outflow
OR
st
nd
NPV = [(Cash inflow in 1 3 year x PVF ) + (Cash inflow in 2 year x PVF ) +(Cash
inflow in 3rdyear x PVF ) +(Cash
inflow in nth year X
0
PVFn)]
- [Initial cash outflow XstPVF ]
1
PVF2 = Present Value Factor in nd1 year
PVF = Present value factor in 2 year and so on.
If PVF is not given, we may calculate NPV as follows:
OR
st
nd
NPV = [Cash inflow in 1 year X 1/(1+r)

] + [Cash inflow in 2 year X 1/(1+r) ] +
3
[Cash inflow
in
3rd
year
X
1/(1+r)
]
+[Cash
inflow in nth year
n
0
X 1/(1+r) ] - [Initial Cash outflow X 1/(1+r) ]
If NPV is positive, the project may be accepted
If NPV is negative, the project may not be accepted.
If NPV is zero, the project may be accepted only if non-financial benefits

are there.
Merits of NPV method :
(i) Time value of money is taken into consideration : Because this
method takes into account the time value of money, it is the best
method to use for long range decisions.
(ii) Full Life of the project is taken into consideration : This method
takes into account the fall life of the project and not only the payback
period.
(iii)Wealth Maximisation : Wealth maximization object of the business
is achieved by this method. By accepting the project with highest NPV,
the wealth of the business is maximized.
Demerits of NPV :
(i) Difficult to Understand and Implement : This method is difficult to
understand as well as implement in comparison to the payback and
the ARR method.
(ii) Difficulty in fixing the required rate of return : Required rate or
discount rate is the most important in calculating the NPV because
different discount rates will give different present values.
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(iii)In case of two projects with unequal initial investment, this method
may not give satisfactory result.
(iv) In case of two projects with different lives, this method may not give
satisfactory result.
(II)
Profitability Index OR (PI) : Second method of evaluating a project

through discounted cash flows is profitability index method. This method
is also called Benefit-Cost Ratio.
This method is similar to NPV approach. A major drawback of the NPV
method was that it does not give satisfactory results while evaluating the
projects requiring different initial investments. PI method provides a
solution to this problem.
Present Value of Cash Inflows
PI =
Present Value of Cash Outflows
If PI is more than one, the project will be accepted
If PI is less than one, the project will be rejected.
If PI is one, project may be accepted only on the basis of non-financial

considerations.
Merits of PI method :
(i) Like the other DCF techniques, the PI method also takes into account
the time value of money.
(ii) It considers all cash flows during the life-time of the project
(iii)PI method is a reliable method in comparison to the NPV method when
the initial investment in various projects are different.
Demerits of PI method :
(i) This method is difficult to understand and implement
(ii) Calculations under this method are complex.
(III) Internal Rate of return Method (IRR) : IRR method is also known as
time adjusted rate of return, marginal efficiency of capital, marginal
productivity of capital and yield on investment.
Like the NPV method the IRR method also takes into consideration the
time value of money by discounting the cash flows. IRR is the discount rate
at which present value of cash inflows is equal to the present value of cash
outflows.
Procedure to Find Out IRR :
Step I : Calculate the fake payback period

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Initial Cash Outflows

Fake Payback Period =
Average Cash Inflows
Total Cash Inflows during the life of the project
Average Cash Inflows =
Number of year of life
Step II : Locate the closest figure to fake payback period in the annuity
table A-2 against the row of number of years of the project. The rate of that
column will be the first discount rate.
Step III : Find the NPV of the project at the first discount rate located
above. If NPV is positive, determine one more discount rate which should
be higher than the first discount rate so that the second NPV may be
negative. Similarly, If NPV from first discount rate located above is
negative, determine second rate lower than the first rate so that second
NPV may be positive. Now there are two NPVs at two different rates, one is
positive and other is negative.
Step IV: Now, apply the following formula to find IRR:

NPV at lower discount rate
IRR = Lower discount rate + X Difference in discount rate
NPV at lower discount rate NPV at higher discount rate
Merits of IRR Method :
(i)
Like the other DCF methods, IRR methods also take into consideration the
time value of money.
(ii) It takes into account all cash inflows and outflows occurring over the
entire life time of the project.
(iii) Although the calculation of IRR involves tedious calculation, its meaning
is easier to understand in comparison to the concept of NPV.
Demerits of IRR Method :
(i)
(ii)
Calculation of IRR involves tedious calculations.

Sometimes, this method produces more than one IRR. In such a case, it
becomes difficult to accept or reject the proposal.
(iii) It is assumed under the IRR method that all cash inflows of the project are
reinvested at IRR rate. This assumption is not valid.
Q.
What do you mean by Risk Analysis in Capital Budgeting? Explain the

Risk Adjusted Discount Rate Method.
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Ans. Risk Analysis : Risk in an investment refers to the variability that is

likely to observed between the estimated returns and the actual returns form
the proposal. The greater is the variability between the two returns, the more is
the risk involved in the project, and vice versa.
Incorporation of the Risk in Investment Proposal : As stated earlier, risk is
involved in every capital budgeting decision. As risk is involved in every capital
budgeting proposal, the management of a firm must take the risk factor into
account, while determining the returns or cash inflows and the profitability of a
project for the purpose of capital budgeting.
Techniques used for Incorporation of Risk Factor in
Capital Budgeting Decision
General Techniques
Risk Adjusted
Discount Rate
Methods
Certainly
Equivalent
Coefficient
Method
Quantitative Techniques
Sensitivity
Analysis
Standard
Deviation
Decisio
Tree
Risk Adjusted Discount Rate Method :

Meaning : Under the risk adjusted discount rate method, the future cash flow
from capital projects are discount at the risk adjusted discount rate and
decision regarding the selection of a project is made on the basis of the net
present value of the project computed at the risk adjusted discount rate.
The risk adjusted discount rate is based on the assumption that investors
expect a higher rate of return on more risky projects and a lower rate of return
on less risky projects, and so, a higher discount rate is used for discounting the
cash flows of more risky project and a lower discount rate is used for
discounting the cash flows of less risky project.
The risk adjusted discount rate comprises two rates, viz.,
(i) Risk-free rate : Risk free rate is the normal rate or the usual discount
rate that takes care of time element and
(ii) Risk Premium Rate : Risk Premium Rate is the surplus rate or extra
rate that takes care of the risk factor.
So, the risk adjusted discount rate is the usual or normal discount rate for the
time factor plus the extra or additional discount rate.
Merits :
(1)
It is easy to understand and simple to calculate.

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(2)
(3)
The risk premium rate included in the risk adjusted rate takes care of the
risk element in the future cash flows of the project.
It takes into account the risk averse attitude of investors.
Demerits :
(1)
The risk premium rates, determined under this method, are arbitrary. SO
this method may not give objective results.
(2)
Under this method, the risk is compounded over time, since the risk
premium is added to the discount rate. Which means, this method
presumes that risk necessarily increases with the passage of time. But
this may not happen in all situations or cases.
(3)
This method presumes that investors are averse to risk I i.e., investors
avoid facing risk). This may not be true in all cases. There are many
investors who would like to take risk and are prepared to pay premium for
taking risk.
Example : From the following date, state which project is preferable:
Year
Project A
Project B
60000
80000
50000
60000
40000
50000
120000
120000
Initial Cost of
the Project1
Riskless discount rate is 5%. Project A is less risky as compared to project B

and so, the management considers risk premium rates at 5% and 10%
respectively as appropriate for discounting the cash inflow.
The discount factors at 10% and 15% are:
Year
10%
15%
0.909
0.876
0.826
0.756
0.751
0.650
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Solution :
First Step : Calculation of Risk-Adjusted Discount Rate
For Project A:
Riskless Discount Rate
And Risk-Premium Rate
Risk Adjusted Discount Rate
5%
5%
10%
For Project B:
Riskless Discount Rate
And Risk-Premium Rate
Risk Adjusted Discount Rate
5%
10%
15%
Second Step : Calculation of Discounted Cash Inflows ( i.e, Present Value

and Net Present Value of the Projects)
Year
Project A
Discounted Cash Inflows at 10%
Cash
Inflows
(Rs)
Project B
Discount Present Value

Cash
Factor
(Rs.)
Inflows
10%
(Cash Inflow x
(Rs.)
Discount Factor)
Discount Present Value

Factor
(Rs.)
15%
(Cash Inflow x
DiscountFactor)
1 60000
.909
54540
80000
.876
70080
2 50000
.826
41300
60000
.756
45360
3 40000
.751
30040
50000
.650
32500
PV of Cash Inflow
125880
Less: PV of Cash Outflow 120000
Net Present Value
5880
147940
120000
27940
Comments : The Net Present Value of Project B is higher than that of Project
A. So Project B is Preferable.
Q.
Explain the Certainty Equivalent Coefficient Method.
Ans. Introduction : Certainty equivalent coefficient method which makes

adjustment against risk in the estimates of future cash inflows for a risky
capital investment project.
Under this method, adjustment against risk is made in the estimates of future
cash inflows of a risky capital project by adjusting to a conservative level of the
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estimated cash flows of a capital investment proposal by applying a correlation

factor termed as certainty equivalent coefficient.
Formula for Calculating Certainty Equivalent Coefficient : The certainty
equivalent coefficient is the ratio of riskless cash flow to risky cash flow. The
certainty equivalent coefficient can be calculated with the help of the following
formula:
Riskless Cash Flow
Certainty Equivalent Coefficient =
Risky Cash Flow
(1)
Riskless Cash Flow : Riskless cash flow means the cash flow which the
management expects, when there is no risk in investment proposal.
(2)
Risky Cash Flow : Risky cash flow means the cash flow which the
management expects when there is risk in investment proposal.
Example : Suppose the risky cash flow is Rs. 200000 and the riskless
cash flow is Rs. 140000.
140000
The Certainty Equivalent Coefficient = = 0.7
200000
Steps Involved in Certainty Equivalent Coefficient Method : The various
steps involved in the certainty equivalent coefficient method are:
(1)
First Step : Firstly, the certainty equivalent coefficient has to be

calculated for each year of a project.
(2)
Second Step : Secondly, the risk-adjusted cash flow of a project for each
year has to be calculated. The risk-adjusted cash flow of a year can be
Risk-Adjusted Cash Flow = Estimated Cash flow for the year X Certainty
Equivalent Coefficient
(3)
Third Step : Thirdly, we have to find out the present value of the capital
project. The present value of the Capital Project can be found by adopting
the following procedure. First, the risk-adjusted cash flow for each year
should be multiplied by the present value factor or discount factor
applicable to that year to get the present value of the risk-adjusted cash
flow of each year.
(4)
Fourth Step : Fourthly, we have to ascertain the net present value of the
project. The net present value of the project will be:
Present Value of the Project
Less: Initial Investment on the Project
Net Present Value of the Project
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(5)
Fifth Step : After the NPV of a project is computed, decision is taken as

to the selection of the project. The selection of a project, is , usually made
on the following line:
(i) Generally, a project becomes acceptable, if it has a positive NPV
(ii) If there are two or more mutually exclusive projects, generally, the
project whose NPV is higher or highest is selected.
Example : Two mutually exclusive investment proposals, X and Y under

consideration before the management of a company. The initial outlay of each
project is Rs. 30000. Both the projects are estimated to have a useful economic
life span of 5 years. The estimates of cash inflows and their certainty equivalent
coefficients are as follows:
Year
Project X
Project Y
Estimated Cash Flows
C.E.C Estimated Cash Flows
C.E.C.
25000
0.7
30000
0.6
30000
0.5
35000
0.5
20000
0.4
25000
0.4
15000
0.3
12000
0.2
10000
0.2
10000
0.1
The cost of capital for the company is 15%.

Compare the NPV of the two projects and suggest which project should be
accepted by the management.
The present value factor at 15% is:
Year
30
Present Value Factor at 15%

Or Discount Factor
0.870
0.750
0.658
0.572
0.497
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Solution :
Computation of the NPV of the Project X :
Year
Estimated cash
Flows
Certainty
Equivalent
Coefficient
Risk Adjusted
Cash Flows
Discount Present
Factor
Velue
10%
25000
0.7
17500
0.870
15225
30000
0.5
15000
0.756
11340
20000
0.4
8000
0.658
5264
15000
0.3
4500
0.572
2574
10000
0.2
2000
0.497
994

Less: PV of Cash Outflow
NPV of Project X
35397
30000
5397
Computation of the NPV of Project Y:

Year
Estimated cash
Flows
Certainty
Equivalent
Coefficient
Risk Adjusted
Cash Flows
30000
0.6
18000
0.870
15660
35000
0.5
17500
0.756
13230
25000
0.4
10000
0.658
6580
12000
0.2
2400
0.572
1373
10000
0.1
1000
0.497
497

Less: PV of Cash Outflow
NPV of Project Y
Discount Present
Factor
Velue
10%
37340
30000
7340
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Comments : Both the projects have positive net present value. So, both are
acceptable.
However, the Net Present Value (NPV) of project Y is more than that of Project X.
That means, Project Y is preferable.
Q.
What do you mean by Cost of Capital? What is its significance and

what are the problems in determination of cost of capital?
Ans. Meaning of Cost of Capital : Cost of capital of a firm is the minimum rate
of return expected by its investors. The capital used by a firm may be in the
form of equity shares, preference shares, debts and retained earnings. The cost
of capital is the weighted average cost of these sources of finance used by the
firms. The concept of cost of capital occupies a very important role in financial
management because the investment decisions are based on it.
Definition :
According to Milton H. Spencer
The cost of capital is the minimum rate of return which a firm requires as
a condition for undertaking an investment.
According to M.J. Gordon
The cost of capital is the rate of return a company must earn on an
investment to maintain the value of the company.
Significance of the Cost of Capital :
(1)
Helpful in Designing the Capital Structure : The concept of cost of

capital plays a vital role in designing the capital structure of a company.
Capital structure of a company is the ratio of debt and equity. These
sources differ from each other in terms of their respective costs. As such a
company will have to design such a capital structure which minimizes
cost of capital.
(2)
Helpful in taking capital Budgeting Decisions : Capital budgeting is

the process of decision making regarding the investment of funds in long
term projects of the company. The concept of cost of capital is very useful
in making capital budgeting decisions because cost of capital is the
minimum required rate of return on an investment project.
(3)
Helpful in evaluation of financial efficiency of top management

:Concept of cost of capital can be used to evaluate the financial efficiency
of top management. Such an evaluation will involve a comparison of
projected overall cost of capital with the actual cost of capital incurred by
the management. Lower the actual cost of capital is the better financial
performance of the management of the firm.
(4)
Helpful in comparative analysis of various sources of finance : Cost of

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capital to be raised from various sources goes on changing from time to

time. Calculation of cost of capital is helpful in analysis of usefulness of
various sources of finance.
(5)
Helpful in taking other financial decisions : The cost of capital concept

is also useful in making other financial decisions such as:
Dividend Policy
Right Issue
Working Capital Decisions
Capitalisation of profits.
Problems in Determination of Cost of Capital :

1.
Historic Cost and Future Cost : One major problem in the

determination of cost of capital arises due to difference of opinion
regarding the concept of cost itself. It is argued that book costs are historic
costs and the calculation of cost of capital on the basis of such costs is
irrelevant for decision making.
2.
Problems in Computation of Cost of Equity : The computation of cost

of equity capital depends upon the rate of return expected by equity
shareholders. But it is very difficult to assess the expectation of equity
shareholders because there are many factors which influence their
expectations.
3.
Problems in computation of cost of retained earnings : Sometimes it

may appear that retained earning are free of cost because they have not
been raised from outside.
4.
Problems in Assigning Weights : Weights have to be assigned to various

sources of finance to compute the weighted average cost of capital. The
choice of using the book value weights or market value weights places
another problem in the computation of cost of capital.
Q.
How will you determine the cost of capital from different sources?
Ans. Meaning of Cost of Capital : Cost of capital of a firm is the minimum rate
of return expected by its investors. The capital used by a firm may be in the
form of equity shares, preference shares, debts and retained earnings. The cost
of capital is the weighted average cost of these sources of finance used by the
firms. The concept of cost of capital occupies a very important role in financial
management because the investment decisions are based on it.
Computation of Cost of Capital : Computation of cost of capital includes:
(A) Computation of cost of specific sources of finance
(B) Computation of weighted average cost of capital
Computation of Cost of Specific Sources of Finance : It includes:
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(1)
Cost of Debt : A company may raise the debt in a number of ways. It may
borrow funds from the financial institutions or public either in the form of
public deposits or debentures for a specified period of time at a specified
rate of interest. A debenture or bond may be issued at par, at a discount or
at a premium.
Debt may either be irredeemable or redeemable after a certain period.
(i) Cost of Irredeemable Debt :
Cost of Irredeemable Debt, before tax : Formula for calculating

cost of debt before tax is:
I
Kdb = X 100
NP
Kdb
I
NP
= Cost of debt before tax

= Annual Interest Charges
= Net Proceeds from the issue of Debt
Cost of Irredeemable Debt, after tax : When a company uses debt

as a source of finance then it saves a considerable amount in payment of tax
because the amount of interest paid on the debts is a deductible expense in
computation of tax. Formula for calculating cost of debt after tax is:
I
Kda = X 100 (1-t)
NP
Kda
I
NP
t
=
=
=
=
Cost of debt after tax

Annual Interest Charges
Net Proceeds from the issue of Debt
Rate of Tax
(ii) Cost of redeemable Debt : Normally a company issues a debt which

is redeemable after a certain period during its life-time. Such a debt is
termed as Redeemable Debt. Cost of redeemable debt may also be
calculated before tax and after tax:
Cost of Redeemable Debt, before tax :

1
I + (RV NP)
n
Kdb = X 100
1
(RV +NP)
2
Kdb
I
34
= Cost of debt before tax

= Annual Interest Charges
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NP
n
RV
= Net Proceeds from the issue of Debt

= Number of years in which debt is to be redeemed
= Redeemable Value of Debt redeemed.
Cost of Redeemable Debt, after tax :

1
I + (RV NP)
n
Kda = X 100 (1-t)
1
(RV +NP)
2
K = Cost of debt before tax
I = Annual Interest Charges
NP= Net Proceeds from the issue of Debt
n = Number of years in which debt is to be redeemed
RV = Redeemable Value of Debt
t = Rate of Tax
db
(2) Cost of Preference Share Capital : A fixed rate of dividend is payable on

preference shares. But, unlike debt, the dividend is payable at the discretion of
the Board of Directors and there is no legal binding to pay the dividend.
Preference Shares may either be irredeemable or redeemable after a certain
period.
(i)
Cost of Irredeemable Preference Share Capital :

Formula for
calculating cost of Irredeemable Preference Share Capital is:
D
KP = X 100
NP
K
D
NP
P
(ii)
= Cost of Irredeemable Preference Share Capital

= Annual Preference Dividend
= Net Proceeds of Preference Share Capital
Cost of Redeemable Preference Share Capital :

Redeemable
preference capital has to be returned to the preference shareholders after
a stipulated period. The cost of redeemable preference share capital is
1
D + (RV NP)
n
Kpr = X 100
1
(RV +NP)
2
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Kpr
D
NP
n
RV
=
=
=
=
=
Cost of Redeemable Preference Capital

Annual Preference Dividend
Net Proceeds of Preference Share Capital
Number of years
Redeemable Value of Preference Share Capital
(3) Cost of Equity Share Capital : The cost of equity is the maximum rate
of return that the company must earn on equity financed position of its
investments in order to leave unchanged the market price of its stock. The cost
of equity capital is a function of the expected return by its investors. The cost of
equity share capital can be computed in the following ways:
(i)
Dividend Yield Method : This method is based on the assumption that

when an investor invests in the equity shares of a company he expects to
get a payment at least equal to the rate of return prevailing in the market.
The equation is:
DPS
Ke = X 100
MP
Ke
DPS
MP
(ii)
= Cost of Equity Capital

= Dividend Per Share
= Market Price Per Share
Dividend Yield Plus Growth in Dividend Method : This method is used

to compute the cost of equity capital when the dividends of a firm are
expected to grow at a constant rate.
DPS
Ke = X 100 + G
MP
Ke
DPS
MP
G
=
=
=
=
Cost of Equity Capital

Dividend Per Share
Market Price Per Share
Rate of growth in Dividend
(iii) Earning Yield Method : As per this method, cost of equity capital is
calculated by establishing a relationship between earning per share and
the current market price of the share. The equation is :
EPS
Ke = X 100
MP
Ke
EPS
36

= Earning Per Share
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MP
= Market Price Per Share
(iv) Earning Yield plus Growth in Earning Method : If the EPS of a company
is expected to grow at a constant rate of growth, the cost of equity capital
can be computed as follows:
EPS
Ke = X 100 + G
MP
Ke
EPS
MP
G
=
=
=
=
Cost of Equity Capital

Earning Per Share
Market Price Per Share
Rate of growth in EPS
(4)
Cost of Retained Earnings : It is sometimes argued that retained
earnings carry no cost since a firm is not required to pay dividend on retained
earnings. However, this is not true. Though retained earnings do not have any
explicit cost to the firm but they involve an opportunity cost. The cost of
retained earning can be calculated as follows:
Kr
Where Kr
Ke
Q.
= Ke (1-Percentage Brokerage or Flotation Cost)

= Cost of Retained Earnings
What is meant by weighted average cost of capital OR Composite ?

How is it computed? Illustrate with an example.
Ans. Weighted Average Cost of Capital : Capital structure of a company

consists of different sources of capital. Cost of these different sources of capital
is also calculated by different methods. Hence, after the calculation of cost of
capital of these different sources of capital a practical difficulty arise as to what
is the cost of overall capital structure of the firm. In order to solve this problem
finance managers developed the concept of Weighted Average Cost of capital. It
is also known as Composite Cost or Overall Cost.
Computation of Weighted Average Cost of Capital : The computation of
weighted cost of capital involves the following steps:
(i) Compute the cost of each source of funds.
(ii) Assign weights to specific costs
(iii)Multiply the cost of each of the sources by the assigned weights
(iv) Divide the total weighted cost by the total weights
Formula :
S
XW
Kw =
S
W
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Kw
X
W
= Weighted Average Cost of Capital

= Cost of specific source of finance
= Weight of specific source of finance.
Assignment of Weights :
For computing weighted average cost of capital, it is necessary to
determine the proportion of each source of finance in the total capitalization.
For this purpose weights will have to be assigned to various sources of finance.
Weights may be assigned by any of the following methods:
(i) Book Value Weights
(i)
(ii) Market Value Weights
Book Value Weights : Book value weights are computed form the values
taken from the balance sheet. The weight to be assigned to each source of
finance is the book value of that source of finance divided by the book
value of total sources of finance.
Advantages of Book Value Weights:
Book values are readily available from the published records pf the
firm.
Book value weights are more realistic because the firms set their
capital structure targets in terms of book values rather than market
values.
Book value weights are not affected by the fluctuations in the capital
market.
In the case of those companies whose securities are not listed, only
book value weights can be used.
Limitations of Book Value Weights :
The costs of various sources of finance are calculated using prevailing

market prices. Hence weights should also be assigned according to
market values.
The present economic values of various sources of capital may be

totally different from their book values.
(ii)
Market Value Weights : As per market value scheme of weighting, the

weights to different sources of finance are assigned on the basis of their
market values.
Advantages of Market Value Weights :
The costs of various sources of finance are calculated using prevailing

market prices. Hence, it is proper to use market value weights
Weights assigned according to market values of the sources of finance

represent the true economic values of various sources of finance.
Limitations of Market Value Weights :
Market value weights may not be available as securities of all the

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companies are not actively traded.
It is very difficult to use market value weights because the market prices of
securities fluctuate widely and frequently.
Example :
A companys after tax specific cost of capital are as follows:
Cost of debt
Cost of Preference Shares
Cost of Equity Shares
10%
12%
15%
The following is the capital structure:

Source
Debt
Amount
3,00,000
2,00,000
5,00,000
____________
10,00,000
____________
Calculate the weighted average cost of capital, K
Computation of Weighted Average Cost of Capital using Book Value Weights :

Sources of
Funds (1)
Book Value
Rs. (2)
Debt
3,00,000
Preference
Share Capital
Proportion or
Weight (3)
Cost (%)
(4)
Weighted
Cost (5)
=(3x4)
.3
10
3.0
2,00,000
.2
12
2.4
Equity
Share Capital
5,00,000
.5
15
7.5
Total
10,00,000
1.00
12.9
The weighted average cost using book value weights is 12.9%
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UNIT III
Q.
Define leverage? Explain its types & Utility.
Ans. Meaning of Leverage : The dictionary meaning of the term leverage

refers to an increased means of accomplishing some purpose. For example,
leverage helps us in lifting heavy objects which may not be otherwise possible.
However, in the area of finance it is used to describes the firms ability to used
fixed cost assets or funds to magnify the returns to its owners.
Leverage can be define as the employment of an assets or fund for which
the firms pays a fixed cost or fixed return thus according to him, leverage result
as a result of the firm employing an assets or source of funds which has a fixed
cost or return. The former may be termed as fixed operating cost while the
latter may be termed as fixed financial cost. It should be noted that fixed cost
or return is the fulcrum of leverage. If a firm is not required to pay fixed cost or
fixed return, there will be no leverage.
A high degree of leverage implies that there will be a large change in the
profits due to relatively small change in sales and vice- versa. Thus, the higher
is the leverage, the higher is the risk and higher is the expected return.
Types of Leverage : Leverage are of two types :
(1)
(2)
(1)
Operating Leverage
Financial Leverage
Operating Leverage : The operating leverage may be defined as the

tendency of the operating profit to vary disproportional with sales. It is
said to exist when a firm has to pay fixed cost regardless of volume of
output or sales. The firm is said to have a high degree of operating leverage
if it employs a greater amount of fixed cost and a smaller amount of
variable cost. On the other hand, a firm will have a low operating leverage
when it employs a greater amount of variable cost and a smaller amount of
fixed cost. Thus, the degree of operating leverage depends upon the
amount of fixed element in the cost structure.
Operating leverage in the firm is a function of three factors :

(a)
(b)
(c)
The amount of fixed cost

The contribution margin
The volume of sales
Formulae :
Operating leverage
40
Contribution
=
Operating profit
or
C_
OP
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Utility : The operating leverage indicates the impact of change in sales on

operating income. If a firm has a high degree of operating leverage, small
changes in sales will have large effect on operating income. In other words, the
operating profit (EBIT) of such firm will increase at a faster rate than the
increase in sales.
Similarly, the operating profit of such a firm will suffer a great loss as compared
to reduction in its sales.
(2)
Financial Leverage : The financial leverage may be defined as the

tendency of the residual net profit to vary disproportionately with
operating profit. It indicates the change that take place in the taxable
income as a result of change in the operating income. It signifies the
existence of fixed interest/ fixed dividend bearing securities in the total
capital structure of the company. Thus the use of fixed interest/ dividend
bearing securities such as debt & capital preference along with the
owners equity in the total owner capital structure of the company is
described as financial leverage. Where in capital structure of the
company, the fixed interest /dividend bearing securities are greater as
compared to the equity capital, the leverage is said to be larger. In the
reverse case the leverage will be said to be smaller.
Favorable and Unfavorable financial leverage : Financial leverage may
be favorable or unfavorable upon whether the earning made by the use of
fixed interest or dividend bearing securities exceed the or not explicit the
fixed cost, the firm has to pay for the employment of such funds. The
leverage will be considered to be favorable so long the firm earns more on
assets purchased with the funds than the fixed cost of there use
unfavorable or negative leverage occurs when the firm does not earns as
much as the fund cost.
Financial leverage is also termed as trading on equity. The company
resorts to trading on equity with the objective of giving the equity
shareholders higher rate of return than the general rate of earning on
capital employed in the company to compensate them for the risk that
they have to bear. For example If a company borrows Rs. 100 @ 10% P.a.
and earns a return for 12%, the balance 4% p.a. after payment of interest
belongs to the shareholders and thus they can be paid a higher rate of
return than the general rate of earning of company. But in case company
could earn a return of only 6% on Rs. 100 employed by it, the equity
shareholders loss will be Rs. 2 p.a. Thus, the financial leverage is a double
edged sword. It has the potentially of increasing the return to equity
shareholders.
Earning before tax and Interest
Formulae :
Financial leverage =
Profit before tax but after interest
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Alternative definition of financial leverage : One of the objectives of

planning an appropriate capital structure is to maximize the return on equity
shareholders fund or maximize the earning per share. Some authorities have
used the term financial leverage in the context that it defines the relationship
between EBIT and EPS. According to Gitman financial leverage is the ability
of a firm to use fixed financial charges to magnify the effects of change in EBIT
on the firms earning per share. The financial leverage, therefore indicate the
percentage change in earning per share in relation to a percentage change in
EBIT. The degree of financial leverage can be written as follows:
Percentage change in EPS
Degree of financial leverage =
(DFL)
Percentage change in EBIT
Utility : Financial leverage helps considerably the financial manager while
devising the capital structure of the company. A high financial leverage means
high fixed financial manager must plan the capital structure in a way that the
firm is in a position to meet its fixed financial costs. Increase in fixed financial
costs requires necessary increase in EBIT level. In the event of failure to do so,
the company may be technically forced into liquidation.
Q.
Explain Net Income Approach (NI) to Capital Structure.
Ans. Net Income Approach : According to the Net Income Approach, as

suggested by Durand, the capital structure decision is relevant for the
valuation of the firm. In other words, a change in the financial leverage (the
ratio of debt to equity) will lead to a corresponding change in the value of the
firm as well as the overall cost of capital.
According to this approach:
(i)
(ii)
If the ratio if debt to equity is increase, the cost of capital will decline, while
the value of the firm as well as the market price of equity shares will
increase.
A decrease in the ratio of debt to equity will cause an increase in the overall
cost of capital and a decline both in the value of the firm as well as the
market price of equity shares.
Hence a firm can minimize the cost of capital and increase the value of the
firm as well as market price of its equity shares by using debt financing to the
maximum possible extent.
Assumptions : Net Income Approach is based upon the following
assumptions:
(i) The cost of debt is lower than the cost of equity.
(ii) There are no corporate or personal income taxes.
(iii)Use of debt does not change the risk perception of investors.
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Explanation :
(i)
Net Income approach says that an increase in the proportion of debt

financing in capital structure results in an increase in the proportion of a
cheaper source of funds. This, in turn, results in the decrease in overall
cost of capital leading to an increase in the value of the firm. The main
reasons are:
The assumption of cost of debt to be less than the cost of equity.
The interest on debt is a deductible expense, when the company gets

the tax benefits on it.
(ii)
With a judicious mixture of debt and equity, a firm can evolve an optimum
capital structure which will be the one at which the overall cost of capital is
lowest and market value of the firm is highest. At that structure, the
market price per share would be maximum.
% Rate of cost of capital
Graphic Presentation of Net Income Approach : Net Income approach is

explained graphically as follows:
Y
Ke
Ko
Kd
Degree of Leverage
In the above figure, the degree of leverage is plotted along the X-axis, while the
percentage rate of cost of capital is shown on Y-axis. The figure shows that K
and Kd remain unchanged. But as the degree of leverage increases, cost of
capital Ko decreases. K however cannot touch K as there cannot be all debt
firm. The optimal capital structure is one at which K is nearest to K . At this
level, the firms overall cost of capital would be lowest and the market value of
the firm and market value per share is highest.
e
Basic Terms :
EBIT
B
NI
Ko
=
=
=
=
Earnings before Interest and Tax

Value of Debt
Net Income
Overall Cost of Capital
S
V
Kd
K
e
=
=
=
=
Value of Equity
Value of firm
Cost of Debt
Cost of Equity
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Basic Formulas :
V
= S+B
NI = EBIT - Interest
EBIT
=
V
NI
S =
K
Example :
EBIT
10% Debentures
K
e
= Rs. 50,000
= Rs. 2,00,000
= 12.5%
Solution :
(a)
Calculation of Value of the Firm (V) & Overall Cost of Capital :

NI
= EBIT Interest
= 50,000 - 20,000 = 30,000
10
Interest = 2,00,000 x = 20,000
100
NI
30,000
30,000
Value of Equity (S) = = = X 100 = 2,40,000
K
12.5 %
12.5
e
Value of Debt
= 2,00,000
Value of Equity
= 2,40,000
Value of the Firm = S + B
= 2,40,000 + 2,00,000
= 4,40,000
Calculation of Overall Cost Of Capital :

EBIT
K = X 100
V
o
Value of the Firm

(b)
50,000
= X 100 = 11.36%
4,40,000
= 4,40,000
= 11.36%
Calculation of Value of the Firm (V) & Overall Cost of Capital, When
debt is raised to Rs, 3,00,000
When the debt is raised to Rs. 3,00,000, Then Value of Firm :
NI
44
= EBIT Interest
= 50,000 - 30,000 = 20,000

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10
Interest = 3,00,000 x
100
= 30,000
20,000
20,000
Value of Equity (S) = = X 100 = 1,60,000
12.5 %
12.5
Value of Equity (S) = 1,60,000
Value of Debt = 3,00,000
= 1,60,000 + 3,00,000
= 4,60,000
Calculation of Overall Cost Of Capital

EBIT
Ko = X 100
V
50,000
= X 100
4,60,000
= 10.87%
Value of The Firm = 4,60,000

Overall Cost of Capital = 10.87%
Thus, the use of additional debt has caused the total value of the
firm to increase and the overall cost of capitalto decrease.
(c) Calculation of Value of the Firm (V) & Overall Cost of Capital, When
debt is lowered to Rs, 1,00,000
When the debt is lowered to Rs. 1,00,000 , then Value of Firm:
NI
= EBIT Interest
= 50,000 - 10,000 = 40,000
10
Interest = 1,00,000 x = 10,000
100
40,000
Value of Equity (S) =
12.5 %
Value of Equity (S) = 3,20,000
40,000
= X 100 = 3,20,000
12.5
Value of Debt = 1,00,000
= 3,20,000 + 1,00,000
= 4,20,000

EBIT
K = X 100
V
o
50,000
= X 100
4,20,000
= 11.90%
Value of the Firm = 4,20,00

Thus, we find that the decrease in leverage has increase the
overall cost of capital and has reduced the value of the firm.
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Criticism of Net Income Approach:

(i) Wrong assumption of no corporate taxes.
(ii) Wrong assumption of constant equity capitalization rate.
(iii)Wrong assumption of constant debt capitalization rate.
(iv) Wrong assumption of constant risk perception.
Q.
Explain Net Operating Income Approach (NOI) to Capital Structure.
Ans: Net Operating Income Approach (NOI) : This is another theory of

capital structure which is propounded by Durand and is just opposite to Net
Income Approach. The essence of this approach is that the capital structure
decision of a firm is irrelevant. Any change in leverage will not lead to any
change in total value of the firm. It means that the overall cost of capital would
remain same whether the debt-equity mix is 50:50 or 30: 70 or 60:40. Thus,
the total value of the firm, the market price of shares as well as the overall cost
of capital is independent of the degree of leverage.
Assumptions of NOI Approach :
(i) The cost of debt is lower than the cost of equity
(ii) There are nor corporate or personal income taxes.
(iii)The business risk remains constant at every level of debt & equity.
Explanation :
(i)
The Net Operating Income approach advocates that the cost of equity
increases with the increase in the financial leverage. This is due to
increased risk assumed by the equity shareholders due to the use of more
debt by the firm. To compensate for increased risk, shareholders would
expect a higher rate of return on their investments.
(ii)
Therefore, the advantage of using the cheaper source of funds, i.e. the debt
is exactly offset by the increased cost of equity. Consequently, the overall
cost of capital remains constant at all degrees of financial leverage. Since
the value of the firm is measured as a whole on the basis of overall cost of
capital and since the overall cost of capital remains constant, the value of
the firm also remains same at all degrees of financial leverage.
Graphic Presentation of Net Operating Income Approach : Net Operating

Income approach is explained graphically as follows:
% Rate of cost
of capital
Ke
Ko
Kd
Degree of
Leverage
X
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K = Cost of Equity
K = Cost of debt
K = Overall cost of capital
e
In the above figure, the degree of leverage is plotted along the X-axis, while
the percentage rate of cost of capital is shown on Y-axis. The figure shows that
K and K remain unchanged. as the degree of leverage is increased. But with
the increase in the leverage the cost of equity rises in such a manner so as to
offset the advantage of using cheaper debt. As a result, K and the value of firm
(V) remain unchanged by the increase in the financial leverage.
d
Basic Terms :
EBIT
B
NI
Ko
=
=
=
=
Earnings before Interest and Tax

Value of Debt
Net Income
S
V
Kd
K
e
=
=
=
=
Value of Equity
Value of firm
Cost of Debt
Cost of Equity
Basic Formulas :
V
= S+B
EBIT
V =
K
o
NI = EBIT Interest
EBIT -I
Ke = X 100
S
EBIT
Ko = X 100
V
Example :
EBIT
= 50,000
10% Debentures
= 2,00000
Overall Cost of Capital (K ) = 12.5%
o
Solution :
(a)
Calculation of Value of the Firm :

EBIT = 50,000
EBIT
V =
Ko
V=S+B
Ko = 12.5%
50,000
=
12.5%
S = V-B
50,000
= X 100 = 4,00,000
12.5
S = 4,00,000 2,00,000 = 2,00,000
50,000 -20,000
Ke = X 100
2,00,000
= 15%
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EBIT
Ko = X 100
V
50,000
K = X 100
4,00,000
= 12.5%
(b) Calculation of Value of the Firm (V) & Overall Cost of Capital, When
debt is raised to Rs, 3,00,000
EBIT = 50,000
Ko = 12.5%
50,000
V = = 4,00,000
12,5%
Value of the firm = 4,00,000
S = 4,00,000- 3,00,000 = 1,00,000
Value of Equity = 1,00,000
50,000 -30,000
Ke = X 100 = 20%
1,00,000
Cost of Equity = 20%

EBIT
Ko = X 100
50,000
= X 100
= 12.5%
4,00,000

Thus, the value of the firm and overall cost of capital remains
unchanged but the cost of equity increases
(c)
Calculation of Value of the Firm (V) & Overall Cost of Capital, When
debt is lowered to Rs, 1,00,000
48
EBIT = 50,000
Ko = 12.5%
50,000
V = = 4,00,000
12,5%
Value of the firm = 4,00,000
S = 4,00,000- 1,00,000 = 3,00,000
Value of Equity = 3,00,000
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50,000 -10,000
Ke = X 100 = 13.33% Cost of Equity = 3.33%
3,00,000
EBIT
Ko = X 100
V
50,000
= = 12.5%
4,00,000

Thus, the value of the firm and overall cost of capital
remains unchanged but the cost of equity decreased.
Criticism :
(i) Irrelevant assumption of constant NOI.
(ii) Wrong assumption of constant interest rate.
(iii)Wrong assumption of business risk.
Q.
What is Traditional Approach of capital Structure? Explain its

various stages.
Ans. Traditional Approach : The traditional approach establishes a midway

between the Net Income approach and the Net Operating Income Approach. It
resembles Net Income approach in arguing that overall cost of capital and the
value of the firm are both affected by capital structure decision. But it does not
subscribe to the view of NI approach that use of debt in capital structure to any
extent will necessarily decrease the overall cost of capital and increase the
value of the firm. It resembles Net Operating Income approach that beyond a
certain degree of leverage, the cost of equity increases. But it differs from the
NOI approach that overall cost of capital and the value of the firm are constant
for all degrees of leverage.
Stages of Traditional Approach: According to the traditional approach, the
manner in which the overall cost of capital and the value of the firm reacts to
changes in the degree of financial leverage can be divided into three stages:
(1)
First Stage : In the first stage, increase in financial leverage, i.e., the use
of increased debt in the capital structure results in decrease in the overall
cost of capital (k ) and increase in the value of the firm. This is because, a
relatively cheaper source of funds debt replaces a relatively costlier source
of funds equity. In this stage, cost of equity(k ) and cost of debt (k ) remains
constant.
o
(2)
Second Stage : Once the firm has reached a certain degree of financial
leverage, increase in leverage does not affect the overall cost of capital and
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the value of the firm. This because the increase in the cost of equity due to
added financial risk completely offsets the advantage of using cheaper
debt. With in that range, the overall cost of capital will be minimum and
the value of the firm will be maximum. This range represents optimum
capital structure.
(3)
Third Stage : In the third stage, the further increase in debt will lead to
increase in overall cost of capital and will reduce the value of the firm. This
happens due to two factors:
(i) Owing to increased financial risk, K will rise sharply and
(ii) K would also rise because the lenders will also raise the rate of interest
as they may require compensation for higher risk.
e
Ke
Cost of Capital
Ko
Kd
Stage I
Stage II
Stage III
R
R
Degree of Leverage
Figure depicts that cost of equity (k ) rises negligibly in the initial stage but
starts rising sharply in the later stage. Cost of debt remains constant upto a
certain degree of leverage and thereafter it also starts rising. The overall cost of
capital (k ) curve is saucer-shaper with a horizontal range RR. The optimum
capital structure of the firm is represented by range RR because in this stage
the overall cost of capital (k ) is minimum and the value of firm is maximum.
e
Q.
Explain the Modigliani and Miller Approach (M-M)of Capital

Structure. What are its limitations?
Ans. Modigliani and Miller Approach : The Modigliani-Miller approach is

similar to the net operating income approach when taxes are ignored. However,
when corporate taxes are assumed to exist, their hypothesis is similar to the
Net Income approach.
(1)
The Modigliani-Miller Approach-When the taxes are ignored : The

theory propounds that a change in capital structure does not affect the
overall cost of capital and the total value of the firm. The reason behind the
theory is that although the debt is cheaper to equity, with the increased
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use of debt as a source of finance, the cost of equity increases and this
increase in the cost of equity offsets the advantage of the low cost of debt.
Thus, although the change in the debt-equity ratio affects the cost of
equity, the overall cost of capital remains constant. The theory further
propounds that beyond a certain limit of debt, the cost of debt increases
but the cost of equity falls thereby again keeping the overall cost of capital
constant.
Graphic Presentation :
Cost of Capital
Ko
Degree of Leverage
Assumptions : MM approach is based on the following assumptions:

(i) Securities are traded in a perfect capital market situation.
(ii) There are no corporate taxes
(iii)All the investors have same expectations about the net operating
income of the firm.
(iv) The cut-off rate of investment in a firm is the capitalization rate.
(v) All the earnings are distributed to the shareholders
(vi) Firms can be grouped into homogeneous risk classes.
Arbitrage Process : The fundamental theory of the MM approach, if we ignore
the taxes, is that the total value of a firm must be constant irrespective of the
degree of leverage. In other words, the basic preposition of the MM approach is
that the capital structure decision is irrelevant. MM approach provides
behavioural justification for the irrelevance of the capital structure decision
and are not content with merely stating the preposition. The justification lies in
the arbitrage process.
Arbitrage process involves buying and selling of those securities whose
prices are lower (undervalued securities) and selling those securities whose
prices are higher (overvalued securities). Buying the undervalued securities
will increase their demand and will result in raising their prices and the selling
of overvalued securities will increase their supply thereby bringing down their
prices. This will continue till the equilibrium is restored. The arbitrage process
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ensures that the securities of two identical firms cannot sell at different prices
for long.
Example : The following is the data regarding two companies X and Y
belonging to the same risk class:
Number of Ordinary Shares
Market price per share
6% Debentures
EBIT
Company X
Company Y
90,000
1.20
60,000
18,000
1,50,000
1.00
18,000
All profits after debentures interest are distributed as dividends.

Explain how under Modigliani and Miller approach an investor holding 10%
shares in company X will be better off in switching his holding to Company Y.
Solution :
(a) Investors current position in company X with 10% equity holdings:
Investments ( 9000 shares X Rs. 1.20)
Rs. 10,800
Dividend Income 10% of (18000-6%of 60,000)
1,440
(b) Investor sells his holdings in X for Rs. 10,800
He creates a personal leverage by borrowing Rs. 6,000. Thus,
The total amount available with him is Rs. 16,800
(c) He purchases 10% equity holding of Y for Rs. 15,000
(15,000 shares X re 1) for which he pays as follows:
From Borrowed funds
From Own funds (15,000-6,000)
(d) His dividend income is 10% of 18,000
Less: Interest on personal borrowings 6% on Rs. 6000
Net Income
6,000
9,000
1,800
360
1,440
Thus, he gets the same income of Rs, 1,440 from switching over to Y. But,
in the process he reduces his investment outlay by Rs. 1800(10,800-9,000).
Therefore, he is better off by investing in company Y.
(2)
The Modigliani-Miller Approach-When corporate taxes are assumed

to exist :
Modigliani and Miller agree that the value of the firm will increase and cost
capital will decline with the use of debt if corporate taxes are considered. Since
interest on debt is tax-deductible, the effective cost of borrowing will be less
than the rate of interest. Hence, the value of the levered firm would exceed that
of the unlevered firm by an amount equal to the levered firms debts multiplied
by the tax rate. Value of the levered firm can be calculated on the basis of the
following equation:
VL = Vu + Dt
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VL = Value of Levered Firm

D = Amount of Debt
Vu = Value of Unlevered Firm

t = Tax Rate
Equation implies that the value of the levered firm equals the value of an
unlevered firm plus tax saving resulting from the use of debt.
Example : Two firm U and L are identical in every respect, except that U is
unlevered and L is levered. L has Rs. 20 Lakh of 8% debt outstanding. The net
operating income of both the firms is identical.i.e., Rs. 6 Lakh. The corporate
tax rate is 35% and equity capitalization rate for U is 10%. Find out the value of
each firm according to the MM Approach.
Solution :
(i)
Value of Unlevered Firm U :

EBIT
Less : Interest
6,00,000
Nil
_________
Earning before tax

Less : Tax @ 35%
6,00,000
2,10,000
Earning After Tax
_________
3,90,000
__________
Cost of Equity(K )
10%
__________
Value of the firm
EBIT (1-t)
=
Ke
3,90,000
Value of the firm (Vu) = = 39,00,000
10%
(ii)
Value of Levered Firm L

VL = Vu + Dt
VL
VL
VL
= 39,00,000 + 20,00,000 (.35)

= 39,00,000 + 7,00,000
= 46,00,000
Limitations or Criticism of MM Approach :

(1)
Risk Perceptions of personal and corporate leverages are different :

It is incorrect to assume that personal leverage is a perfect substitute for
corporate leverage. Liability of an investor is limited in corporate
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enterprises whereas the liability of an individual borrower is unlimited as

even his personal property is liable to be used for payment to lenders.
Hence, the risk to the individual borrower is higher.
(2)
Difference in cost of borrowing by the firm and individuals : The

assumption that firms and individuals can borrow at the same rate of
interests does not hold good in practice.
(3)
Convenience : The corporate borrowing is more convenient to the

investor because the formalities and procedures in borrowing are to be
observed by corporates.
(4)
Institutional Restrictions : Institutional restrictions stand in the way of

a smooth operation of arbitrage process.
Q.
Define Dividend. Explain various factors determining Dividend

Policy.
Ans: Dividend : Dividend refers to that part of net profits of a company which
is distributed among shareholders as a return on their investment in the
company. Dividend is paid on preference as well as equity shares of the
company. On preference shares, dividend is paid at a predetermined fixed rate.
But decision of dividend on equity shares, dividend is taken for each year
separately. A settled approach for the payment of dividend is known as
dividend policy. Thus, the dividend policy divide the net profits or earnings
after taxes into two parts:
(1) Earnings to be distributed as dividend
(2) Earnings retained in the business.
Factors Determining Dividend Policy :
(1)
Financial Needs of the Firm : Financial needs of a firm are directly

related to the investment opportunities available to it.
If a firm has abundant profitable investment opportunities, it will

adopt a policy of distributing lower dividends.
On the other hand, if the firm has little or no investment opportunities,

it should retain only a small portion of its earnings and should
distribute the rest as dividends.
(2)
Stability of Dividends : Investors always prefer a stable dividend policy.

They expect that they should get a fixed amount as dividends which
should increase gradually over the years.
(3)
Legal Restrictions : The firms dividend policy has to be formulated

within the legal provisions and restrictions. For instance, section 205 of
the Indian Companies Act provides that dividend shall be paid only out of
the current profits or past profits after providing for depreciation.
(4)
Restrictions in Loan Agreement : Lenders, mostly the financial

institutions, put certain restrictions on payment of dividend to safeguard
their interests. The following restrictions may be:
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A loan agreement may prohibit the payment of any dividend as long as

the firms current ratio is less than, say, 2:1
A loan agreement may prohibit the payment of any dividend as long as

the firms Debt-Equity ratio is more than, say, 1.5:1
They may prohibit the payment of dividends in excess of a certain

percentage, say, 10%.
When such restrictions are put, the company will have to keep a low
dividend payout ratio.
(5)
Liquidity : Payment of dividend causes sufficient outflow of cash.

Although a firm may have adequate profits, it may not have enough cash
to pay the dividends. Thus, the cash position is a significant factor in
determining the size of dividends. Higher the cash and overall liquidity
position of a firm, higher will be its ability to pay the dividends.
(6)
Access to Capital Market : A company which is not sufficiently liquid

can still pay dividends if it has easy accessibility to the capital market. In
other words, if a company is able to raise debt or equity in the capital
market, it will be able to pay dividends even if its liquid position is not
good.
(7)
Stability of Earnings : Stability of earnings also has a significant effect

on the dividend policy of a firm. Normally, the greater the stability of
earnings, greater will be the dividend payout ratio.
(8)
Objectives of Maintaining Control : Sometimes the present

management employs dividend policy to retain control of the company in
its own hands. When a company pays larger dividends, its liquidity
position adversely affected and it may have to issue new shares to raise
funds to finance its investment opportunities. If the existing shareholders
do not want purchase the new share, their control over the company will
be diluted. Under such circumstances, the management will declare lower
dividends and earnings will be retained to finance the investment
opportunities.
(9)
Effect on Earning Per Share : As discussed above, higher dividend

payout ratio affects the liquidity position adversely and may necessitate
the issue of new equity shares in the near future, causing an increase in
the number of equity shares and ultimately the earning per share may
reduce. On the other hand, by keeping a low dividend payout ratio the firm
can retain earnings resulting in increase in future earnings and thereby
an increase in earning per share.
(10) Firms Expected Rate of Return : If the firms expected rate of return
would be less than the rate which could be earned by the shareholders
themselves from external investment of their funds, the firm should retain
smaller part of its earnings and should opt for a higher dividend payout
ratio.
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(11) Inflation : Inflation may also act as a constraint on paying larger

dividends. Depreciation is charged on the original cost of the asset and as
a result, when there is an increase in price level, funds generated from
depreciation become inadequate to replace the obsolete assets.
Consequently, companies will have to retain more of its earnings to
provide funds to replace the assets and hence their dividend payout ratio
will be low during periods of inflation.
(12) General State of Economy : Earnings of a firm are subject to general
economic conditions of the country. If the future economic conditions are
uncertain, it may lead to retention of larger part of the earnings of a firm to
absorb any eventuality. Likewise, in the event of depression, when the
level of business activity is very low, the management may reduce the
dividend payout ratio of preserve its liquidity position.
All the above factors must be carefully considered before formulating a
dividend policy.
Q. Explain the Walters dividend model. Discuss its assumptions and
limitations.
Ans. Walters Model : Walters model supports the doctrine that the dividend
policy is relevant for the value of the firm. According to Walter, the investment
policy of the firm and its dividend policy are interlinked.
The main proposition of the Walter approach is the relationship between
the following two factors:
(i) the return on firms investment or its internal rate of return (r) and
(ii) Its cost of capital or the required rate of return (ke)
According to Walter approach optimum dividend policy of the firm shall be
determined by the relationship between r and Ke.
(i)
When Internal Rate of Return is greater than Cost of Capital ( r > Ke) :
If the firms return on investment is more than the cost of capital, the firm
should retain the earnings rather than distributing it to the shareholders
because of the reason that the money is earning more profits in the hands
of the firm than it would if it was paid to the shareholders.
(ii)
When Internal Rate of Return is less than Cost of Capital ( r < Ke) : On
the other hand, if r is less than Ke, the firm should pay off the money to the
shareholders in the form of dividends because of the reason that the
shareholders can earn higher return by investing it elsewhere.
(iii) If Internal Rate of Return is equal to Cost of Capital (r = Ke) : Lastly, if

r is equal to Ke, it is a matter of indifference whether the earnings are
retained or distributed. For such firms, there is no optimum dividend
policy.
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The Walters model, thus relates the question of distributing the dividends
and retaining the earnings to the investment opportunities that are available
with the firm.
(i)
If a firm has adequate profitable investment opportunities, it will be able to

earn more than what the investors expect as r> Ke i.e. return on
investment is more than the cost of capital. Such firms are called the
growth firms. For growth firms, the optimum dividend policy would be
given by Dividend Payout Ratio of zero, .i.e. they would retain their entire
earnings. The market value of the shares will be maximized as a result.
(ii)
On the contrary, if a firm does not have profitable investment

opportunities, i.e. when r is less than Ke, the shareholders will be better off
if the earnings are paid out to them so that they are able to earn a higher
return by investing the funds elsewhere. In such a case, the market price
of shares will be maximised by the distribution of the entire earnings as
dividend. For such firms the optimum dividend policy would be given by
Dividend Payout Ratio of 100%.
Assumptions :
1.
2.
3.
4.
5.
Constant Return and Cost of Capital : The Walter model assumes that
the firms rate of return and its cost of capital are constant.
Internal Financing : All financing is done through the retained earnings;
that is, external sources of funds like debt or new equity capital are not
used.
100% Payout or Retention : All earnings are either distributed as
dividends or reinvested internally immediately.
Constant Earnings per share and Constant Dividends per share :
There is no change in key variables, namely, beginning earnings per share
and dividend per share.
Infinite Time : The firm has a very long life.
Walters Formula for determining the value of a share :

r
D + (E-D)
Ke
P =
Ke
Where
P
D
E
r
K
=
=
=
=
=
Market price per share

Dividend per share
Earnings per share
Internal Rate of Return
Cost of Equity Capital or Capitalisation Rate
Example : The following information is available in respect of a firm:

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Capitalisation Rate (Ke)

Earning Per Share (E)
= 10%
= Rs. 8
Calculate the market price of share under Walters Model by assuming

Rate of Return
(i) 15%
(ii) 10%
(iii) 5% and
Dividend Payout Ratio
(i) 0%
(ii) 25%
(iii) 50%
(iv) 75%
(v) 100%
Solution :
DIVIDEND POLICY AND THE VALUE OF SHARE ( WALTERS MODEL)
Sr.
No.
(i)
(ii)
58
r > Ke
r = Ke
r= 0.15
Ke = 0 .10
E = Rs. 8
r= 0.10
Ke = 0 .10
E = Rs. 8
D/P Ratio = 0%
r < Ke
r= 0.05
Ke = 0 .10
E = Rs. 8
D/P Ratio = 0%
D/P Ratio=0%
(Dividend per
share = Rs.0)
(Dividend per
share =Rs.0)
(Dividend per
share = Rs.0)
0.15
0 + (8-0)
0.10
P =
0.10
0.10
0 + (8-0)
0.10
P =
0.10
0.05
0 + (8-0)
0.10
P =
0.10
P = 120
P = 80
P = 40
D/P Ratio = 25%
D/P Ratio = 25%
D/P Ratio=25%
(Dividend per
share = Rs.2)
(Dividend per
share =Rs.2)
(Dividend per
share = Rs.2)
0.15
2 + (8-2)
0.10
P =
0.10
0.10
2 + (8-2)
0.10
P =
0.10
0.05
2 + (8-2)
0.10
P =
0.10
P = 110
P = 80
P = 50
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(iii)
(iv)
(v)
D/P Ratio = 50%
D/P Ratio = 50%
D/P Ratio=50%
(Dividend per
share = Rs.4)
(Dividend per
share =Rs.4)
(Dividend per
share = Rs.4)
0.15
4 + (8-4)
0.10
P =
0.10
0.10
4 + (8-4)
0.10
P =
0.10
0.05
4 + (8-4)
0.10
P =
0.10
P = 100
P = 80
P = 40
D/P Ratio = 75%
D/P Ratio = 75%
(Dividend per
share = Rs.6)
(Dividend per
share =Rs.6)
(Dividend per
share = Rs.6)
0.15
6 + (8-6)
0.10
P =
0.10
0.10
6 + (8-6)
0.10
P =
0.10
0.05
4 + (8-6)
0.10
P =
0.10
P = 90
`P = 80
D/P Ratio = 100%
D/P Ratio = 100%
D/P Ratio=75%
P = 70
D/P Ratio=100%
(Dividend per
share = Rs.8)
(Dividend per
share =Rs.8)
(Dividend per
share = Rs.8)
0.15
8 + (8-8)
0.10
P =
0.10
0.10
8 + (8-8)
0.10
P =
0.10
0.05
8 + (8-8)
0.10
P =
0.10
P = 80
P = 80
P = 80
Criticism of Walters Model :

(i)
No External Financing : Walter model assumes that the firms

investment are financed exclusively by retained earnings and no external
financing is used. If it was so then the model would be applicable to only
those firms in which equity was the only source of finance.
(ii)
Constant Rate of Return : The model assumes that r is constant. This is

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not a realistic assumption because when increased investments are made

by the firm, r also changes.
(iii) Constant Equity Capitalisation Rate (Ke) : The model assumes that
equity capitalization rate remains constant. This is also not a realistic
assumption because equity capitalization rate changes directly with the
change in risk complexion of the firm.
Q.
Explain the Gordons dividend model. Discuss its assumptions and

limitations.
Ans. Gordons Model : Gordons model is another theory which contends that
dividend policy is relevant for the value of the firm. In other words, the dividend
decision of the firm affects the value of the firm.
Assumptions :
(i)
No External Financing : Gordons model assumes that no external

financing is available and retained earnings are the only source of finance.
(ii)
All-Equity Firm : This model assumes that the firm is an all equity firm
and it has absolutely no debt.
(iii) No Taxes : Corporate taxes do not exist

(iv) Perpetual earnings : it is assumed that the firm has perpetual life and its
stream of earnings are also perpetual.
(v)
Constant Internal Rate of Return : The internal rate of return of the

firm is assumed to be constant.
(vi) Constant Cost of Capital : The cost of capital of the firm is assumed to be
constant.
(vii) Constant Retention Ratio : The retention ratio once decided upon is
constant.
(viii) Cost of capital greater than growth rate : It is assumed that the firms
cost of capital is greater than the growth rate.
Explanation : The implications of Gordons basic valuation may be as below:
(1)
When the rate of return of the firm on its investment is greater than the
cost of capital, the price per share increases as the dividend payout ratio
decrease. Thus, the growth firm should distribute smaller dividends and
should retain maximum earnings.
(2)
When the rate of return is equal to the cost of capital, than the price per
share remains unchanged and is not affected by dividend policy. Thus, for
a normal firm there is nor optimum dividend policy.
(3)
When the rate of return is less than the cost of capital, the price per share
increases as the dividend payout increases. Thus, the shareholders of
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declining firm stand to gain if the firm distributes its earnings for such
firms.
(4)
According to Gordon, the market value of the share is equal to the present
value of future stream of dividends. Thus,
D1
D2
Dt
P = + + +
1
2
n
(1+K) (1+K)
(1+K)
P = Market Price per share
K = Appropriate discount rate to measure risk and time factors
Gordons Formula for determining the value of a share :

(1-b)
P = E x
Ke-br
Where
P
r
br
Ke
=
=
=
=
D
P =
Ke-g
OR
Market Price per share

Firms rate of return
g = Growth rate
Cost of Capital
= Earnings Per Share

b
= retention ratio
(1-b) = D/P ratio
Example : The following is the information is available :

Rate of Return :
(i) 15%
(ii) 10%
(iii)8%
Cost of Capital (Ke) = 10%
Earning per share (E) = Rs. 10
Calculate the dividend policy and the value of the firm using Gordons
Model when
D/P Ratio
Retention Ratio
(a)
40%
60%
(b)
60%
40%
(c)
90%
10%
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Solution :
DIVIDEND POLICY AND THE VALUE OF SHARE (GORDONS MODEL)
Sr.
No.
(i)
r > Ke
r = Ke
r < Ke
r= 0.15
Ke = 0 .10
E = Rs. 10
r= 0.10
Ke = 0 .10
E = Rs. 10
r= 0.08
Ke = 0 .10
E = Rs. 10
D/P Ratio (I-b) = 40%

Retention ration(b)=60% Retention ration(b)=60% Retention ration(b)=60%
(ii)
g=br=0.6.15=0.09
g=br=0.6.10=0.06
10(1-0.6)
P =
0.10-0.09
10(1-0.6)
P =
0.10-0.06
P = 400
P = 100
10(1-0.6)
P =
0.10-0.048
P = 77
D/P Ratio (I-b) = 60% D/P Ratio (I-b) = 60%

g=br=0.4.15=0.06
10(1-0.4)
P =
0.10-0.06
P = 150
(iii)
g=br=0.4.10=0.04
g=br=0.4.08=0.032
10(1-0.4)
P =
0.10-0.04
10(1-0.4)
P =
0.10-0.032
P = 100
P = 88

g=br=0.1.15=0.015 g=br=0.1.10=0.01
10(1-0.1)
P =
0.10-0.015
P = 106
Q.
g=br=0.6.08=0.048
10(1-0.1)
P =
0.10-0.01
P = 100
g=br=0.1.08=0.008
10(1-0.1)
P =
0.10-0.008
P = 98
Discuss the Modigliani and Miller Approach of irrelevance of

dividends. What are its limitations?
Ans. Modigliani and Miller Approach (MM Model) : The most prominent
theory in support of irrelevance of dividends and value of the firm is provided by
Modigliani and Miller. The crux of the hypothesis is that the dividend policy of a
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firm is a passive decision which does not affect the value of the firm. The
dividend policy is a residual decision which depends upon the availability of
investment opportunities to the firm. There are two situations:
(i)
(ii)
If a firm has sufficient investment opportunities, it will not pay dividends

and retain the earnings to finance them.
On the contrary, if there are inadequate investments opportunities,
dividends will be declared to distribute the earnings.
Assumptions of MM Hypothesis :
(i) There are perfect capital markets.
(ii) Investors behave rationally.
(iii) Information about the company is available to all without any cost
(iv) There are no floatation and transaction costs
(v) No investor is large enough to influence the market price of shares.
(vi) There are no taxes
(vii) The firm has rigid investment policy
(viii) There is no risk or uncertainty in regard to the future profits of the
firm.
The Argument of MM :
The argument given by MM in support of their hypothesis is that whatever
increase in the value of the firm results from the payment of dividend will be
exactly off set by the decline in the market price of shares because of external
financing and there will be no change in the total wealth of the shareholders.
For example, if a company having investment opportunities, distributes
all its earnings among the shareholders, it will have to raise additional funds
from external sources. To be more specific, the market price of a share in the
beginning of a period is equal to the present value of dividends paid at the end of
the period plus the market price of the shares at the end of the period.
MM Hypothesis can be explain by following steps :
Step I : Calculation of the Value of the firm :
D1 + P1
Po = 1 + Ke
Po = Market Price per share at the beginning of the period or
prevailing market price of share.
D1 = Dividend to be received at the end of year 1
P1 = Market price of shares at the end of year 1
K = Cost of equity capital or rate of capitalization.
Calculation of P1 : The value of P1 can be derived by the above equation:
P1 = Po (1 + Ke) D1
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Step II : Calculation of Number of shares to be issued, when firm requires

additional funds:
I ( E-nD1)
m =
P1
m
I
E
nD1
=
=
=
=
Number of Shares to be issued

Total amount required for investment
Earning of the firm during the year
Total Dividends to be paid.
Step III : Further calculation of the value of the firm with the help of following
formula:
( n + m) P1 I + E
nPo =
1 + Ke
m
E
I
P1
Ke
n
nPo
D
1
= Number of shares to be issued

= Total earnings of the firm during the period
= Investment Required
= Market price per share at the end of the period
= Cost of equity
= number of shares outstanding at the beginning of period
= Value of the firm
= Dividend to be received at the end of year 1
Example : MM Foam Company currently has 5,000 outstanding shares

selling at Rs. 100 each. The firm expects to have a net earning of Rs. 50,000 and
contemplating a dividend of Rs. 6 per share at the end of the current financial
year. There is a proposal for making new investment of Rs. 1,00,000.
Assuming 10% cost of capital show that under MM hypothesis, the payment of
dividend does not affect the value of the firm.
Solution :
(1)
Calculation of the value of firm when dividends are paid :

(i) Price of the share at the end of current financial year :
P = Po (1 + Ke) D1
1
P = 100 (1+.10) 6
1
= Rs. 104
(ii) Number of shares to be issued :

I ( E-nD1) 1,00,000 (50,000 5,000 x 6) 80,000
m = = =
P1
104
104
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(iii) Value of the firm :

( n + m) P1 I + E
nPo =
1 + Ke
( 5,000 + 80,000/104) 104 1,00,000 + 50,000
nPo =
1 + .10
6,00,000 -50,000
nPo = = Rs. 5,00,000
1.10
(2)
Value of the Firm when dividends are not paid

(i) Price of the share at the end of current financial year :
P = Po (1 + Ke) D1
1
P = 100 (1+.10) 0
1
= Rs. 110
(ii) Number of shares to be issued :

I ( E-nD1)
m =
P1
1,00,000 (50,000 5,000 x 0)

50,000
= - =
110
110
(iii) Value of the firm :

( n + m) P1 I + E
nPo = 1 + Ke
( 5,000 + 50,000/110) 110 1,00,000 + 50,000
nPo =
1 + .10
6,00,000 -50,000
nPo = = Rs. 5,00,000
1.10
Conclusion : Hence, whether dividends are paid or not, the value of the firm
remains the same Rs. 5,00,000
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UNIT IV
Q.
Define Working Capital.
Ans. Introduction : Working capital plays the same role in the business as the
role of heart in the human body. Just like heart gets blood and circulates the
same in the body, in the same way in working capital, funds are generated and
then circulated in the business. As and when this circulation stops the
business becomes lifeless. Thus, prudent management of Working capital is
necessary for the success of a business.
Meaning of Working Capital : Working capital management is an important
aspect of financial management. In business, money is required for fixed assets
and working capital. Fixed assets include land and building, plant and
machinery, furniture and fittings etc. Fixed assets are acquired to be retained
in the business for a long period and yield returns over the life of such assets.
The main objective of working capital management is to determine the
optimum amount of working capital required. Generally, management of
working capital means management of current assets.
Concepts Of Working Capital : There are two concepts of working capital(1) Gross Working Capital Concept
(2) Net Working Capital Concept.
1.
Gross working capital : Gross working capital; refers to firms

investment in current assets. Current assets are the assets which can be
converted into cash within an accounting year and include cash, shortterm securities, debtors, bill receivables and stock. According to this
concept, working capital means Gross working Capital which is the total
of all current assets of a business. It can be represented by the following
equation:
Gross Working Capital = Total Current Assets
According to Bonneville and Dewey :

Any acquisition of funds which increases the current assets increases working
capital, for they are one and the same.
2.
Net Working Capital Concept : Net working capital refers to the

difference between current assets and current liabilities. Current
liabilities are those claims of outsiders which are expected to mature for
payment within an accounting year and include creditors, bills payables,
and outstanding expenses. Net working capital can be positive or negative.
A positive net working capital will arise when current assets exceed
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current liabilities. A negative Net working capital occurs when current

liabilities are in excess of current assets.
Net Working Capital = Current Assets - Current Liabilities
According to Lawrence. J. Gitmen : The most common definition of net
working capital is the difference of firms current assets and current liabilities.
Q.
What is the need of Working Capital?
Ans. Meaning of Working Capital : Working capital management is an

important aspect of financial management. In business, money is required for
fixed assets and working capital. Fixed assets include land and building, plant
and machinery, furniture and fittings etc. Fixed assets are acquired to be
retained in the business for a long period and yield returns over the life of such
assets. The main objective of working capital management is to determine the
NEED FOR WORKING CAPITAL :
Along with the fixed capital almost every Small-Scale industries requires
working capital though the extent of working capital requirement differs in
different businesses. Working capital is needed for running the day-to-day
business activities. The need for working capital can also be explained with the
help of operating cycle. Operating cycle of a manufacturing concern involves
five phases:
Conversion of cash into raw material
Conversion of raw material into work-in-progress
Conversion of work-in-progress into finished goods
Conversion of finished goods into debtors by credit sales
Conversion of debtors into cash by realising cash from them.

Cash
Debtors and Bills
Receivables
Raw Materials
Finished Goods
Work-in-progress
Diagram : Operating Cycle

Working capital in a business is needed because of operating cycle. But
the need for working capital does not come to an end after the cycle if
completed. Since the operating cycle is a continuous process, there remains
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a need for continuous supply of working capital. However, the amount of

working capital required is not constant throughout the year, but keeps
fluctuating. On the basis of this concept, working capital is classified into
two types:(i)
Permanent Working Capital : The need for working capital fluctuates

from time to time. However, to carry on day-to-day operations of the
business without any obstacles, a certain minimum level of raw materials,
work-in-progress, finished goods and cash must be maintained on a
continuous basis. The amount needed to maintain current assets on this
minimum level is called permanent or regular working capital.
(ii)
Temporary or Variable Working Capital : Any amount over and above

the permanent level of working capital is called temporary, fluctuating or
variable working capital. The distinction between permanent and
temporary working capital is illustrated in the following diagram:SHOWING PERMANENT AND TEMPORARY WORKING CAPITAL:
Amount of
Working Capital
Y
Temporary
Working Capital
Permanent
Working Capital
O
Time
Amount of
Working Capital
SHOWING PERMANENT AND TEMPORARY WORKING CAPIRAL IN A

GROWING CONCERN:
Y
Permanent
Working Capital
O
Q.
Temporary
Working Capital
Time
What is the meaning of Working Capital? Explain the factors

affecting the working capital requirements of a business.
Ans. Meaning of Working Capital : Working capital management is an

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working capital means management of current assets
Determinants of Working Capital : The working capital requirement is
determined by a large number of factors but, in general, the following factors
influence the working capital needs of an enterprise:
(1) Nature of Business : Working capital requirements of an enterprise are
largely influenced by the nature of its business. For instance, public utilities
such as railways, transport, water, electricity etc. have a very limited need for
working capital because they have invested fairly large amounts in fixed assets.
Their working capital need is minimal because they get immediate payment for
their services and do not have to maintain big inventories. On the other extreme
are the trading and financial enterprises which have to invest fewer amounts in
fixed assets and a large amount in working capital. This is so because the
nature of their business is such that they have to maintain a sufficient amount
of cash, inventories and debtors. Working capital needs of most of the
manufacturing enterprises fall between these two extremes, that is, between
public utilities and trading concerns.
(2)
Size of Business : Larger the size of the business enterprise, greater

would be the need for working capital. The size of a business may be
measured in terms of scale of its business operations.
(3)
Growth and Expansion : As a business enterprise grows, it is logical to

expect that a larger amount of working capital will be required. Growing
industries require more working capital than those that are static.
(4)
Production cycle:- Production cycle means the time-span between the

purchase of raw materials and its conversion into finished goods. The
longer the production cycle, the larger will be the need for working capital
because the funds will be tied up for a longer period in work in process. If
the production cycle is small, the need for working capital will also be
small.
(5)
Business Fluctuations : Business fluctuations may be in the direction of

boom and depression. During boom period the firm will have to operate at
full capacity to meet the increased demand which in turn, leads to
increase in the level of inventories and book debts. Hence, the need for
working capital in boom conditions is bound to increase. The depression
phase of business fluctuations has exactly an opposite effect on the level of
working capital requirement.
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(6)
Production Policy : The need for working capital is also determined by

production policy. The demand for certain products (such as woolen
garments) is seasonal. Two types of production policies may be adopted for
such products. Firstly, the goods may be produced in the months of
demand and secondly, the goods may be produced throughout the year. If
the second alternative is adopted, the stock of finished goods will
accumulate progressively upto the season of demand which requires an
increasing amount of working capital that remains tied up in the stock of
finished goods for some months.
(7)
Credit Policy Relating to Sales : If a firm adopts liberal credit policy in

respect of sales, the amount tied up in debtors will also be higher.
Obviously, higher book debts mean more working capital. On the other
hand, if the firm follows tight credit policy, the magnitude of working
capital will decrease.
(8)
Credit Policy Relating to Purchase : If a firm purchases more goods on

credit, the requirement for working capital will be less. In other words, if
liberal credit terms are available from the suppliers of goods (i.e.,
creditors), the requirement for working capital will be reduced and vice
versa.
(9)
Availability of Raw Material : If the raw material required by the firm is

available easily on a continuous basis, there will be no need to keep a large
inventory of such materials and hence the requirement of working capital
will be less. On the other hand, if the supply of raw material is irregular,
the firm will be compelled to keep an excessive inventory of such raw
materials which will result in high level of working capital. Also, some raw
materials are available only during a particular season such as oil seeds,
cotton, etc. They would have to be necessarily purchased in that season
and have to be kept in stock for a period when supplies are lean. This will
require more working capital.
(10) Availability of Credit from Banks : If a firm can get easy bank facility in
case of need, it will operate with less working capital. On the other hand, if
such facility is not available, it will have to keep large amount of working
capital.
(11) Volume of Profit : The net profit is a source of working capital to the
extent it has been earned in cash. Higher net profit would generate more
internal funds thereby contributing the working capital pool.
(12) Level of Taxes : Full amount of cash profit is not available for working
capital purpose. Taxes have to be paid out of profits. Higher the amount of
taxes less will be the profits available for working capital.
(13) Dividend Policy : Dividend policy is a significant element in determining
the level of working capital in an enterprise. The payment of dividend
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reduces the cash and, thereby, affects the working capital to that extent.
On the contrary, if the company does not pay dividend but retains the
profits, more would be the contribution of profits towards capital pool.
(14) Depreciation Policy : Although depreciation does not result in outflow of
cash, it affects the working capital indirectly. In the first place, since
depreciation is allowable expenditure in calculating net profits, it affects
the tax liability. In the second place, higher depreciation also means lower
disposable profits and, in turn, a lower dividend payment. Thus, outgo of
cash is restricted to that extent.
(15) Price Level Changes : Changes in price level also affect the working
capital requirements. If the price level is rising, more funds will be
required to maintain the existing level of production. Same level of current
assets will need increased investment when prices are increasing.
However, companies that can immediately revise their product prices with
rising price levels will not face a severe working capital problem. Thus, it is
possible that some companies may not be affected by rising prices while
others may be badly hit.
(16) Efficiency of Management : Efficiency of management is also a
significant factor to determine the level of working capital. Management
can reduce the need for working capital by the efficient utilization of
resources. It can accelerate the pace of cash cycle and thereby use the
same amount working capital again and again very quickly.
Q.
Give the Classification of Working Capital.
Ans. Classification of Working Capital : Working Capital can be classified in

two ways, firstly, on the basis of concept, and secondly, on the basis of its need.
(1)
On the Basis of Concept : On this basis working capital may be of two

types:
(i) Gross Working Capital
(ii) Net Working Capital
(2)
On the Basis of Need : On this basis also working capital may be of two
types:
(i) Permanent Working Capital
(ii) Temporary Working Capital.
Q.
Define Working Capital. Briefly explain the techniques used in

making working capital forecast or Estimating Working Capital
Requirements
Ans:- Meaning of Working Capital : Working capital management is an

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Working Capital Forecasting Techniques Or Computation Of Working
Capital :
A number of methods are used to determine working capital needs of a
business. The important among them are:
(1)
Operating Cycle Method : Operating cycle is the time span the firm
requires in the purchase of raw materials, conversion of raw materials into
work in progress and finished goods, conversion of finished goods into
sales and in collecting cash from debtors. Larger the time span of
operating cycle, larger the investment in current assets. Hence, time
period of each stage of operating cycle is estimated and then working
capital needed in each stage is computed on the basis of cost of each item.
A certain percentage for contingencies may also be added to the above
estimates to determine the working capital requirement.
On the basis of operating cycle, the working capital can be forecasted in the
following way:
STATEMENT SHOWING WORKING CAPITAL REQUIREMENT
Current Assets :
Stock of Raw-Materials :
Cost of yearly consumption
Of raw material
Average Inventory holding period

(weeks/months)
x =
52 weeks / 12 months
Work in Progress :
Of raw material
72
Average time span of work in process

(weeks/months)
x
52 weeks/ 12 months
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50
+ Yearly wages x x
100

(weeks/months)
52 weeks/ 12 months
+ Yearly manufacturing and administrative overheads (excluding dep.)

50
(weeks/ months)
x x
100
52 weeks/ 12 months
Stock of Finished Goods :

Cost of goods produced (i.e., yearly cost of raw materials +Wages +
manufacturing & administrative overheads(excluding depreciation)
Average finished goods holding period
(weeks / months)
x
52 weeks/ 12 months
Debtors :
Working Capital tied up in debtors should be estimated on the
basis of cost of sales (excluding depreciation):
Average debt collection period
Cost of goods produces
(weeks / months)
(i.e., raw materials + wages
x =
manufacturing, administrative
52 weeks/ 12 months
& selling overhead)
Cash and Bank Balance :

(i.e., minimum cash balance required to be maintained
Total Current Assets (A)
_______
Less: Current Liabilities
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Trade Creditors :
Credit period allowed by creditors
(weeks/ months)
Of raw material
x
=
52 weeks/ 12 months
Wages :
Average time lag in payment of wages
(weeks/ months)
Yearly wages x =
52 weeks/ 12 months
Overheads:
Average time lag in payment of overheads
Yearly Overheads(other
(weeks/ months)
Than Depreciation) x
=
52 weeks/ 12 months
____________
Total Current Liabilities (B)
-------------____________
Working Capital (A) (B)
--------------
Add: Provision for Contingencies
-------------____________
Estimated Working Capital Requirement
-------------____________
(2)
Forecasting of Current Assets and Current Liabilities Method :

According to this method, an estimate is made of forthcoming periods
current assets and current liabilities on the basis of factors like past
experience, credit policy, stock policy and payment policy of the previous
years. First of all, such estimate is made for each current asset on the
basis of each month and then monthly requirements are converted into
yearly requirement of current assets. The estimated amount of current
liabilities is deducted from this amount in order to estimate the
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requirement of working capital. A certain percentage for contingencies

may also be added to this amount.
(3)
Cash Forecasting Method : Under this method, an estimate is made of

cash receipts and payments for the next period. Estimated cash receipts
are added to the amount of working capital which exists at the beginning
of the year and estimated cash payments are deducted from this amount.
The difference will be the amount of working capital.
(4)
Percentage of Sales Method : Under this method, certain key ratios

based on past years information are established. These ratios can be ratio
of sales to raw material stock, ratio of sales to semi-finished goods stock,
ratio of sales to finished goods stock, ratio of sales to debtors, ratio of sales
to cash balance etc. After this, sales for the next year will be estimated and
the requirement of working capital will be determined on the basis of these
ratios.
(5)
Projected Balance Sheet Method : Under this method, an estimate is

made of assets and liabilities for a future date and a projected balance
sheet is prepared for that future date. The difference in current assets and
current liabilities shown in projected balance sheet will be the amount of
working capital.
Q.
What do you mean by Cash? What are the motives of holding cash?
Explain the Objectives of Cash Management?
Ans. Cash : For the purpose of cash management, the term cash not only
includes coins, currency, notes, cheques, bank drafts, demand deposits with
banks but also the near-cash assets like marketable securities and time
deposits with banks because they can be readily converted into cash. For the
purpose of cash management, near-cash assets are also included under cash
because surplus cash is required to be invested in near-cash assets for the time
being.
Motives of Holding Cash : In every business assets are kept because they
generate profit. But cash is an asset which does not generate any profit itself,
yet in every business sufficient cash balance is maintained. There are four
primary motives or causes for maintaining cash balances:
(1)
Transaction Motive : A number of transactions take place in every

business. Some transactions result in cash outflow such as payment for
purchases, wages, operating expenses, financial charges like interest,
taxes, dividends etc. Similarly, some transactions result in cash inflow
such as receipt from sales, receipt from investment, other incomes etc.
But the cash outflows and inflows do not perfectly match with each other.
At times, inflows exceed outflows while, at other times outflows exceed
inflows. To meet the shortage of cash in situation when cash outflows
exceed cash inflows, the business must have an adequate cash balance.
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(2)
Precautionary Motive : In every business, some cash balance is kept as

a precautionary measure to meet any unexpected contingency. These
contingencies may contingencies may include the following:
(i) Floods, strikes and failure of important customers.
(ii) Unexpected slow down in collection from debtors.
(iii)Cancellation of orders by customers.
(3)
Speculative Motive : In business, some cash is kept in reserve to take

advantage of profitable opportunities which may arise from time to time.
These opportunities are:
(i) Opportunity to purchase raw material at low prices on payment of
immediate cash.
(ii) Opportunity to purchase other assets for the business when their
prices are low.
(4)
Compensative Motive: - Banks provide a number of services to the

business such as clearance of cheques, supply of credit information about
other customers, transfer of fund and so on. Bank charge commission or
fee for some of these services. For other services, banks do not charge any
commission or fee they require indirect compensation. For this purpose,
bank requires the client to maintain a minimum balance in their accounts
in the bank. Therefore, cash is also kept at the bank to compensate for free
services by banks to the business.
Objectives of Cash Management :

(i)
To maintain Optimum Cash Balance : The main objective of cash

management is to determine the optimum cash balance required in the
business and to maintain the cash balance at that level. It is necessary to
bring equilibrium between liquidity and profitability of business to
determine the optimum cash balance.
(ii)
To Keep the optimum cash balance requirement at minimum level :

The second main objective of cash management is to minimize the
optimum cash requirement because cash is a non-earning asset.
Q.
What is Cash Management? What are the Methods OR Devices of

Cash Management?
Ans. Cash Management : Cash management includes maintaining optimum

cash balance and efficient collection and disbursement of cash.
Methods or Devices of Cash Management : The following are the methods of
cash management:
(1) Cash Budget
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(2) Cash Flow Statements

(3) Cash Flow Ratios
(4) Cash Management Model or Baumol Model.
(1)
Cash Budget : A cash budget is an estimate of cash receipts and cash

payments for a future period of time. It is prepared to forecast the cash
requirements for a given period and indicates the surplus or shortage of
cash during the budget period. There are two parts of cash budget:
(i) Cash Receipts : Cash is mainly received from cash sales, collection
from debtors, income from investments etc.
(ii) Cash Payments : Cash is mainly paid for cash purchases, payment to
creditors, payment for expenses etc. By estimating the cash receipts
and cash payments for a future period it can be estimated that in which
months there will be surplus cash and in which months there will be
deficiency of cash resources.
(2)
Cash Flow Statement : This is another method of cash management. A

cash flow statement is a statement showing inflows and outflows of cash
during a particular period. In other words, it is a summary of sources and
applications of cash during a particular span of time. It analyses the
reasons for changes in balance of cash between the two balance sheet
dates.
(3)
Cash Flow Ratios : Cash Flow Ratios are another device of cash
management. Some important cash flow ratios are:
(i) Cash Turnover Ratio :
Sales Per Period
Cash Turnover Ratio =
Cash Balance
Higher cash turnover ratio indicates that a given level of sales, cash balance
requirement is less.
(ii) Cash Coverage Ratio :
Annual Cash Flow Before Interest and Taxes
Cash Coverage Ratio =
Interest + Principal Payments ( 1/1-tax rate)
Higher the cash coverage ratio, higher will be the credit worthiness of the firm
because the lender risk will be lower in such a case.
(iii)Cash to average Daily Purchase Ratio :
Cash to Average Daily Purchase Ratio =
Cash Balance
Average Daily Purchase

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Purchases during the period

Average Daily Purchase =
Days during the period
(iv) Days of Cash Available:
Average Cash Balance
Days of Cash Available =
Average Daily Outflows
(v)
Cash Break-Even Point:

Cash Fixed Costs
Cash Break-Even Point =
Contribution Per Unit
Contribution Per Unit = Selling price per unit Variable Cost Per Unit.
(4)
Baumol Model : Baumol model is a device of cash management which is

used to determine optimum cash balance. Optimum cash balance is
determined by establishing a balance between liquidity and profitability.
Higher liquidity or higher cash balance means excessive cash is kept in
business which results in loss of interest which can be earned by investing
this excessive cash in marketable securities. On the contrary, lower
liquidity or a very low cash balance means no idle cash and interest is
being earned by investing the excess cash into securities. But in this case
also, additional costs are incurred such as brokerage of converting
securities into cash, accounting costs of securities, cost of registration of
securities etc.
Therefore two types of costs are involved in keeping cash balance in a

business(i) Opportunity Cost
(ii) Transaction Cost
When cash balance increases, opportunity cost increases but transaction
cost decreases. On the other hand, when cash balance is less, opportunity cost
decreases but transaction cost increases.
Optimum cash balance is that level of cash at which the opportunity cost
and transaction cost becomes equal. In other words, total cost of keeping cash
balance will be minimum if both of its component namely opportunity cost and
transaction cost are equal.
Assumptions : The Baumol Model is based on the following assumptions:78
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(i) The cash needs of the firm are known with certainty
(ii) The cash disbursements of the firm occurs uniformly over a period of
time and is known with certainty
(iii)The opportunity cost of holding cash is known and it remains constant.
(iv) The transaction cost of converting securities into cash is known and
remains constant.
Baumol model is in the form of following formula :
C =
Where
C
U
P
S
=
=
=
=
2U X P
________________
S
Optimum Cash Balance

Cash disbursement of a year (or month)
Fixed cost per transaction
Opportunity cost of one rupee p.a. (per month)
Example :
Monthly cash requirements according to cash budget
Fixed cost per transaction
Interest Rate 12% p.a.
Calculate optimum cash balance
Rs. 50,000
Rs. 10
Solution :
C =
2 X 50,000 X 10
______________________
.01
= Rs. 10,000
Therefore, optimum cash balance= Rs. 10,000

Q.
Define Inventory. What are the benefits and costs of holding

inventory?
Ans. Inventory : Every enterprise needs inventory for smooth running of its
activities. The term inventory refers to stock of goods kept for sale by the firm.
Kinds of Inventories:(A) In Trading Concern.
(B) In Manufacturing Concern.
(A) In Trading Concern : In case of trading concerns, it includes only
finished goods.
(B) Manufacturing Concern : In case of manufacturing concern,
inventory may include:Institute of IT & Management
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(i) Inventory of Raw Materials

(ii) Inventory of Work-in-progress
(iii)Consumables
(iv) Inventory of Finished Goods
Benefits of Holding Inventories :
(1)
Timing of Demand and Supply : Need to hold inventory of raw materials

arises because it is not possible for a firm to procure raw materials
whenever it is needed. If the firm is assured of supply of raw material
without delay, at the rate it is used in its manufacturing process, it need
not to hold stock of raw materials. But in actual practice, a time lag exists
between demand of raw materials in manufacturing process and its
supply. Supply of raw material to the firm mat also be delayed because of
such factors as strike, transport problems, short supply etc. Therefore,
the firm should maintain adequate inventory of raw material to run its
manufacturing process regularly. Similarly, need to hold inventory of
finished goods arises because the rate of manufacturing and the rate of
sale do not match. A firm cannot manufacture the goods immediately on
demand by customers.
(2)
Quantity Discounts : Raw materials are required as and when

production process is run. But instead of procuring raw materials in small
quantities at the time of each production run, firm may purchase large
quantities of raw material in advance to obtain quantity discounts of bulk
purchasing. This results in a significant saving in costs.
(3)
Anticipation of Price Rise : Anticipation of price rise may also

necessitate purchasing and holding of raw material inventories.
(4)
Reducing Ordering Cost : These cost include the cost of preparing

purchase orders, transporting cost, receiving costs, inspecting costs etc.
These cost increase in proportion to number of order placed. Therefore, a
firm may purchase raw materials in excess of its immediate needs by
placing one bulk order to reduce the ordering costs. This also results in
accumulation of raw material inventory.
Cost of Holding Inventories : The holding of inventories involves blocking of

a firms funds. The various risks and costs in holding inventories are as below:
(1)
Capital Costs : Maintaining of inventories results in blocking of the

firms financial resources. The firm has, therefore, to arrange additional
funds to meet the cost of inventories. The funds may be arranged from own
resources or from outsiders. But in both cases, the firm incurs a cost. In
the former case, there is an opportunity cost of investment while in the
later case, the firm has to pay interest to outsiders.
(2)
Storage and Handling Costs : Holding of inventories also involves costs

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on storage as well as handling of materials. The storage costs includes:

(i) Rent of the Godown
(ii) Insurance charges etc.
(3)
Risk of Price Decline : There is always a risk of reduction in the prices of

inventories by the suppliers on holding inventories. This may be due to
increased market supplies, competition or general depression in the
market.
(4)
Risk of Obsolescence : The inventories may become obsolete due to

improved technology, change in requirements, change in customers
tastes, etc.
(5)
Risk Deterioration in Quality : The quality of the materials may also

deteriorate while the inventories are kept in stores.
Q.
What are the Objectives and techniques of Inventory Management?
Ans. Objectives of Inventory Management : The objectives of Inventory

Management are:
(i)
To maintain a sufficient large size of inventory to meet the demand of

finished goods and to meet the demand of raw material by production
department.
(ii) To keep the investment in inventory at minimum level by efficiently
organizing the purchase and sales operations.
(iii) To maintain sufficient inventory of raw materials in period of short supply.
(iv) To minimize the carrying cost of inventory namely cost of godown,
insurance expenses etc.
(v) To control investment in inventory and keep it at an optimum level.
Tools and Techniques of Inventory Management : Effective inventory
management requires an effective control system for inventories. A proper
inventory control not only helps in solving the problems of liquidity but also
increases profits and causes substantial reduction in the working capital of the
concern. The following are the important tools and techniques of inventory
management and control:
(1)
(2)
(3)
(4)
(1)
Re-order point.
Economic Order Quantity (EOQ)
ABC Analysis.
Inventory Turnover Ratios.
Re-order point: - The re-order point is that inventory level at which an

order should be placed. Both the excessive and inadequate level of
inventory are not favourable for business. Therefore, re-order level should
not be set up very high or very low. Re-order point is calculated by the
following formula:
Re-order Level/Point = Lead Time X Average Usage
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Lead Time : Lead time is the time period between the date of placing
order and the date of receiving delivery. Lead time may also be called
procurement of inventory.
Average Usage : Average usage means the quantity of inventory
consumed daily. Therefore, re-order point can be identified as the
inventory level which should be maintained for consumption during the
lead time.
For Example : Lead time in a business is 15 days and average daily
usage of inventory is 2,000 units. Re-order point of the business will be:
Re-Order Point = 15 days X 2000 units
= 30000 units.
Safety Stock : in determining re-order point, we have assumed that lead time
and average usage rate have been correctly estimated. But in actual practice,
both of these factors are difficult to predict accurately. Receipt of raw materials
may be delayed beyond the estimated lead time due to strike, floods, transport
problems etc. In such situation, the re-order point will be:
Re-order Point = Lead Time X Average Usage + Safety Stock.
(2)
Economic Order Quantity (EOQ) : Economic order quantity is that

quantity of material for which each order should be placed. Purchasing
large quantities at one time and keeping the same as stock, increases
carrying cost of inventories but reducing ordering cost of inventories. On
the other hand, small orders reduce the average inventory level thereby
reducing the carrying cost of inventories but increasing the ordering costs
because of increased number of purchase orders. Therefore,
determination of economic order quantity is a trade-off between two types
of inventory costs:
(i) Ordering costs : Ordering costs includes costs of placing orders and
cost of receiving delivery of goods such as clerical expenses in
preparing a purchase order, transportation expenses, receiving
expenses, inspection expenses and recording expenses of goods
received.
(ii) Carrying Cost : Carrying cost include costs of maintaining or
carrying inventory, such as godown rent, insurance expenses etc.
These costs vary with inventory size.
The sum of ordering costs and carrying costs represents the total costs
of inventory. Economic order quantity is that order quantity at which
the total of ordering and carrying cost is minimum.
Economic order quantity can be explained with the help of following
diagram:
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Minium
Total Cost
Cost (Rs.)
Carrting Cost
Ordering Cost
Order Size (in units)
Formula :
EOQ can be determined by the following formula:

EOQ=
EOQ
R
O
C
=
=
=
=
2xRxO
---------------C
Economic Order Quantity

Annual purchase Requirements in units
Ordering cost per order
Carrying cot per unit.
Example :
Compute the Economic Order Quantity from the following details:
Annual Inventory Requirements
= 4,00,000 units
Cost of placing each order
= Rs. 20
Carrying cost for one year
= Rs. 4 per unit.
EOQ =
2xRxO
EOQ =
2 x 4, 00,000 x 20
= 2,000 units
(3) ABC Analysis:- ABC Analysis is a technique of controlling different items

of inventory. Usually a firm has to maintain several different items as
inventory. All these items are not equally important. Therefore, it is not
desirable to keep same degree of control on all these items. The firm should give
more attention to those items whose value is higher in comparison to others.
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Under this analysis all the items of inventory are classified into three
categories:(i)
In category A those items are included which are small in number, say,
15 percent of the total items but they are quite valuable, the value being 70
per cent of the total value of the inventory.
(ii)
Category B stands midway and consists of items which are 30 percent in

number and 20 percent of the total value.
(iii) In category C those items are included which are quite large in number,
say, 55 percent of the total items but carrying little value, say, 10 percent
of the total value of inventory.
Thereby, all the items can be classified as follows:
Class
Number of Items
(In terms of their % of
total items)
Inventory Value
(In terms of their % of
total value)
15
70
30
20
55
10
TOTAL
100
100
(4) Inventory Turnover Ratio : Certain items of inventory are slow moving. It
means that their consumption is quite slow and capital remains locked up
in such items for along period. As a result, carrying costs continue to incur
on such items. Slow moving items can be identified with the help of
inventory turnover ratios.
Cost of Goods Sold
Inventory Turnover Ratio (in times) =
Average Stock
Q.
What do you mean by Receivables Management? What are the

motives and cost of maintaining Receivables? Also explain the
objectives of Receivable Management.
Ans. Receivable Management : The term receivables refers to debt owed to

the firm by the customers resulting from sale of goods or services in the
ordinary course of business. These are the funds blocked due to credit sales.
Receivables are also called as trade receivables, accounts receivables, book
debts, sundry debtors and bills receivables etc. Management of receivables is
also known as management of trade credit.
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Motives of Maintaining Receivables :

(i)
Sales Growth Motives : The main objectives of credit sales is to increase

the total sales of the business. On being given the facility of credit,
customers have shortage of cash may also purchase the goods. Therefore,
the prime motive for investment in receivables is sales growth.
(ii)
Increased profit Motive : Due to credit sales, the total sales of business
increases. Thus, in turn, results in increase in profits of the business.
(iii) Meeting Competition Motive : In business, goods are sold on credit to

protect the current sales against emerging competition. If goods are not
sold on credit, the customers may shift to the competitors who allow credit
facility to them.
Costs of Investment in Receivables : When a firm sells goods or services on
credit, it has to bear several types of costs. These costs are as follows:(i)
Administrative Cost : To record the credit sale and collections from

customers, a separate credit department with additional staff, accounting
records, stationery etc is needed. Expenses have also to be incurred on
acquiring information about the credit worthiness of the customers.
(ii)
Capital Cost : There is a time lag between sale of goods and its collection
from customers. In that time period, the firm has to pay for purchases,
wages, salary and other expenses. Therefore, the firm needs additional
funds which may arrange either from external sources or from retained
earnings. Both of these sources involve cost. If funds are arranged from
external sources, interest has to be paid. On the other hand, if retained
earnings are used for this purpose, the firm has to bear opportunity cost.
Opportunity cost means the income which could have been earned by
investing this amount elsewhere.
(iii) Collection Cost : These are the expenses incurred by the firm on
collection from the customers after expiry of the credit period.
(iv) Default Cost : Despite all efforts by the management, the firm may not be
able to recover full amount due from the customers. Such dues are known
as bad debts or default cost.
Objectives of Receivable Management :
(i) To obtain optimum (not maximum) volume of sales.
(ii) To minimize cost of credit sales.
(iii)To optimize investment in receivables.
Q.
Explain briefly the aspects or Scope of receivables management.
Ans. Receivable Management:- The term receivables refers to debt owed to the
firm by the customers resulting from sale of goods or services in the ordinary
course of business. These are the funds blocked due to credit sales. Receivables
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are also called as trade receivables, accounts receivables, book debts, sundry
debtors and bills receivables etc. Management of receivables is also known as
management of trade credit.
Scope or Aspects or Receivables Management : Scope of receivables
management is quite wide. It includes the following aspects:
(A) Formulation of Optimum Credit Policy.
(B) Determination of Credit Terms.
(C) Formulation of Collection Policy.
(D) Evaluation of Credit Policy.
(A)
Formulation of Optimum Credit Policy : A firm needs a clear policy

regarding as to whether the credit should be allowed to a customer and if
yes, to what extent. Credit standards are set for making such decisions.
Therefore, a credit policy has two dimensions:
(1) Credit Standards
(2) Credit Analysis.
(1) Credit Standards : Credit standards are the basic criteria set for
extension of credit to customers. Decision of credit to customers are
taken on the basis of their credit rating, security provided by them,
average collection period of the firm and financial ratios. Standards
are set for all these factors. A firm can control its credits by setting the
credit standards accordingly. If credit standards are liberal, more
credit will be extended. On the other hand, if standards are tight, less
credit will be extended. Factors for which standards are set can be
classified into two broad categories namely:
a) Qualitative Factors : Qualitative factors such as willingness and
ability of the customers to pay for purchase, public image of the
customer and other social factor are included.
b) Quantitative Factors : Quantitative factors such as average
collection period and financial ratios.
(2) Credit Analysis : Credit Analysis is made to evaluate the credit
worthiness of the customers before making credit sales. Decision of
sale on credit is taken only on the basis of credit analysis. The firm
need not follow the policy of treating all the customers equal for
allowing credit. Each customer may be fully examined before offering
credit terms to him. Credit evaluation involves two steps:
a. Obtaining Credit Information : Credit Information concerning each
customer is gathered from different sources. Gathering credit
information involves cost. Cost of collecting information should be less
than the expected profit accruing from it. Credit information can be
obtained from internal as well as external sources.
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Internal Sources : As internal sources of credit information, firm can

require its customers to fill up forms giving details about their financial
activities. They may also be asked to furnish trade references with
whom the firm can have contact to obtain the required information.
External Sources : Credit information can also be obtained

externally from:
(i) Financial Statements : Financial statements, that is , Balance Sheet
and profit & loss a/c are major source of credit information.
(ii) Bank References : Bank of the customer is also a useful source of
credit
information about the customer. Firms
obtain credit
information from customers bank with the help of its own bank.
Information such as normal balance of customer, loan taken by him,
any default in repaying such loan etc. can obtain from the bank of the
customer.
(iii)Reports of Credit Rating Agencies : Credit rating agencies collect
information about the financial and managerial aspects of large
number of business concerns from various sources such as market,
newspapers, private investigation etc.
(iv) Bazaar Reports : Credit information about the customer can also be
maintained from the business concerns in the same trade or industry.
(v) Other Sources : Other sources from where credit information can be
obtained are trade directories, journals, government revenue records
such as income tax returns, sales tax returns etc.
b. Analysis of Credit Information : After obtaining the desired
information from various source, the information is analysed to
determine the credit worthiness of the customer.
(B)
Determination of Credit Terms : The second aspect of receivable

management, after setting the credit standards and assessment of credit
worthiness of the customers, is the determination of the terms on which
credit will be given. Credit terms are the terms which relate to the
repayment of the amount of credit sale. There are three components of
credit terms namely:(i) Credit Period : Credit period is the time period for which credit is
extended to the customers and after which they have to make the
payment.
(ii) Cash Discount : To encourage the customers for prompt payment,
cash discount may be offered by the firm. Customers can take
advantage of cash discount by paying amount within the period of cash
discount.
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(iii)Cash Discount Period : It is the duration within which cash discount

is available.
(C)
Formulation of Collection Policy : The third aspect of the receivable

management is to formulate a collection policy. Collection policy is
required because all the customers do not pay in time. Some customers
pay after the due date and some do not pay at all. If collection is delayed,
additional funds are needed during the meantime to pay for purchase,
wages etc. Delay in collection also increases risk of bad-debts.
Collection policy Lays down the collection procedure followed to collect
the amounts from the customers who do not pay within credit period
allowed to them. After the expiry of credit period, the firm should initiate
collection procedures to make collection from debtors. The efforts should
be polite in the beginning but, with the passage of time, they should be
made strict. The efforts usually made by the firm include:
(i) Reminder Letters
(ii) Telephone Calls
(iii)Personal Visits
(iv) Engaging collection agencies.
(v) Settlement at extended payment period.
(vi) Legal Action.
(D) Evaluation of Credit Policy : A credit policy is formulated to maintain

the investment in receivables at optimum level. Receivable Turnover Ratio
can be used:Net Credit Sales
Receivable Turnover Ratio=
Average Debtors + Average Bills Receivables
If this ratio comes to 6, it means that the collection from receivables is
being made after 12/6= 2 months. Similarly, if the ratio comes to 3, it means
that the collection is being made after 12/3 = 4 months.
Months or days in a period
Average Collection Period=
Receivables Turnover Ratio
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Define Financial Management and explain its nature.

Ans. Introduction : Financial management is that part of managerial process

Financial Management is an essential part of Top Management : In

Institute of IT & Management

Less Descriptive and More Analytical : Financial management is less

Continuous Function : Financing is a continuous function. In addition

Different from Accounting Function : There are key difference between

Wide Scope : There is wide scope of financial management. It is

Centralised Nature : Financial management is centralized in nature. It

Measurement of Performance : Financial management is concerned

Inseparable Relationship between Finance and other Activities :

Applicable to All Types of Organisations : It is applicable to all forms of

Define Financial Management. Explain the Scope of Financial

Define Finance Function and discuss its nature and scope

Ans. Meaning of Finance : Finance is defined as the provision of money at the

Institute of IT & Management

Meaning of Financial Management : Financial management is a vital and an

Traditional Approach : Under this approach the role of financial

Institute of IT & Management

viewpoint of external parties who provide funds to the business and

Modern Approach : The modern approach considers the term financial

Thus, in the modern approach, the financial management is responsible

Loan from Bank

Loan from Financial Institutions

Equity Share Capital

Institute of IT & Management

Preference Share Capital

Determining the Financial Needs

Determining the Financial Needs : The first task of the financial

Nature of the Business

Possibilities for future expansion

Attitude of the management towards risk

General economic circumstances etc.

Financing Decision : This function is related to raising of finance from

Institute of IT & Management

Loan from Bank

Loan from Financial Institutions

Equity Share Capital

Preference Share Capital

Reserve & Accumulated Profits

Investment Decision : Investment decision also known as Capital

Working Capital Decision : It is concerned with the management of

Dividend Policy Decision : The financial management has to decide as

Financial Control : The establishment and use of financial control

Ratio Analysis etc.

Institute of IT & Management

(iii)Comparison of Actual Performance with standards

Routine Functions : The routine functions are :

Supervision of cash receipts and payments.

Opening Bank Accounts and managing them

Safeguarding of securities, insurance policies and other valuable

Maintaining records and preparation of reports

What do you mean by Organisation of Finance Function? Explain the

Ans. Organisation of Finance Function : organization of finance function

Institute of IT & Management

Institute of IT & Management

Functions of Financial Manager : The financial manager is a member of top

Controlling the Costs

Analysing the Profits

Change in Govt. Policy

Change in social and business environment and studies their effect

Cash Management : It includes the managing of cash receipts and cash

Banking Relations : It includes banking relations, operating