MBA608 - Corporate Finance

MASTER OF BUSINESS
ADMINISTRATION
SEMESTER-II
CORPORATE FINANCE
MBA608
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CU IDOL SELF LEARNING MATERIAL (SLM)
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CONTENT
Unit -1 Corporate Finance Basic-I

Unit -2 Corporate Finance Basic-II
Unit -3 Financial Analysis, Profit Planning and Control
Unit -4 Capital Budgeting
Unit -5 Current Assets Management
Unit -6 Financial Decisions- I
Unit -7 Financial Decisions- II
Unit -8 Dividend Decision
Unit -9 Risk Management
Unit -10 Financial Risk Management
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UNIT 1 CORPORATE FINANCE BASIC-I
Structure
Learning objectives
Introduction
Meaning of Corporate Finance
Definition by Malcolm Evans
Nature and scope of Corporate Finance
Nature of Corporate Finance

Scope of Corporate Finance
Objectives and Functions of corporate finance
Functions of Corporate Finance
Objective of Corporate Finance
The role of financial manager
The Firm in Corporate Finance
The Objective of the Firm
Profit maximization
Wealth maximization
Time value of Money
Understanding the Time Value of Money
Time Value of Money Formula
Summary
Keywords
Learning activity
Unit end questions
References
LEARNING OBJECTIVES
After studying this unit, you will be able to:
 Explain about meaning, nature and scope of Corporate finance,
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 State about objectives and functions of Corporate finance,
 List about the role of financial manager and the firm in corporate finance
 Discuss the concept of time value money
INTRODUCTION
Every decision made in a business has financial implications, and any decision that involves
the use of money is a corporate financial decision. Defined broadly, everything that a
business does fits under the rubric of corporate finance. It is, in fact, unfortunate that we even
call the subject corporate finance, because it suggests to many observers a focus on how large
corporations make financial decisions and seems to exclude small and private businesses
from its purview. A more appropriate title for this discipline would be Business Finance,
because the basic principles remain the same, whether one looks at large, publicly traded
firms or small, privately run businesses. All businesses have to invest their resources wisely,
find the right kind and mix of financing to fund these investments, and return cash to the
owners if there are not enough good investments.
In this introduction, we will lay the foundation for this discussion by listing the three
fundamental principles that underlie corporate finance—the investment, financing, and
dividend principles—and the objective of firm value maximization that is at the heart of
corporate financial theory.
Corporate finance deals with the capital structure of a corporation, including its funding and
the actions that management takes to increase the value of the company. Corporate finance
also includes the tools and analysis utilized to prioritize and distribute financial resources.
The ultimate purpose of corporate finance is to maximize the value of a business through
planning and implementation of resources, while balancing risk and profitability.
MEANING OF CORPORATE FINANCE
Corporate finance is one of the most important subjects in the financial domain. It is deep
rooted in our daily lives. All of us work in big or small corporations. These corporations raise
capital and then deploy this capital for productive purposes. The financial calculations that go
behind raising and successfully deploying capital is what forms the basis of corporate
finance. Here is a short introduction:
Separation of Ownership and Management

The basis of corporate finance is the separation of ownership and management. Now, the firm
is not restricted by capital which needs to be provided by an individual owner only. The
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general public needs avenues for investing their excess savings. They are not content with
putting all their money in risk free bank accounts. They wish to take a risk with some of their
money. It is because of this reason that capital markets have emerged. They serve the dual
need of providing corporations with access to source of financing while at the same time they
provide the general public with a plethora of choices for investment.
Liaison between Firms and Capital Markets

The corporate finance domain is like a liaison between the firm and the capital markets. The
purpose of the financial manager and other professionals in the corporate finance domain is
twofold. Firstly, they need to ensure that the firm has adequate finances and that they are
using the right sources of funds that have the minimum costs. Secondly, they have to ensure
that the firm is putting the funds so raised to good use and generating maximum return for its
owners. These two decisions are the basis of corporate finance and have been listed in greater
detail below:
Financing Decision
As stated above the firm now has access to capital markets to fulfill its financing needs.
However, the firm faces multiple choices when it comes to financing. The firm can firstly
choose whether it wants to raise equity capital or debt capital. Even within the equity and
debt capital the firm faces multiple choices. They can opt for a bank loan, corporate loans,
public fixed deposits, debentures and amongst a wide variety of options to raise funds. With
financial innovation and securitization, the range of instruments that the firm can use to raise
capital has become very large. The job of a financial manager therefore is to ensure that the
firm is well capitalized i.e. they have the right amount of capital and that the firm has the
right capital structure i.e. they have the right mix of debt and equity and other financial
instruments.
Investment Decision
Once the firm has gained access to capital, the financial manager faces the next big decision.
This decision is to deploy the funds in a manner that it yields the maximum returns for its
shareholders. For this decision, the firm must be aware of its cost of capital. Once they know
their cost of capital, they can deploy their funds in a way that the returns that accrue are more
than the cost of capital which the company has to pay. Finding such investments and
deploying the funds successfully is the investing decision. It is also known as capital
budgeting and is an integral part of corporate finance.
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Capital budgeting has a theoretical assumption that the firm has access to unlimited financing
as long as they have feasible projects. A variation of this decision is capital rationing. Here
the assumption is that the firm has limited funds and must choose amongst competing
projects even though all of them may be financially viable. The firm thus has to select only
those projects that will provide the best return in the long term.
Financing and investing decisions are like two sides of the same coin. The firm must raise
finances only when it has suitable avenues to deploy them. The domain of corporate finance
has various tools and techniques which allow managers to evaluate financing and investing
decisions. It is thus essential for the financial wellbeing of a firm.
1.2.1 Definition by Malcolm Evans
“Corporate Finance is the process of matching capital needs to the operations of a business.”
It differs from accounting, which is the process of the historical recording of the activities of
a business from a monetized point of view.
Capital is money invested in a company to bring it into existence and to grow and sustain it.
This differs from working capital which is money to underpin and sustain trade - the purchase
of raw materials; the funding of stock; the funding of the credit required between production
and the realization of profits from sales.
Corporate Finance can begin with the tiniest round of Family and Friends money put into a
nascent company to fund its very first steps into the commercial world. At the other end of
the spectrum it is multi-layers of corporate debt within vast international corporations.
Corporate Finance essentially revolves around two types of capital: equity and debt. Equity is
shareholders' investment in a business which carries rights of ownership. Equity tends to sit
within a company long-term, in the hope of creating a return on investment. This can come
either through dividends, which are payments, usually on an annual basis, related to one's
percentage of share ownership.
Dividends only tend to accrue within very large, long-established corporations which are
already carrying sufficient capital to more than adequately fund their plans.
Younger, growing and less-profitable operations tend to be voracious consumers of all the
capital they can access and thus do not tend to create surpluses from which dividends may be
paid.
In the case of younger and growing businesses, equity is often continually sought.
In very young companies, the main sources of investment are often private individuals. After
the already mentioned family and friends, high net worth individuals and experienced sector
figures often invest in promising younger companies. These are the pre-start up and seed
phases.
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At the next stage, when there is at least some sense of a cohesive business, the main investors
tend to be venture capital funds, which specialize in taking promising earlier stage companies
through quick growth to a hopefully highly profitable sale, or a public offering of shares.
The other main category of corporate finance related investment comes via debt. Many
companies seek to avoid diluting their ownership through ongoing equity offerings and
decide that they can create a higher rate of return from loans to their companies than these
loans cost to service by way of interest payments. This process of gearing-up the equity and
trade aspects of a business via debt is generally referred to as leverage.
Whilst the risk of raising equity is that the original creators may become so diluted that they
ultimately obtain precious little return for their efforts and success, the main risk of debt is a
corporate one - the company must be careful that it does not become swamped and thus
incapable of making its debt repayments.
Corporate Finance is ultimately a juggling act. It must successfully balance ownership
aspirations, potential, risk and returns, optimally considering an accommodation of the
interests of both internal and external shareholders.
NATURE AND SCOPE OF CORPORATE FINANCE
Corporate finance as managing financial activities involved in running a corporation. It

involves managing the required finances and its sources. The basic role of corporate finance
is to maximize the shareholders’ value in both short and long-term.
Corporate finance understands the financial problems of the organization beforehand and
prevents them. Capital investments become an important part of corporate financial decisions
such as, if dividends should be offered to shareholders or not, if the proposed investment
option should be rejected or accepted, managing short-term investment and liabilities.
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Figure 1.1
Corporate finance is different from business finance, while business finance refers to finance
to all types of business such as partnership firms, joint stock companies, etc.., corporate
finance includes, planning, raising, investing and monitoring of finance in order to achieve
the financial goals of the organization.
Nature of Corporate Finance
Financing as well as investing choices are always termed as two sides of a same coin. That
the firm must increase funds only when this has suitable ways in order to invest them.
Features of corporate finance and characteristics of corporate finance offers different
technology and also strategies what allow managers to evaluate financing and also investing
choices. It’s therefore important for us to understand nature of corporate finance for well-
being of a company. Here are some of the guidelines below discuss the characteristics,
features and nature of corporate finance.
1. Financial Planning
Corporate finance is a financial planning for a company. The characteristics of corporate
finance includes preparation, raising funds, investing plus tracking each finance of
organization. At short, it offers all financial aspects for the firm. This research, techniques
and strategies are defined by each financial department lead through that finance supervisor.
2. Fund Raising
An important feature of corporate finance is to raise funds for the company. Finance can be
accumulated through shares, bank loans, debentures, bonds, etc. It’s most hard for newer
service providers in order to collect finance as their investors do not have confident and
vision towards new businesses. Nevertheless, it is quite easy for respected companies to
gather finance considering goodwill, reputation in the market.
3. Goal Oriented
One of the features of corporate finance is goal oriented. That means, it is important to
regularly achieve each objectives associated with the company. The main goal of corporate
finance are to maximize profits, giving good dividends to shareholders, as well as creating
fund reserves for future expansion activities and so forth.
4. Investing Objective
The nature of corporate finance notes for every company is to optimize investing needs for
maximizing profits. Your finance can be used to quickly attain your investing objectives of
the company. For example: it can be used to invest in machines or fixed assets. It’s can also
be used for day to day company operations. That finance needs to be optimized for profitably.
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5. Finance Options
There are two main options in the nature of corporate finance, i.e. working capital and fixed
capital. Working-capital normally called as short-term finance. It’s mainly used to meet the
short-term financial requirements for your business. For example: It can be used to cover
your day-to-day expenses or operational cost of a company. Fixed capital normally called as
long-term finance. It is always used to fulfil your very long-term financial requirements for
your business. For example: buying a new manufacturing unit or fixed assets.
6. Legal Requirements
There are definitely various legal criteria to corporate finance. The company need to take the
appropriate permission, from the finance regulatory board of the country for the rising
finance from public. For example: In India SEBI (Securities and Exchange Board of India)
and SEC (Securities Exchange Commission) in United States also offers to follow all of the
guidelines to a company. This features of corporate finance need to be taken utmost care
when raising funds.
7. Managing and Controlling
Financial management is excellent art considering that it needs individual skills, techniques,
strategies as well as judgement. Nature of corporate finance requires ideal way for planning
as well as control. Creating is needed in order to collect finance from the investors. It’s also
necessary for investing their finance. Control is needed to find whether the finance are
optimized and invested appropriately. If the finance is not been utilized properly then
corrective steps should be taken and may also need to restructure the way finance is been
utilized.
8. Business Management
Corporate finance is plays a crucial and important role in business management.

Characteristics of corporate finance is that it is a blood or life-line of a business. A nature of
corporate finance is needed towards many business tasks. For example: It’s necessary for
performing that business smoothly, its required for promoting business, for expansion,
modernization, diversification, replacing old assets with new assets and more. Finance is also
required for paying interest, dividend, taxes as well as for managing risks.
9. Dynamic in Nature
A dynamic in nature of corporate finance is a distinct feature of finance. That it goes on

changing based on the change in planning, environment, circumstances, times, project delays
etc. Your finance supervisor must suggestions new and innovative ideas to utilize savings,
invested money and corporate finance. He must be a creativity when doing his task.
10. Connecting with Other Divisions
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A nature of corporate finance has a near relationship with different divisions within a
company. For example: marketing and promotional department, manufacturing department,
advertising division, accounting department, etc. That is mainly because all the divisions
require finance to perform their operation constantly and smoothly.
Scope of Corporate Finance
1. Estimating Financial Requirements

A primary task associated with financial manager is to calculate long-term and short term
financial requirements out of his business. To make certain you’ve got sufficient money, it is
crucial to calculate the financial requirements before beginning a newer or expanding a
current business. Firstly, figure out expenses, then divided into recurring expenses and one-
time cost. According to the scope of corporate finance, management will create a current
financial plan as well as forecast financial plan for future. For example: finance necessary for
purchasing fixed assets, requirement of funds for working capital, etc. An essential factor to
be considered when estimating financial requirements are repayment time, cost, liquidity, etc.
2. Deciding Capital Structure
The capital structure looks how a firm finances their general operations, research and
development by making use of various sources of funds. Financial debts appear in the form of
bond issues or long-term bonds. While equity is classified as a preferred stock, retained
earnings or common stock. Short-term debt including working capital fund as a scope of
corporate finance for capital structure. Factors determining capital structure are trading on
equity, flexibility of financial plan, degree of control, choice of investors, capital market
condition, cost of financing, period of financing, sizes of a company, Stability of sales and
more.
3. Choosing the Source of Finance
One efficient financial control calls concerning various type of decision-making. A major
significant move for any company should determine that sources of funds. Broadly, that the
category of finance presented for any business is debt and also equity. Your proportion of
funding will determine the capital structure of your company. When making that choice, you
need to ensure that it fits your business conditions. An essential factor to be considered while
selecting a source of finance are risk associated with source of finance, cost of finance, long
term versus short term borrowing, dilution of control and management, flexibility in
repayment, etc.
4. Selecting a Pattern of Investment
Investment analysis actually broad term which encompasses a lot of different aspects to
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investing. This include evaluating historical returns to make predictions about future returns,
selecting a right type of investment vehicle which best suit for investors requirement or
analyzing bonds / stocks for valuation and investor specificity. A factor used for selecting
pattern of investments as a scope of corporate finance are choosing the right asset classes,
balancing stocks and bonds, figuring out your timeline, projected profitability, favorable asset
utilization, intrinsic value (rather than market value), conservative capital structure, earnings
momentum and more.
5. Proper Cash Management
Cash management relates to a diverse area of finance involving the collection, planning,
handling and use of cash. This involves evaluating promote liquidity, assets / investments and
cash flow. The objective of cash management should be to regulate the cash balances or cash
liquidity rather than investing in inventories or fixed assets to avoid the risk of insolvency.
Aspects checked being a role of cash management incorporate a company liquidity, short-
term investing methods and techniques and cash balances. Factors to be considered as a scope
of corporate finance when managing liquidity are right time to buys raw materials, when to
transforms those raw materials into products, effective manufacturing process, when it sells
products, when it pays their bills and more.
6. Implementing Financial Controls
Financial controls are definitely processes, procedures and policies that are implemented in
order to handle funds. They play a role in an organization’s financial goals to fulfilling
commitments of corporate governance, due diligence and fiduciary duty. Financial controls
are implemented with automation, accountability and responsibility. An essential factor in
implementing financial controls are Accounting Standards, Financial Statements, Policies,
Operating Metrics, Segregation of Duties, Reconciliation, Approvals, Responsibilities,
Disbursement Policies, Audit Trail, Information Security and more.
7. Proper Usage of Surpluses
Surplus is that levels of an amount or resource in which exceeds your section that is used. A
surplus can be used towards explain countless excess assets plus income, profits, goods and
capital. A surplus frequently occurs in financial budgets, even spending have always been
below the earnings. Finance excess is associated with demand and supply needs.
Your idea is to plan and make use of procedures to ensure this value creation works well and
effectively. Therefore, things just like capital investment as well as investment banking are
component concerning scope of corporate finance basics. Either the business is actually large
or small; we probably have a committed person or even a division to oversee each financial
strategy. They look after their corporate finance associated with company to ensure that
business works effectively and appropriately.
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OBJECTIVES AND FUNCTIONS OF CORPORATE FINANCE
Corporate finance is the field of finance dealing with financial decisions that business
enterprise make and the tools and analysis used to make these decisions. The primary goal of
corporate finance is to maximize corporate value while managing the firm’s financial risks.
Although it is in principle different from managerial finance which studies the financial
decisions of all firms, rather than corporations alone, the main concepts in the study of
corporate finance are applicable to the financial problems of all kinds of firms. The discipline
can be divided into long-term and short-term decisions and techniques. Capital investment
decisions are long-term choices about which projects receive investment, whether to finance
that investment with equity or debt, and when or whether to pay dividends to shareholders.
On the other hand, short term decisions deal with the short-term balance of .current assets and
current liabilities; the focus here is on managing cash, inventories, and short-term borrowing
and lending.
Corporate finance covers every decision a firm makes that may affect its finances which can
be grouped into five areas for the conceptual understanding.
• The first is the objective function, where we define what exactly the objective in decision
making should be.
• The second is the investment decision, where we look at how a business should allocate of
resources across competing uses.
• The third is the financing decision, where we examine the sources of financing and
whether there is an optimal mix of financing.
• The fourth is the dividend decision, which relates to how much a business should reinvest
back into operations and how much should be returned to the owners.
• Finally, there is valuation, where all of the decisions made by a firm are traced through to
a final value
Functions of Corporate Finance
1. Acquisition of Resources: Acquisition of resource indicates fund generation at the lowest

possible cost. Resource generation is possible through:
(a) Equity: This includes proceeds received from retained earnings, stock selling,
and investment returns.
(b) Liability: This includes warranties of products, bank loans, and payable
account.
2. Allocation of Resources: Allocation of resources is nothing but investment of funds for
profit maximization. Investment can be categorized into 2 groups:
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(a) Fixed Assets – Buildings, Land, Machinery etc.
(b) Current Assets – cash, receivable accounts, inventory, etc. Broad Functions of
Corporate
• Finance are:
 Raising of Capital or Financing
 Budgeting of Capital
 Corporate Governance
 Financial management
 Risk Management
Objective of Corporate Finance
It is essential for all the corporate organizations to have objectives of corporate financing to
make optimum utilization of available finance for maximizing your business profit earnings,
stock valuations, give best returns to investors or shareholders for their investors and more.
Let us see some of the key primary objectives of corporate finance going further on this topic:
1. Income Margins:
In case your product sales method comprises of offering in the best reduced pricing to
generate higher volumes, you might set an excellent objective of corporate finance towards
increasing your profit margins on each product. It might be done without having a price tag
augment with enhancing your manufacturing undertaking, the use of a variety of contents or
negotiating better agreements from suppliers. In case a person carryout market review, you
may discover you can enhance on your price tag not greatly decreasing sales volume. Your
objectives of corporate financing should be to negotiate with best contracts using wholesalers
to retailers as their best deals always improve your income margins.
2. Sales and Promotions:
Companies have a range of selling objectives that go increasing with growing sales. You
might set increased on the internet sales as a part of objectives of corporate finance.
Assuming on the web sales incorporate most of your income therefore you may consider
increasing sales and promotions in those areas as well as retail outlets. This probably provide
you with a much healthier opportunity of exponential, instead of incremental sale growth in
volume. Different financial objectives of corporate financing might be used to improve
purchases of the specified product or service, whereas other objectives of corporate financing
may include increasing revenues starting a specific segment for the market.
3. Financial Reporting System:
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Key financial objectives of corporate finance for many smaller business is creation of a great
financial reporting system that provides management with a range of informational data to
help planning the preparation of pricing, budgeting, goals setting, distribution channel and
other objectives. These reports include a professional general ledger, budgeting reports,
expenses plan, overhead to production computational report, accounts receivable aging,
profit-loss statement, cash flow analysis and balance sheet.
THE ROLE OF FINANCIAL MANAGER
Financial managers perform data analysis and advise senior managers on profit-maximizing
ideas. Financial managers are responsible for the financial health of an organization. They
produce financial reports, direct investment activities, and develop strategies and plans for the
long-term financial goals of their organization. Financial managers typically:
• Prepare financial statements, business activity reports, and forecasts,
• Monitor financial details to ensure that legal requirements are met,
• Supervise employees who do financial reporting and budgeting,
• Review company financial reports and seek ways to reduce costs,
• Analyze market trends to find opportunities for expansion or for acquiring other
companies,
• Help management make financial decisions.
The role of the financial manager, particularly in business, is changing in response to
technological advances that have significantly reduced the amount of time it takes to produce
financial reports. Financial managers’ main responsibility used to be monitoring a company’s
finances, but they now do more data analysis and advise senior managers on ideas to
maximize profits. They often work on teams, acting as business advisors to top executives.
Financial managers also do tasks that are specific to their organization or industry. For
example, government financial managers must be experts on government appropriations and
budgeting processes, and healthcare financial managers must know about issues in healthcare
finance. Moreover, financial managers must be aware of special tax laws and regulations that
affect their industry.
Capital Investment Decisions

Capital investment decisions are long-term corporate finance decisions relating to fixed assets
and capital structure. Decisions are based on several inter-related criteria. Corporate
management seeks to maximize the value of the firm by investing in projects which yield a
positive net present value when valued using an appropriate discount rate in consideration of
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risk. These projects must also be financed appropriately. If no such opportunities exist,
maximizing shareholder value dictates that management must return excess cash to
shareholders (i.e., distribution via dividends). Capital investment decisions thus comprise an
investment decision, a financing decision, and a dividend decision.
Management must allocate limited resources between competing opportunities (projects) in a

process known as capital budgeting. Making this investment decision requires estimating the
value of each opportunity or project, which is a function of the size, timing and predictability
of future cash flows.
Achieving the goals of corporate finance requires that any corporate investment be financed
appropriately. The sources of financing are, generically, capital self-generated by the firm
and capital from external funders, obtained by issuing new debt or equity.
Types of Financial Managers
There are distinct types of financial managers, each focusing on a particular area of
management.
Controllers direct the preparation of financial reports that summarize and forecast the
organization’s financial position, such as income statements, balance sheets, and analyses of
future earnings or expenses. Controllers also are in charge of preparing special reports
required by governmental agencies that regulate businesses. Often, controllers oversee the
accounting, audit, and budget departments.
Treasurers and finance officers direct their organization’s budgets to meet its financial goals
and oversee the investment of funds. They carry out strategies to raise capital and also
develop financial plans for mergers and acquisitions.
Credit managers oversee the firm’s credit business. They set credit-rating criteria, determine
credit ceilings, and monitor the collections of past-due accounts.
Cash managers monitor and control the flow of cash that comes in and goes out of the
company to meet the company’s business and investment needs.
Risk managers control financial risk by using hedging and other strategies to limit or offset
the probability of a financial loss or a company’s exposure to financial uncertainty.
Insurance managers decide how best to limit a company’s losses by obtaining insurance
against risks such as the need to make disability payments for an employee who gets hurt on
the job or costs imposed by a lawsuit against the company.
Important Skills for Financial Managers
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Finance manager skills are those that help individuals in this role oversee all aspects of a
company's financial transactions, including budget analysis and calculation of return on
investment (ROI) as well as purchasing and staffing decisions. Finance managers provide
accurate data analysis and strategic propositions to create profit and reduce loss. A finance
manager's skills are built from a wide array of roles and responsibilities.
1. Understand and evaluate cash flow scenarios

2. Analyze financial data
3. Forecast future earnings and expenses
4. Understand and apply contract provisions
5. Oversee vendor or government contracts
6. Implement contract compliance policy
7. Secure financial management systems
8. Apply advanced mathematics
9. Use and understand statistical modeling software and spreadsheets.
THE FIRM IN CORPORATE FINANCE
The Firm: Structural Set-Up

In corporate finance, we will use firm generically to refer to any business, large or small,
manufacturing or service, private or public. Thus, a corner grocery store and Microsoft are
both firms. The firms investments are generically termed assets. Although assets are often
categorized by accountants into fixed assets, which are long-lived, and current assets, which
are short-term, we prefer a different categorization. The assets that the firm has already
invested in are called assets in place, whereas those assets that the firm is expected to invest
in the future are called growth assets. Though it may seem strange that a firm can get value
from investments it has not made yet, high-growth firms get the bulk of their value from
these yet-to-be-made investments.
To finance these assets, the firm can raise money from two sources. It can raise funds from
investors or financial institutions by promising investors a fixed claim (interest payments) on
the cash flows generated by the assets, with a limited or no role in the day-to-day running of
the business. We categorize this type of financing to be debt. Alternatively, it can offer a
residual claim on the cash flows (i.e., investors can get what is left over after the interest
payments have been made) and a much greater role in the operation of the business. We call
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this equity. Note that these definitions are general enough to cover both private firms, where
debt may take the form of bank loans and equity is the owners own money, as well as
publicly traded companies, where the firm may issue bonds (to raise debt) and common stock
(to raise equity).
Thus, at this stage, we can lay out the financial balance sheet of a firm as follows:
Figure 1.2
Note the contrast between this balance sheet and a conventional accounting balance sheet.
Figure 1.3
An accounting balance sheet is primarily a listing of assets in place, though there are some
circumstances where growth assets may find their place in it; in an acquisition, what gets
recorded as goodwill is a conglomeration of growth assets in the target firm, synergies and
overpayment.
The Objective of the Firm
No discipline can develop cohesively over time without a unifying objective. The growth of
corporate financial theory can be traced to its choice of a single objective and the
development of models built around this objective. The objective in conventional corporate
financial theory when making decisions is to maximize the value of the business or firm.
Consequently, any decision (investment, financial, or dividend) that increases the value of a
business is considered good one, whereas one that reduces firm value is considered a poor
one. Although the choice of a singular objective has provided corporate finance with a
unifying theme and internal consistency, it comes at a cost. To the degree that one buys into
19
this objective, much of what corporate financial theory suggests makes sense. To the degree
that this objective is flawed, however, it can be argued that the theory built on it is flawed as
well. Many of the disagreements between corporate financial theorists and others (academics
as well as practitioners) can be traced to fundamentally different views about the correct
objective for a business. For instance, there are some critics of corporate finance who argue
that firms should have multiple objectives where a variety of interests (stockholders, labor,
customers) are met, and there are others who would have firms focus on what they view as
simpler and more direct objectives, such as market share or profitability.
Given the significance of this objective for both the development and the applicability of
corporate financial theory, it is important that we examine it much more carefully and address
some of the very real concerns and criticisms it has garnered: It assumes that what
stockholders do in their own self-interest is also in the best interests of the firm, it is
sometimes dependent on the existence of efficient markets, and it is often blind to the social
costs associated with value maximization.
Profit maximization
• An assumption in classical economics is that firms seek to maximize profits.

• Profit = Total Revenue (TR) – Total Costs (TC).
• Therefore, profit maximization occurs at the biggest gap between total revenue and total
costs.
• A firm can maximize profits if it produces at an output where marginal revenue (MR) =
marginal cost (MC)
Diagram of Profit Maximization
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Figure 1.4
To understand this principle, look at the above diagram.
 If the firm produces less than Output of 5, MR is greater than MC. Therefore, for this
extra output, the firm is gaining more revenue than it is paying in costs, and total
profit will increase.
 At an output of 4, MR is only just greater than MC; therefore, there is only a small
increase in profit, but profit is still rising.
 However, after the output of 5, the marginal cost of the output is greater than the
marginal revenue. This means the firm will see a fall in its profit level because the
cost of these extra units is greater than revenue.
Profit maximization for a monopoly
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Figure 1.5
 In this diagram, the monopoly maximizes profit where MR=MC – at Qm. This
enables the firm to make supernormal profits (green area). Note, the firm could
produce more and still make normal profit. But, to maximize profit, it involves setting
a higher price and lower quantity than a competitive market.
 Note, the firm could produce more and still make a normal profit. But, to maximize
profit, it involves setting a higher price and lower quantity than a competitive market.
 Therefore, in a monopoly profit maximization involves selling a lower quantity and at

a higher price. see also: Diagram of monopoly
Profit Maximization in Perfect Competition
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Figure 1.6
In perfect competition, the same rule for profit maximization still applies. The firm
maximizes profit where MR=MC (at Q1).
For a firm in perfect competition, demand is perfectly elastic, therefore MR=AR=D.
This gives a firm normal profit because at Q1, AR=AC.
Profit Maximization in the Real World
Limitations of Profit Maximization
• In the real world, it is not so easy to know exactly your marginal revenue and the marginal
cost of last goods sold. For example, it is difficult for firms to know the price elasticity of
demand for their good – which determines the MR.
• It also depends on how other firms react. If they increase the price, and other firms follow,
demand may be inelastic. But, if they are the only firm to increase the price, demand will be
elastic (see: kinked demand curve and game theory.
• However, firms can make a best estimation. Many firms may have to seek profit
maximization through trial and error. e.g. if they see increasing price leads to a smaller % fall
in demand they will try to increase price as much as they can before demand becomes elastic
• It is difficult to isolate the effect of changing the price on demand. Demand may change
due to many other factors apart from price.
• Firms may also have other objectives and considerations. For example, increasing the
price to maximize profits in the short run could encourage more firms to enter the market;
therefore, firms may decide to make less than maximum profits and pursue a higher market
share.
• Firms may also have other social objectives such as running the firm like a cooperative –
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to maximize the welfare of stakeholders (consumers, workers, suppliers) and not just the
profit of owners.
• Profit satisficing. This occurs when there is a separation of ownership and control and
where managers do enough to keep owners happy but then maximize other objectives such as
enjoying work.
Wealth maximization
Wealth maximization is the concept of increasing the value of a business in order to increase
the value of the shares held by its stockholders. The concept requires a company's
management team to continually search for the highest possible returns on funds invested in
the business, while mitigating any associated risk of loss. This calls for a detailed analysis of
the cash flows associated with each prospective investment, as well as constant attention to
the strategic direction of the organization.
The most direct evidence of wealth maximization is changes in the price of a company's
shares. For example, if a company spends funds to develop valuable new intellectual
property, the investment community is likely to recognize the future positive cash flows
associated with this new property by bidding up the price of the company's shares. Similar
reactions may occur if a business reports continuing increases in cash flow or profits.
The concept of wealth maximization has been criticized, since it tends to drive a company to
take actions that are not always in the best interests of its stakeholders, such as suppliers,
employees, and local communities. For example:
A company may minimize its investment in safety equipment in order to save cash, thereby
putting workers at risk.
A company may continually pit suppliers against each other in the unmitigated pursuit of the
lowest possible parts prices, resulting in some suppliers going out of business.
A company may only invest minimal amounts in pollution controls, resulting in
environmental damage to the surrounding area.
Because of these types of issues, senior management may find it necessary to back away from
the sole pursuit of wealth maximization, and instead pay attention to other issues, as well.
The result is likely to be a modest reduction in shareholder wealth.
Given the issues noted here, wealth maximization should be considered just one of the goals
that a company must attend to, rather than its only goal.
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Figure 1.7
TIME VALUE OF MONEY
The time value of money (TVM) is the concept that money you have now is worth more than
the identical sum in the future due to its potential earning capacity. This core principle of
finance holds that provided money can earn interest, any amount of money is worth more the
sooner it is received. TVM is also sometimes referred to as present discounted value.
Understanding the Time Value of Money
The time value of money draws from the idea that rational investors prefer to receive money
today rather than the same amount of money in the future because of money's potential to
grow in value over a given period of time. For example, money deposited into a savings
account earns a certain interest rate and is therefore said to be compounding in value.
25
Figure 1.8
This chapter is a practical approach to the time value of money. We fully understand that
today's technology provides multiple calculators and applications to help you derive both
present value and future value of money. If you do not take the time to comprehend how
these calculations are derived, you may make critical financial decisions using inaccurate
data (because you may not be able to recognize whether the answers are correct or incorrect).
There are five (5) variables that you need to know:
Present value (PV) - This is your current starting amount. It is the money you have in your
hand at the present time, your initial investment for your future.
Future value (FV) - This is your ending amount at a point in time in the future. It should be
worth more than the present value, provided it is earning interest and growing over time.
The number of periods (N) - This is the timeline for your investment (or debts). It is usually
measured in years, but it could be any scale of time such as quarterly, monthly, or even daily.
Interest rate (I) - This is the growth rate of your money over the lifetime of the investment. It
is stated in a percentage value, such as 8% or .08.
Payment amount (PMT) - These are a series of equal, evenly-spaced cash flows.
Further illustrating the rational investor's preference, assume you have the option to choose
26
between receiving $10,000 now versus $10,000 in two years. It's reasonable to assume most
people would choose the first option. Despite the equal value at the time of disbursement,
receiving the $10,000 today has more value and utility to the beneficiary than receiving it in
the future due to the opportunity costs associated with the wait. Such opportunity costs could
include the potential gain on interest were that money received today and held in a savings
account for two years.
Time Value of Money Formula
Depending on the exact situation in question, the time value of money formula may change
slightly. For example, in the case of annuity or perpetuity payments, the generalized formula
has additional or less factors. But in general, the most fundamental TVM formula takes into
account the following variables:
FV = Future value of money
PV = Present value of money
i = interest rate
n = number of compounding periods per year
t = number of years
Based on these variables, the formula for TVM is:
FV = PV x [ 1 + (i / n)] (n x t)
Time Value of Money Examples

Assume a sum of $10,000 is invested for one year at 10% interest. The future value of that
money is:
FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000
The formula can also be rearranged to find the value of the future sum in present day dollars.
For example, the value of $5,000 one year from today, compounded at 7% interest, is:
PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673
Effect of Compounding Periods on Future Value
27
The number of compounding periods can have a drastic effect on the TVM calculations.
Taking the $10,000 example above, if the number of compounding periods is increased to
quarterly, monthly, or daily, the ending future value calculations are:
Quarterly Compounding: FV = $10,000 x [1 + (10% / 4)] ^ (4 x 1) = $11,038
Monthly Compounding: FV = $10,000 x [1 + (10% / 12)] ^ (12 x 1) = $11,047
Daily Compounding: FV = $10,000 x [1 + (10% / 365)] ^ (365 x 1) = $11,052
This shows TVM depends not only on interest rate and time horizon, but also on how many
times the compounding calculations are computed each year.
You can calculate the fifth variable if you are given any four of the five (all) variables listed
above. A simple example of this would be: If you invest one dollar (PV) for one year (N) at
6% (I), you will receive $1.06 (FV). This would be the same as saying the present value of
$1.06 you expect to receive in one year, is only $1.00 (PV).
SUMMARY
Corporate finance is the area of finance that deals with sources of funding, the capital
structure of corporations, the actions that managers take to increase the value of the firm to
the shareholders, and the tools and analysis used to allocate financial resources. The primary
goal of corporate finance is to maximize or increase shareholder value.
Correspondingly, corporate finance comprises two main sub-disciplines. Capital budgeting is
concerned with the setting of criteria about which value-adding projects should receive
investment funding, and whether to finance that investment with equity or debt capital.
Working capital management is the management of the company's monetary funds that deal
with the short-term operating balance of current assets and current liabilities; the focus here is
on managing cash, inventories, and short-term borrowing and lending (such as the terms on
credit extended to customers).
In any ways your important primary objectives of corporate finance should be to increasing
the trust and giving good returns to investors and shareholders. Once your basic objective of
corporate financing is achieved all rest of the task to be perform will have a smoother road
ahead. Hope you enjoyed reading this article.
KEYWORDS
• Capital Budget – a company’s plan for capital expenditures (acquisition of fixed assets).
• Capital Expenditures – money used to acquire or improve fixed assets.

• Quick Ratio – a calculation of a company’s financial strength and liquidity – determined
by subtracting inventories from total current assets and dividing by current liabilities.
28
• Restrictive Covenant - an agreement placing constraints on the operations of a borrower.
• Retained Earnings – earnings retained by a company for reinvestment in its operations
LEARNING ACTIVITY
1. What are Financial Statements of a company and what do they tell about a company?
2. How do managing the Corporate Finance helps in managing time value for money?
UNIT END QUESTIONS
A. Short Descriptive Question

1. Explain what do you understand by corporate finance?
2. Explain the functions of corporate finance. What is the role of firm in
corporate finance?
3. Discuss, what is time value of money? Explain it with the help of formula.
4. Discuss, what are the objectives of corporate finance? What is the role of
manager in corporate finance?
Long questions
1. Explain, what the nature and scope of corporate finance?
2. If you wish to accumulate $140,000 in 13 years, how much must you deposit
today in an account that pays an annual interest rate of 14%?
3. If you wish to accumulate $197,000 in 5 years, how much must you deposit
today in an account that pays a quoted annual interest rate of 13% with semi-annual
compounding of interest?
4. How many years will it take for $197,000 to grow to be $554,000 if it is
invested in an account with a quoted annual interest rate of 8% with monthly
compounding of interest?
B. Multiple Choice Questions (MCQs)

1. The time value of money (TVM) is the concept that money you have now is worth more
than the identical sum in the future due to its potential……… .
29
a. earning capacity
b. spending capacity
c. financial transactions
d. saving capacity
2. The ………in conventional corporate financial theory when making decisions is to

maximize the value of the business or firm.
a. Decision
b. Nature
c. Scope
d. Objective
3. The assets that the firm has already invested in are called ……….
a. Assets in growth
b. Assets in place
c. Assets in save
d. Asset in subject
4. Financial management is excellent art considering that it needs individual skills,

techniques, strategies as well as …………. .
a. Judgement
b. Techniques
c. Nature
d. Technology
5. Financial controls are definitely processes, procedures and policies that are implemented
in order to handle …………
a. Funds
b. Savings
c. Money
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d. None of these
6. The Short Holder bank pays 5.60%, compounded daily (based on 360 days), on a 9-month
certificate of deposit. If you deposit $20,000 you would expect to earn around in
interest.
a. $840
b. $858
c. $1,032
d. $1,121
7. With continuous compounding at 8 percent for 20 years, what is the approximate future
value of a $20,000 initial investment?
a. $52,000
b. $93,219
c. $99,061
d. $915,240
8. In 2 years you are to receive $10,000. If the interest rate were to suddenly decrease, the
present value of that future amount to you would .
a. falls
b. rises
c. remains unchanged
d. The correct answer cannot be determined without more information.
9. Assume that the interest rate is greater than zero. Which of the following cash-inflow
streams totaling $1,500 would you prefer? The cash flows are listed in order for Year 1, Year
2, and Year 3 respectively.
a. $700 $500 $300
b. $300 $500 $700
c. $500 $500 $500
d. Any of the above, since they each sum to $1,500.
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10. You are considering investing in a zero-coupon bond that sells for $500. At maturity
in 8 years, it will be redeemed for $1,000. During the life of the bond NO interest coupons
will be paid. Using the Rule of 72, what approximate
a. 8 percent.
b. 9 percent.
c. 12 percent.
d. 25 percent.
Answers
1. a 2. d 3. b 4. a 5. A 6.b 7.c 8.b 9.a 10. b
REFERENCES
 Joel M. Stern, ed. (2003). The Revolution in Corporate Finance (4th ed.). Wiley-
Blackwell. ISBN 9781405107815.
 Jean Tirole (2006). The Theory of Corporate Finance. Princeton University Press.
ISBN 0691125562.
 Ivo Welch (2014). Corporate Finance (3rd ed.). ISBN 978-0-9840049-1-1.
 Damodaran, A. (2007). Corporate Finance–Theory & Practice, Hoboken, New

Jersey: John Wiley and Sons, Inc.
 M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill.
 Pandey, I.M. (2016). Financial Management. New Delhi:

Vikas Publication House Pvt. Ltd.
 Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018).

Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill.
32
UNIT 2 CORPORATE FINANCE BASIC-II
Structure
Learning objectives
Introduction
Financial decisions
Investment Decision
Factors Affecting Investment Decisions / Capital Budgeting Decisions:
Financing Decision
Factors Affecting Financing Decision:
Dividend Decision
Factors affecting Dividend Decision:
Working Capital Management Decision
Risk-Return Trade-Off:
Corporate Financial Decisions, Firm Value, and Equity Value
Some Fundamental Propositions about Corporate Finance
Summary
Keywords
Learning activity
Unit end questions
References
LEARNING OBJECTIVES

• List financial decision,
• State the factors affecting various financial decisions

• Explain the working capital management concept
• State about fundamental propositions and firm value
INTRODUCTION
Corporate finance is the area of finance dealing with monetary decisions that business
33
enterprises make and the tools and analysis used to make those decisions. The primary goal
of corporate finance is to maximize shareholder value. Although it is in principle different
from managerial finance, which studies the financial decisions of all firms, rather than
corporations alone, the main concepts in the study of corporate finance are applicable to
financial problems of all kinds of firms.
The discipline can be divided into long-term and short-term decisions and techniques. Capital
investment decisions are long-term choices about which projects receive investment, whether
to finance that investment with equity or debt, and when or whether to pay dividends to
shareholders. On the other hand, short-term decisions deal with the short-term balance of
current assets and current liabilities; the focus here is on managing cash, inventories, short-
term borrowing, and lending (such as the terms on credit extended to customers).
The terms corporate finance and corporate financier are also associated with investment
banking. The typical role of an investment bank is to evaluate the company’s financial needs
and raise the appropriate type of capital that best fits those needs. Thus, the terms “corporate
finance” and “corporate financier” may be associated with transactions in which capital is
raised in order to create, develop, grow, or acquire businesses.
FINANCIAL DECISIONS
Everything you need to know about the types of financial decisions taken by a company. The
key aspects of financial decision-making relate to financing, investment, dividends and
working capital management.
Decision making helps to utilize the available resources for achieving the objectives of the
organization, unless minimum financial performance levels are achieved, it is impossible for
a business enterprise to survive over time.
Therefore financial management basically provides a conceptual and analytical framework
for financial decision making.
The types of financial decisions can be classified under: - 1. Long-Term Finance Decisions 2.
Short-Term Finance Decisions.
There are four main financial decisions: - 1. Capital Budgeting or Long term Investment
Decision 2. Capital Structure or Financing Decision 3. Dividend Decision 4. Working Capital
Management Decision.
INVESTMENT DECISION
It is the decision for creation of assets to earn income. Selec•tion of assets in which
34
investment is to be made is the invest•ment decision. It has to be decided how the funds
realized will be utilized on various investments.
Generally, the assets of a company are of two types — those which yield income spread•ing
over a year or so and assets which are easily convertible into cash within a short time. The
first type of investment deci•sion is capital budgeting and the second one is the working
cap•ital management.
Capital budgeting is the allocation of funds on a new asset or reallocation of capital when an
old asset becomes non-profitable. The worthiness of different investment proposals forms a
vital part of capital budgeting exercise.
Risks of investment are there, so the management has to consider it with sufficient cau•tion
and prudence. Capital budgeting decision has another im•portant aspect. It is to determine the
norm or standard against which benefits are to be judged. This is known as cut-off rate,
hurdle rate, minimum rate of return etc. This is actually cost of capital.
Working capital management relates to management of the cur•rent assets. To meet current
obligations, sufficient working cap•ital may be necessary. This can be termed as liquidity. In
case proper amount of working capital cannot be estimated, there may revenue lying idle or
there may be dearth of capital.
Nei•ther is desirable. In case working capital remains in excess which could otherwise be
utilized in the long term productive assets, profit earning would suffer a setback. The very
significant point here to note is that in working capital management there is the trade-off
between liquidity and profit•ability.
A financial decision which is concerned with how the firm’s funds are invested in different
assets is known as investment decision. Investment decision can be long-term or short-term.
A long term investment decision is called capital budgeting decisions which involve huge
amounts of long term investments and are irreversible except at a huge cost. Short-term
investment decisions are called working capital decisions, which affect day to day working of
a business. It includes the decisions about the levels of cash, inventory and receivables.
A bad capital budgeting decision normally has the capacity to severely damage the financial
fortune of a business.
A bad working capital decision affects the liquidity and profitability of a business.
Factors Affecting Investment Decisions / Capital Budgeting Decisions:
1. Cash flows of the project- The series of cash receipts and payments over the life of an
investment proposal should be considered and analyzed for selecting the best proposal.
2. Rate of return- The expected returns from each proposal and risk involved in them should
be taken into account to select the best proposal.
35
3. Investment criteria involved- The various investment proposals are evaluated on the basis
of capital budgeting techniques. Which involve calculation regarding investment amount,
interest rate, cash flows, rate of return etc. It is to be considered which technique to use for
evaluation of projects.
It is more important than the other two decisions. It begins with a determination of the total
amount of assets needed to be held by the firm. In other words, investment decision relates to
the selection of assets, on which a firm will invest funds.
The required assets fall into two groups:
(i) Long-term Assets (fixed assets – plant & machinery land & buildings, etc.,) which
involve huge investment and yield a return over a period of time in future. Investment in
long-term assets is popularly known as “capital budgeting”. It may be defined as the firm’s
decision to invest its current funds most efficiently in fixed assets with an expected flow of
benefits over a series of years.
(ii) Short-term Assets (current assets – raw materials, work-in-process, finished goods,
debtors, cash, etc.,) that can be converted into cash within a financial year without diminution
in value. Investment in current assets is popularly termed as “working capital management”.
It relates to the management of current assets.
It is an important decision of a firm, as short-survival is the prerequisite for long-term
success. Firm should not maintain more or less assets. More assets reduce return and there
will be no risk, but having less assets is more risky and more profitable. Hence, the main
aspects of working capital management are the trade-off between risk and return.
Management of working capital involves two aspects. One determination of the amount
required for running of business and second financing these assets.
Firms have scarce resources that must be allocated among competing needs. The first and
foremost function of corporate financial theory is to provide a framework for firms to make
this decision wisely. Accordingly, we define investment decisions to include not only those
that create revenues and profits (such as introducing a new product line or expanding into a
new market) but also those that save money (such as building a new and more efficient
distribution system). Furthermore, we argue that decisions about how much and what
inventory to maintain and whether and how much credit to grant to customers that are
traditionally categorized as working capital decisions, are ultimately investment decisions as
well. At the other end of the spectrum, broad strategic decisions regarding which markets to
enter and the acquisitions of other companies can also be considered investment decisions.
Corporate finance attempts to measure the return on a proposed investment decision and
compare it to a minimum acceptable hurdle rate to decide whether the project is acceptable.
The hurdle rate has to be set higher for riskier projects and has to reflect the financing mix
used, i.e., the owners funds (equity) or borrowed money (debt). In the discussion of risk and
36
return, we begin this process by defining risk and developing a procedure for measuring risk.
In risk and return models, we go about converting this risk measure into a hurdle rate, i.e., a
minimum acceptable rate of return, both for entire businesses and for individual investments.
Having established the hurdle rate, we turn our attention to measuring the returns on an
investment. In analyzing projects, we evaluate three alternative ways of measuring returns—
conventional accounting earnings, cash flows, and time-weighted cash flows (where we
consider both how large the cash flows are and when they are anticipated to come in). In
extensions of this analysis, we consider some of the potential side costs that might not be
captured in any of these measures, including costs that may be created for existing
investments by taking a new investment, and side benefits, such as options to enter new
markets and to expand product lines that may be embedded in new investments, and
synergies, especially when the new investment is the acquisition of another firm.
FINANCING DECISION
This decision relates to how, when and where funds are to be acquired to meet investment
needs. It is related to the capital structure or financial leverage. This is debt-equity ratio. If
more recourse is taken to debt capital, shareholders’ risk is lessened and the prospects of their
dividend earning are reduced. So, in financing decision, the crucial point is the trade-off
between returned risks.
The financing decision— unlike investment de•cision— relates to the determination of the
capital structure — the proper balance between debt and equity.
Financing deci•sion has two important dimensions:
(1) Is there an optimum capital structure, and
(2) In what proportion should funds be raised to maximize the return to the shareholders?
Once the best debt-equity mix is determined, the finance manager will be on the lookout for
appropriate sources for raising loans and selling shares.
A financial decision which is concerned with the amount of finance to be raised from various
long term sources of funds like, equity shares, preference shares, debentures, bank loans etc.
Is called financing decision. In other words, it is a decision on the ‘capital structure’ of the
company.
Capital Structure Owner’s Fund + Borrowed Fund
The risk of default on payment of periodical interest and repayment of capital on ‘borrowed
funds’ is called financial risk.
Factors Affecting Financing Decision:
1. Cost- The cost of raising funds from different sources is different. The cost of equity is
37
more than the cost of debts. The cheapest source should be selected prudently.
2. Risk- The risk associated with different sources is different. More risk is associated with
borrowed funds as compared to owner’s fund as interest is paid on it and it is also repaid
after a fixed period of time or on expiry of its tenure.
3. Flotation cost- The cost involved in issuing securities such as broker’s commission,
underwriter’s fees, expenses on prospectus etc. Is called flotation cost. Higher the
flotation cost, less attractive is the source of finance.
4. Cash flow position of the business- In case the cash flow position of a company is good
enough then it can easily use borrowed funds.
5. Control considerations- In case the existing shareholders want to retain the complete
control of business then finance can be raised through borrowed funds but when they are
ready for dilution of control over business, equity shares can be used for raising finance.
6. State of capital markets- During boom period, finance can easily be raised by issuing
shares but during depression period, raising finance by means of debt is easy.
After estimation of the amount required and the selection of assets required to be purchased,
the next financing decision comes into the picture. Financial manager is concerned with
makeup of the right hand side of the balance sheet. It is related to the financing mix or capital
structure or leverage. Financial manager has to determine the proportion of debt and equity in
capital structure.
It should be on optimum finance mix, which maximizes shareholders’ wealth. A proper
balance will have to be struck between risk and return. Debt involves fixed cost (interest),
which may help in increasing the return on equity but also increases risk. Raising of funds by
issue of equity shares is one permanent source, but the shareholders will expect higher rates
of earnings.
The two aspects of capital structure are- One capital structure theories and two determination
of optimum capital structure.
Every business, no matter how large and complex, is ultimately funded with a mix of
borrowed money (debt) and owners funds (equity). With a publicly trade firm, debt may take
the form of bonds and equity is usually common stock. In a private business, debt is more
likely to be bank loans and an owner’s savings represent equity. Though we consider the
existing mix of debt and equity and its implications for the minimum acceptable hurdle rate
as part of the investment principle, we throw open the question of whether the existing mix is
the right one in the financing principle section. There might be regulatory and other real-
world constraints on the financing mix that a business can use, but there is ample room for
flexibility within these constraints. We begin the discussion of financing methods, by looking
at the range of choices that exist for both private businesses and publicly traded firms
38
between debt and equity. We then turn to the question of whether the existing mix of
financing used by a business is optimal, given the objective function of maximizing firm
value. Although the trade-off between the benefits and costs of borrowing are established in
qualitative terms first, we also look at two quantitative approaches to arriving at the optimal
mix. In the first approach, we examine the specific conditions under which the optimal
financing mix is the one that minimizes the minimum acceptable hurdle rate. In the second
approach, we look at the effects on firm value of changing the financing mix.
When the optimal financing mix is different from the existing one, we map out the best ways
of getting from where we are (the current mix) to where we would like to be (the optimal),
keeping in mind the investment opportunities that the firm has and the need for timely
responses, either because the firm is a takeover target or under threat of bankruptcy. Having
outlined the optimal financing mix, we turn our attention to the type of financing a business
should use, such as whether it should be long-term or short-term, whether the payments on
the financing should be fixed or variable, and if variable, what it should be a function of.
Using a basic proposition that a firm will minimize its risk from financing and maximize its
capacity to use borrowed funds if it can match up the cash flows on the debt to the cash flows
on the assets being financed, we design the perfect financing instrument for a firm. We then
add additional considerations relating to taxes and external monitors (equity research analysts
and ratings agencies) and arrive at strong conclusions about the design of the financing.
DIVIDEND DECISION
The profit of a company can be dealt with in two alternative ways — to distribute them as
dividends to shareholders or to retain them in the business. If sufficient dividend is not paid,
shareholders will not be satisfied, the market value of shares will come down and there may
be financial crisis.
If the profits, on the other hand, are distrib•uted to the maximum extent, the company will
lose on impor•tant source of self-financing. So a judicious decision is a must. There should be
a good combination of distribution and reten•tion.
The dividend decision boils down to the determination of net profits to be paid out to
shareholders as dividends. Here the management is to consider two major factors —
preference of the shareholders and the investment opportunities in the com•pany.
The functions of financial management can be discussed from different angles but the fact
remains that finance plays the piv•otal role in the whole organization. Whatever has to be
done needs money and that money procurement is the financial manager’s function.
How to use the money, how much to use and where to use are also matters of consultation
with the finance management. Even the top management personnel cannot by•pass the
financial management to decide matters relating to fi•nance which is so vital to keep the
39
organization in sound health.
Financial planning, investment of funds procured, financial con•trol and the future financial
policy — all are within the preview of financial management.
A financial decision which is concerned with deciding how much of the profit earned by the
company should be distributed among shareholders (dividend) and how much should be
retained for the future contingencies (retained earnings) is called dividend decision.
Dividend refers to that part of the profit which is distributed to shareholders. The decision
regarding dividend should be taken keeping in view the overall objective of maximizing
shareholder s wealth.
Factors affecting Dividend Decision:
1. Earnings- Company having high and stable earnings could declare high rate of dividends
as dividends are paid out of current and past earnings.
2. Stability of dividends- Companies generally follow the policy of stable dividend. The
dividend per share is not altered in case earning changes by small proportion or increase
in earnings is temporary in nature.
3. Growth prospects- In case there are growth prospects for the company in the near future
then, it will retain its earnings and thus, no or less dividend will be declared.
4. Cash flow positions- Dividends involve an outflow of cash and thus, availability of
adequate cash is foremost requirement for declaration of dividends.
5. Preference of shareholders- While deciding about dividend the preference of shareholders
is also taken into account. In case shareholders desire for dividend then company may go
for declaring the same. In such case the amount of dividend depends upon the degree of
expectations of shareholders.
6. Taxation policy- A company is required to pay tax on dividend declared by it. If tax on
dividend is higher, company will prefer to pay less by way of dividends whereas if tax
rates are lower, then more dividends can be declared by the company.
This is the third financial decision, which relates to dividend policy. Dividend is a part of
profits, which are available for distribution to equity shareholders. Payment of dividends
should be analyzed in relation to the financial decision of a firm. There are two options
available in dealing with net profits of a firm, viz., distribution of profits as dividends to the
ordinary shareholders where there is no need of retention of earnings or they can be retained
in the firm itself if they are required for financing of any business activity.
But distribution of dividends or retaining should be determined in terms of its impact on the
shareholders’ wealth. Financial manager should determine the optimum dividend policy,
which maximizes market value of the share thereby market value of the firm. Considering the
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factors to be considered while determining dividends is another aspect of dividend policy.
Most businesses would undoubtedly like to have unlimited investment opportunities that
yield returns exceeding their hurdle rates, but all businesses grow and mature. As a
consequence, every business that thrives reaches a stage in its life when the cash flows
generated by existing investments is greater than the funds needed to take on good
investments. At that point, this business has to figure out ways to return the excess cash to
owners. In private businesses, this may just involve the owner withdrawing a portion of his or
her funds from the business. In a publicly traded corporation, this will involve either paying
dividends or buying back stock. The discussion of dividend policy, we introduce the basic
trade-off that determines whether cash should be left in a business or taken out of it. For
stockholders in publicly traded firms, we note that this decision is fundamentally one of
whether they trust the managers of the firms with their cash, and much of this trust is based
on how well these managers have invested funds in the past. Finally, we consider the options
available to a firm to return assets to its owners—dividends, stock buybacks and spin-offs—
and investigate how to pick between these options.
WORKING CAPITAL MANAGEMENT DECISION
Working capital management is a business strategy designed to ensure that a company

operates efficiently by monitoring and using its current assets and liabilities to the best effect.
The primary purpose of working capital management is to enable the company to maintain
sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
A company's working capital is made up of its current assets minus its current liabilities.
Current assets include anything that can be easily converted into cash within 12 months.
These are the company's highly liquid assets. Some current assets include cash, accounts
receivable, inventory, and short-term investments.
Current liabilities are any obligations due within the following 12 months. These include
operating expenses and long-term debt payments.
Working capital management can improve a company's earnings and profitability through
efficient use of its resources. Management of working capital includes inventory management
as well as management of accounts receivables and accounts payables.
The objectives of working capital management, in addition to ensuring that the company has
enough cash to cover its expenses and debt, are minimizing the cost of money spent on
working capital, and maximizing the return on asset investments.
Working capital management is concerned with management of a firm’s short-term or current
assets, such as inventory, cash, receivables and short-term or current liabilities, such as
creditors, bills payable. Assets and Liabilities which mature within the operating cycle of
41
business or within one year are termed as current assets and current liabilities respectively.
Working capital management involves following issues:
(1) What are the possible sources of raising short term funds?
(2) In what proportion should the funds be raised from different short term sources?
(3) What should be the optimum levels of cash and inventory?
(4) What should be the firm’s credit policy while selling to customers?
Risk-Return Trade-Off:
Working capital management also involves risk-return trade off as it affects liquidity and
profitability of a firm. Liquidity is inversely related to profitability, i.e., increase in liquidity
results in decrease in profitability and vice versa. Higher liquidity would mean having more
of current assets. This reduces risk of default in meeting short term obliga•tions.
But current assets provide lower return than fixed assets and hence reduce profitability as
funds that could earn higher return via investment in fixed assets are blocked in current
assets. Thus higher liquidity would mean lower risk but also lower profits and lower liquidity
would mean more risk but more returns. Therefore the finance manager should have optimal
level of working capital.
Inter-Relationships between Financial Decisions:
All the four financial management decisions explained above are not inde•pendent but related
with each other’s. Capital budgeting decision requires calculation of present values of cost
and benefits for which we need some appropriate discount rate. Cost of capital which is the
result of capital structure decision of a firm is generally used as the discount rate in capital
budgeting decision.
Hence investment and financing decisions are inter•related. When operating risk of a business
is high due to huge investment in long term assets (i.e. capital budgeting decision) then
companies should have low debt capital and less financial risk. Dividend decision depends
upon the operating profitability of a firm which in turn depends on the capital budgeting
decision.
Sometimes firms use retained earnings for financing their investment projects and if some
amount of profit is left, that amount is distributed as dividend. Hence there is a relationship
between dividends and capital budgeting on one hand and dividends and financing decision
on the other.
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CORPORATE FINANCIAL DECISIONS, FIRM VALUE, AND
EQUITY VALUE
If the objective function in corporate finance is to maximize firm value, it follows that firm
value must be linked to the three corporate finance decisions outlined—investment,
financing, and dividend decisions. The link between these decisions and firm value can be
made by recognizing that the value of a firm is the present value of its expected cash flows,
discounted back at a rate that reflects both the riskiness of the projects of the firm and the
financing mix used to finance them. Investors form expectations about future cash flows
based on observed current cash flows and expected future growth, which in turn depend on
the quality of the firms projects (its investment decisions) and the amount reinvested back
into the business (its dividend decisions). The financing decisions affect the value of a firm
through both the discount rate and potentially through the expected cash flows.
This neat formulation of value is put to the test by the interactions among the investment,
financing, and dividend decisions and the conflicts of interest that arise between stockholders
and lenders to the firm, on one hand, and stockholders and managers, on the other. We
introduce the basic models available to value a firm and its equity, and relate them back to
management decisions on investment, financial, and dividend policy. In the process, we
examine the determinants of value and how firms can increase their value.
SOME FUNDAMENTAL PROPOSITIONS ABOUT CORPORATE

FINANCE
There are several fundamental arguments we will make repeatedly in this discussion:
1. Corporate finance has an internal consistency that flows from its choice of maximizing
firm value as the only objective function and its dependence on a few bedrock principles:
Risk has to be rewarded, cash flows matter more than accounting income, markets are not
easily fooled, and every decision a firm makes has an effect on its value.2. Corporate finance
must be viewed as an integrated whole, rather than a collection of decisions. Investment
decisions generally affect financing decisions and vice versa; financing decisions often
influence dividend decisions and vice versa. Although there are circumstances under which
these decisions may be independent of each other, this is seldom the case in practice.
Accordingly, it is unlikely that firms that deal with their problems on a piecemeal basis will
ever resolve these problems. For instance, a firm that takes poor investments may soon find
itself with a dividend problem (with insufficient funds to pay dividends) and a financing
problem (because the drop in earnings may make it difficult for them to meet interest
expenses).
2. Corporate finance matters to everybody. There is a corporate financial aspect to almost
every decision made by a business; though not everyone will find a use for all the
43
components of corporate finance, everyone will find a use for at least some part of it.
Marketing managers, corporate strategists, human resource managers, and information
technology managers all make corporate finance decisions every day and often don’t realize
it. An understanding of corporate finance will help them make better decisions.
3. Corporate finance is fun. This may seem to be the tallest claim of all. After all, most
people associate corporate finance with numbers, accounting statements, and hardheaded
analyses. Although corporate finance is quantitative in its focus, there is a significant
component of creative thinking involved in coming up with solutions to the financial
problem’s businesses do encounter. It is no coincidence that financial markets remain
breeding grounds for innovation and change.
4. The best way to learn corporate finance is by applying its models and theories to real-
world problems. Although the theory that has been developed over the past few decades is
impressive, the ultimate test of any theory is application. As we will argue, much (if not all)
of the theory can be applied to real companies and not just to abstract examples, though we
have to compromise and make assumptions in the process.
SUMMARY
Every decision made in a business has financial implications, and any decision that involves
the use of money is a corporate financial decision. Defined broadly, everything that a
business does fits under the rubric of corporate finance. It is, in fact, unfortunate that we even
call the subject corporate finance, because it suggests to many observers a focus on how large
corporations make financial decisions and seems to exclude small and private businesses
from its purview. A more appropriate title for this discipline would be Business Finance,
because the basic principles remain the same, whether one looks at large, publicly traded
firms or small, privately run businesses. All businesses have to invest their resources wisely,
find the right kind and mix of financing to fund these investments, and return cash to the
owners if there are not enough good investments.
In this introduction, we will lay the foundation for this discussion by listing the three
fundamental principles that underlie corporate finance—the investment, financing, and
dividend principles—and the objective of firm value maximization that is at the heart of
corporate financial theory.
This introduction establishes the first principles that govern corporate finance. The
investment principle specifies that businesses invest only in projects that yield a return that
exceeds the hurdle rate. The financing principle suggests that the right financing mix for a
firm is one that maximizes the value of the investments made. The dividend principle
requires that cash generated in excess of good project needs be returned to the owners. These
principles are the core for corporate finance.
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KEYWORDS
• Dividends: Dividends are payments made by a corporation to its shareholder members. It
is the portion of corporate profits paid out to stockholders
• Corporation:Legal entities which is separate and distinct from its owners, and can own
assets, incur liabilities, and issue stock.
• Coverage Ratio – a formula used to assess the adequacy of cash flow generated through
earnings for the purposes of meeting debt and lease obligations.
• Depreciation: the charge to amortize the cost of long-term assets over the useful life of the
assets.
• Long-Term Debt: a debt with a maturity of more than one year.
LEARNING ACTIVITY
1. Dividend policy is often described as "sticky. What is meant by this description?

What might explain the sticky nature of dividends?
2. As a financial advisor of a company what are major investment decision you will take
or suggest in company.
UNIT END QUESTIONS
A. Descriptive Question
1. Explain what do you understand by financial decisions? What are the fundamental
propositions about corporate finance?
2. Discuss the Investment decisions? What are the factors affecting investment decision?
3. Discuss the financing decisions? What are the factor affecting this decision?
4. Explain the Dividend decisions? What are the factors affecting this decisions?
5. Discuss what do you understand by Working capital management decision? Explain
corporate financial decision and firm value.
Long Descriptive questions
1. Following are the details regarding three companies X Ltd., Y Ltd. and Z Ltd. X Ltd. Y
Ltd. Z Ltd. r = 15% r = 15% r = 10% Ke = 10% Ke = 10% Ke = 10% E = ` 8 E = ` 8 E = `.8
45
Calculate the value of equity share of each of the company applying Walter’s model, when
dividend payout ratio is: (a) 50%, (b) 75% and (c) 25%. You are required to offer your
comments on the result.
2. X Ltd. has an investment of ` 5,00,000 in assets and 50,000 shares outstanding at ` 10 each.
It earns a rate of 15% on its investment and has a policy of retaining 50% of the earnings. If
the appropriate discount rate is 10%, determine the price of company’s share using Gordon’s
Growth Model. What will be the share price if the company has a payout of 80% or 40%?
3. Ruchi Soya Ltd. is an established company having its shares quoted in the stock market.
The company has distributed dividend at 20% p.a. The paid-up capital of the company was `
50 lakh shares of ` 10 each. Annual growth rate in dividend expected is 3%. The expected
rate of return on its equity capital is 15%. Calculate the value of shares of Ruchi Soya Ltd.
based on Gordon’s dividend growth model.

1. In a private business, debt is more likely to be bank loans and an owner’s savings
represent ………. .
a. Equity
b. Equivalent
c. Finance
d. Investment
2. When the optimal ................ mix is different from the existing one, we map out the
best ways of getting from where we are (the current mix) to where we would like to be (the
optimal), keeping in mind the investment opportunities that the firm has and the need for
timely responses, either because the firm is a takeover target or under threat of bankruptcy.
a. Investing
b. Financing
c. Dividend
d. Working capital
3. Corporate finance attempts to measure the return on a proposed ................. decision

and compare it to a minimum acceptable hurdle rate to decide whether the project is
acceptable.
46
a. Financing
b. Dividend
c. Working capital
d. Investment
4. If there are not enough investments that earn the hurdle rate, return the cash to the
owners of the business
a. Dividend Principle
b. Financing
c. Investment
d. Work capital
5. The growth of corporate.......... theory can be traced to its choice of a single objective
and the development of models built around this objective.
a. Financial
b. Investment
c. Decision
d. None of these
6. Capital budgeting actually the process of making investment decisions in

a. Sales Planning
b. Production process and style
c. Fixed Assets
d. Current Assets
7. Which is helpful in evaluation of financial efficiency of top management?

a. Brand
b. Cost of capital
c. Capital structure
d. Product quality
47
8. Capital budgeting is
a. A long term investment
b. Anirreversible decision
c. A strategic investment decisions

d. All of these
9. Dividend is income for the

a. Shareholders
b. SEBI
c. Company
d. Goods Suppliers
10. Which is the method of Capital budgeting?

a. Net Present Value Method
b. Rate of Return Method
c. Payback period Method
d. All of these
Answers
1. a 2. b 3. d 4. a 5. A 6.c 7.b 8.d 9.a 10.d
REFERENCES
 Joseph Ogden; Frank C. Jen; Philip F. O'Connor (2002). Advanced Corporate

Finance. Prentice Hall. ISBN 978-0130915689.
 Pascal Quiry; Yann Le Fur; Antonio Salvi; Maurizio Dallochio; Pierre Vernimmen
(2011). Corporate Finance: Theory and Practice (3rd ed.). Wiley. ISBN 978-
1119975588.
 Stephen Ross, Randolph Westerfield, Jeffrey Jaffe (2012). Corporate Finance (10th
ed.). McGraw-Hill. ISBN 978-0078034770
 Damodaran, A. (2007). Corporate Finance –Theory & Practice, Hoboken, New

48
 Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House
Pvt. Ltd.

49
UNIT 3 FINANCIAL ANALYSIS, PROFIT PLANNING
AND CONTROL
Structure
Learning objectives
Introduction
Meaning and Concept of Financial Analysis
Elements of a Company Assessed by the financial analysts:
Objectives
The Financial Analysis Process
Distinguishing between Computations and Analysis
Financial statement
Horizontal and vertical analysis:
Ratio Analysis
Tools of Analysis of Financial Statements
Comparative Statements
Common size statement
Trend Analysis
Procedure for Calculating Trend Percentage
Limitations of Financial Analysis
Ratio analysis
Types of Ratios
Liquidity Ratios
Cash flow statement
Illustrations
I.L1 Comparative statement
I.L 2 Common size income statement
I.L 3 Trend analysis
I.L 4 Ratio Analysis
Cash Flow statement
50
Summary
Keywords
Learning activity
Unit end questions
References
LEARNING OBJECTIVES
 explain the nature and significance of financial analysis;
 identify the objectives of financial analysis;
 describe the various tools of financial analysis;
 state the limitations of financial analysis;
 prepare comparative and common size statements and interpret the data given therein;
and
 Calculate the trend percentages and interpret them.
 About ratio analysis, about cash flow statement as well
INTRODUCTION
Financial analysis tools can be useful in assessing a company’s performance and trends in
that performance. In essence, an analyst converts data into financial metrics that assist in
decision making. Analysts seek to answer such questions as: How successfully has the
company performed, relative to its own past performance and relative to its competitors?
How is the company likely to perform in the future? Based on expectations about future
performance, what is the value of this company or the securities it issues? A primary source
of data is a company’s annual report, including the financial statements and notes, and
management commentary (operating and financial review or management’s discussion and
analysis). This reading focuses on data presented in financial reports prepared under
International Financial Reporting Standards (IFRS) and United States generally accepted
accounting principles (US GAAP).
However, financial reports do not contain all the information needed to perform effective
financial analysis. Although financial statements do contain data about the past performance
of a company (its income and cash flows) as well as its current financial condition (assets,
liabilities, and owners’ equity), such statements do not necessarily provide all the information
useful for analysis nor do they forecast future results. The financial analyst must be capable
51
of using financial statements in conjunction with other information to make projections and
reach valid conclusions. Accordingly, an analyst typically needs to supplement the
information found in a company’s financial reports with other information, including
information on the economy, industry, comparable companies, and the company itself. This
reading describes various techniques used to analyze a company’s financial statements.
Financial analysis of a company may be performed for a variety of reasons, such as valuing
equity securities, assessing credit risk, conducting due diligence related to an acquisition, or
assessing a subsidiary’s performance. This reading will describe techniques common to any
financial analysis and then discuss more specific aspects for the two most common
categories: equity analysis and credit analysis.
MEANING AND CONCEPT OF FINANCIAL ANALYSIS
Financial analysis refers to an assessment of the viability, stability and profitability of a

business, sub-business or project.
It can also be defined as the process of identifying financial strengths and weaknesses of the
firm by properly establishing relationship between the items of the balance sheet and the
profit and loss account. It is the examination of a business from a variety of perspectives in
order to fully understand the greater financial situation and determine how best to strengthen
the business and it also looks at many aspects of a business from its profitability and stability
to its solvency and liquidity. It is a process of scanning the Financial Statements for
evaluating the relationship between the items as disclosed in them.
In other words it can be defined as an analysis which critically examines the relationship
between various elements of the Financial Statements with a view to obtain the necessary and
effective information from them.
According to John N. Myer, ‘Financial Statement Analysis is largely a study of relationships

among the various financial factors in a business, as disclosed by a single set of statements,
and study of these factors as shown in a series of statements.’
Financial Statement Analysis involves a systematic and critical examination of the

information contained in the Financial Statements with a view to provide effective and more
meaningful information to its different users. It is an exceptionally powerful tool for a variety
of users of financial statements, each having different objectives in learning about the
financial circumstances of the entity.
52
Financial analysis is an aspect of the overall business finance function that involves
examining historical data to gain information about the current and future financial health of
a company.
According to Alan S. Donnahoe - "The inability to understand and deal with financial data is
a severe handicap in the corporate world"
Financial analysis can be applied in a wide variety of situations to give business managers the
information they need to make critical decisions. “In a very real sense, finance is the
language of business. Goals are set and performance is measured in financial terms. Plants
are built, equipment ordered, and new projects undertaken based on clear investment return
criteria. Financial analysis is required in every such case."
Financial statement analysis is an analysis that highlights the important relationship in the
financial statements. Financial statement analysis focuses on the evaluation of past
performance of the business firm in terms of liquidity, profitability, operational efficiency
and growth potentiality. Financial statements analysis includes the method use in assessing
and interpreting the result of past performance and current financial position as they relate to
particular factors of interest in investment decisions. Therefore financial statement analysis is
an important means of assessing past performance and in forecasting and planning future
performance.
It is performed by professionals who prepare reports using ratios that make use of
information taken from financial statements and other reports. These reports are usually
presented to top management as one of their bases in making business decisions, such as:
1. Continuing or discontinuing the business
2. Making or purchasing certain materials in the manufacture product
3. Acquire or rent/lease certain machineries and equipment in the production of its goods
4. Negotiating for a bank loan to increase its working capital and to issue the stocks
5. Making decisions regarding investing or lending capital
6. Allowing management to make an informed selection on various alternatives in the
conduct of its business
3.2.1 Elements of a Company Assessed by the financial analysts:
Generally financial analysts assess the following elements:
53
1. Profitability – It is the ability to earn income and sustain growth in both the short- and
long-term. A company's degree of profitability is usually based on the income statement,
which reports on the company's results of operations.
2. Solvency – It is the ability to pay its obligation to creditors and other third parties in the
long-term. It is also based on the company's balance sheet, which indicates the financial
condition of a business at a given point of time.
3. Liquidity – It is the ability to maintain positive cash flow, while satisfying immediate
obligations and it is also based on the company's balance sheet, which indicates the financial
condition of a business at a given point of time.
4. Stability - The firm's ability to remain in business in the long run, without having to
sustain significant losses in the conduct of its business.
Assessing a company's stability requires the use of the income statement and the balance
sheet, as well as other financial and non-financial indicators.
OBJECTIVES
Assessment of Past Performance

Past performance is a good indicator of future performance. Investors or creditors are
interested in the trend of past sales; cost of goods sold, operating expenses, net income, cash
flows and return on investment. These trends offer a means for judging management's past
performance and are possible indicators of future performance.
Assessment of current position

Financial statement analysis shows the current position of the firm in terms of the types of
assets owned by a business firm and the different liabilities due against the enterprise.
Prediction of profitability and growth prospects
Financial statement analysis helps in assessing and predicting the earning prospects and
growth rates in earning which are used by investors while comparing investment alternatives
and other users in judging earning potential of business enterprise.
Prediction of bankruptcy and failure
Financial statement analysis is an important tool in assessing and predicting bankruptcy and
probability of business failure.
54
Assessment of the operational efficiency
Financial statement analysis helps to assess the operational efficiency of the management of a
company. The actual performance of the firm which are revealed in the financial statements
can be compared with some standards set earlier and the deviation of any between standards
and actual performance can be used as the indicator of efficiency of the management.
Some other objectives are:
• Provide reliable financial information.
• Provide other needed information about changes in economic resources and obligation.
• Provide reliable information about changes in net resources.
• Provide financial information that assess in estimating the earnings of a business.
• Disclosing other information according to the needs of the users.
THE FINANCIAL ANALYSIS PROCESS
In financial analysis, it is essential to clearly identify and understand the final objective and
the steps required to reach that objective. In addition, the analyst needs to know where to find
relevant data, how to process and analyze the data (in other words, know the typical questions
to address when interpreting data), and how to communicate the analysis and conclusions.
The Objectives of the Financial Analysis Process Because of the variety of reasons for
performing financial analysis, the numerous available techniques, and the often substantial
amount of data, it is important that the analytical approach be tailored to the specific
situation. Prior to beginning any financial analysis, the analyst should clarify the purpose and
context, and clearly understand the following:
 What is the purpose of the analysis? What questions will this analysis answer?
 What level of detail will be needed to accomplish this purpose?
 What data are available for the analysis?
 What are the factors or relationships that will influence the analysis?
 What are the analytical limitations, and will these limitations potentially impair the
analysis?
Having clarified the purpose and context of the analysis, the analyst can select the set of
techniques (e.g., ratios) that will best assist in making a decision. Although there is no single
approach to structuring the analysis process, a general framework is set forth in Exhibit 1.2
The steps in this process were discussed in more detail in an earlier reading; the primary
focus of this reading is on Phases 3 and 4, processing and analyzing data.
55
Figure 3.1
DISTINGUISHING BETWEEN COMPUTATIONS AND ANALYSIS
An effective analysis encompasses both computations and interpretations. A well-reasoned

analysis differs from a mere compilation of various pieces of information, computations,
tables, and graphs by integrating the data collected into a cohesive whole. Analysis of past
performance, for example, should address not only what happened but also why it happened
and whether it advanced the company’s strategy. Some of the key questions to address
include:
 How well did the company’s performance meet these critical aspects? (Established
through computation and comparison with appropriate benchmarks, such as the
company’s own historical performance or competitors’ performance.)
 What were the key causes of this performance, and how does this performance reflect
the company’s strategy? (Established through analysis.) If the analysis is forward
56
looking, additional questions include:
 What is the likely impact of an event or trend? (Established through interpretation of

analysis.)
 What is the likely response of management to this trend? (Established through

evaluation of quality of management and corporate governance.)
 What is the likely impact of trends in the company, industry, and economy on future
cash flows? (Established through assessment of corporate strategy and through
forecasts.)
 What are the recommendations of the analyst? (Established through interpretation and
forecasting of results of analysis.)
 What risks should be highlighted? (Established by an evaluation of major

uncertainties in the forecast and in the environment within which the company
operates.)
Example 1 demonstrates how a company’s financial data can be analyzed in the context of its
business strategy and changes in that strategy. An analyst must be able to understand the
“why” behind the numbers and ratios, not just what the numbers and ratios are
Analysts often need to communicate the findings of their analysis in a written report. Their
reports should communicate how conclusions were reached and why recommendations were
made.
FINANCIAL STATEMENT
Types of Financial Statement Analysis

Financial statement analysis can be performed by employing a number of methods or
techniques.
There are two key methods for analyzing financial statements:
Horizontal and vertical analysis:
Horizontal analysis is the comparison of financial information over a series of reporting

periods, Horizontal analysis looks at amounts on the financial statements over the past years.
This allows you to see how each item has changed in relationship to the changes in other
items. Horizontal analysis is also referred to as trend analysis.
Vertical analysis is the proportional analysis of a financial statement, where each line item on
a financial statement is listed as a percentage of another item. Typically, this means that
every line item on an income statement is stated as a percentage of gross sales, while every
line item on a balance sheet is stated as a percentage of total assets.
57
Thus, horizontal analysis is the review of the results of multiple time periods, while vertical
analysis is the review of the proportion of accounts to each other within a single period.
Ratio Analysis
The second method for analyzing financial statements is the use of many kinds of ratios. You
use ratios to calculate the relative size of one number in relation to another. After you
calculate a ratio, you can then compare it to the same ratio calculated for a prior period, or
that is based on an industry average, to see if the company is performing in accordance with
expectations. In a typical financial statement analysis, most ratios will be within expectations,
while a small number will flag potential problems that will attract the attention of the
reviewer. The methods to be selected for the analysis depend upon the circumstances and the
users' need. The user or the analyst should use appropriate methods to derive required
information to fulfill their needs.
Financial Statements are divided into three parts named
• Income Statement/Profit & loss account
• Balance Sheet and
• Notes to Financial Statements
TOOLS OF ANALYSIS OF FINANCIAL STATEMENTS
• The most commonly used techniques of financial analysis are as follows:

• Comparative Statements: These are the statements showing the profitability and financial
position of a firm for different periods of time in a comparative form to give an idea about the
position of two or more periods. It usually applies to the two important financial statements,
namely, balance sheet and statement of profit and loss prepared in a comparative form. The
financial data will be comparative only when same accounting principles are used in
preparing these statements. If this is not the case, the deviation in the use of accounting
principles should be mentioned as a footnote. Comparative figures indicate the trend and
direction of financial position and operating results. This analysis is also known as
‘horizontal analyses.
• Common Size Statements: These are the statements which indicate the relationship of
different items of a financial statement with a common item by expressing each item as a
percentage of that common item. The percentage thus calculated can be easily compared with
the results of corresponding percentages of the previous year or of some other firms, as the
numbers are brought to common base. Such statements also allow an analyst to compare the
operating and financing characteristics of two companies of different sizes in the same
58
industry. Thus, common size statements are useful, both, in intra-firm comparisons over
different years and also in making inter-firm comparisons for the same year or for several
years. This analysis is also known as ‘Vertical analysis’.
• Trend Analysis: It is a technique of studying the operational results and financial position
over a series of years. Using the previous years’ data of a business enterprise, trend analysis
can be done to observe the percentage changes over time in the selected data. The trend
percentage is the percentage relationship, in which each item of different years bear to the
same item in the base year. Trend analysis is important because, with its long run view, it
may point to basic changes in the nature of the business. By looking at a trend in a particular
ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From
this observation, a problem is detected or the sign of good or poor management is detected.
• Ratio Analysis: It describes the significant relationship which exists between various items
of a balance sheet and a statement of profit and loss of a firm. As a technique of financial
analysis, accounting ratios measure the comparative significance of the individual items of
the income and position statements. It is possible to assess the profitability, solvency and
efficiency of an enterprise through the technique of ratio analysis.
• Cash Flow Analysis: It refers to the analysis of actual movement of cash into and out of an
organization. The flow of cash into the business is called as cash inflow or positive cash flow
and the flow of cash out of the firm is called as cash outflow or a negative cash flow. The
difference between the inflow and outflow of cash is the net cash flow. Cash flow statement
is prepared to project the manner in which the cash has been received and has been utilized
during an accounting year as it shows the sources of cash receipts and also the purposes for
which payments are made. Thus, it summarizes the causes for the changes in cash position of
a business enterprise between dates of two balance sheets.
Comparative Statements
As stated earlier, these statements refer to the statement of profit and loss and the balance
sheet prepared by providing columns for the figures for both the current year as well as for
the previous year and for the changes during the year, both in absolute and relative terms. As
a result, it is possible to find out not only the balances of accounts as on different dates and
summaries of different operational activities of different periods, but also the extent of their
increase or decrease between these dates. The figures in the comparative statements can be
used for identifying the direction of changes and also the trends in different indicators of
performance of an organization.
The following steps may be followed to prepare the comparative statements:
Step 1: List out absolute figures in rupees relating to two points of time (as shown in columns
2 and 3 of Exhibit 4.1).
59
Step 2: Find out change in absolute figures by subtracting the first year (Col.2) from the
second year (Col.3) and indicate the change as increase (+) or decrease (–) and put it in
column 4.
Step 3: Preferably, also calculate the percentage change as follows and put it in column 5.
Particulars First Year Second Absolute Percentage

Year Increase Increase (+)
(+) or or Decrease
Decrease (–)
(–)
1 2 3 4 5
Rs. Rs. Rs. %.
Figure 3.2
Common size statement
Figure 3.3
Common Size Statement, also known as component percentage statement, is a financial tool
for studying the key changes and trends in the financial position and operational result of a
60
company. Here, each item in the statement is stated as a percentage of the aggregate, of
which that item is a part. For example, a common size balance sheet shows the percentage of
each asset to the total assets, and that of each liability to the total liabilities. Similarly, in the
common size statement of profit and loss, the items of expenditure are shown as a percentage
of the net revenue from operations. If such a statement is prepared for successive periods, it
shows the changes of the respective percentages over a period of time. Common size analysis
is of immense use for comparing enterprises which differ substantially in size as it provides
an insight into the structure of financial statements. Inter-firm comparison or comparison of
the company’s position with the related industry as a whole is possible with the help of
common size statement analysis.
The following procedure may be adopted for preparing the common size statements.
 List out absolute figures in rupees at two points of time, say year 1, and year 2
(Column 2 & 4 of Exhibit 4.2).
 Choose a common base (as 100). For example, revenue from operations may be taken
as base (100) in case of statement of profit and loss and total assets or total liabilities
(100) in case of balance sheet.
 For all items of Col. 2 and 3 work out the percentage of that total. Column 4 and 5
shows these percentages.
Trend Analysis
The financial statements may be analyzed by computing trends of series of information.

Trend analysis determines the direction upwards or downwards and involves the computation
of the percentage relationship that each item bears to the same item in the base year. In case
of comparative statement, an item is compared with itself in the previous year to know
whether it has increased or decreased or remained constant. Common size analysis is to
ascertain whether the proportion of an item (say cost of revenue from operations) is
increasing or decreasing in the common base (say revenue from operations). But in case of
trend analysis, we learn about the behavior of the same item over a given period, say, during
the last 5 years. Take for example, administrative expenses, whether they are exhibiting
increasing tendency or decreasing tendency or remaining constant over the period of
comparison. Generally trend analysis is done for a reasonably long period. Many companies
present their financial data for a period of 5 or 10 years in various forms in their annual
reports.
Procedure for Calculating Trend Percentage
One year is taken as the base year. Generally, the first year is taken as the base year. The
figure of base year is taken as 100. The trend percentages are calculated in relation to this
base year. If a figure in other year is less than the figure in base year, the trend percentage
61
will be less than 100 and it will be more than 100 if figure is more than the base year figure.
Each year’s figure is divided by the base year figure.
The accounting procedures and conventions used for collecting data and preparation of
financial statements should be similar; otherwise the figures will not be comparable
Limitations of Financial Analysis
Though financial analysis is quite helpful in determining financial strengths and weaknesses
of a firm, it is based on the information available in financial statements. As such, the
financial analysis also suffers from various limitations of financial statements. Hence, the
analyst must be conscious of the impact of price level changes, window dressing of financial
statements, changes in accounting policies of a firm, accounting concepts and conventions,
personal judgement, etc. Some other limitations of financial analysis are:
 Financial analysis does not consider price level changes.
 Financial analysis may be misleading without the knowledge of the changes in

accounting procedure followed by a firm.
 Financial analysis is just a study of reports of the company.
 Monetary information alone is considered in financial analysis while non-monetary

aspects are ignored.
 The financial statements are prepared on the basis of accounting concept, as such, it
does not reflect the current position.
RATIO ANALYSIS
As stated earlier, accounting ratios are an important tool of financial statements analysis. A
ratio is a mathematical number calculated as a reference to relationship of two or more
numbers and can be expressed as a fraction, proportion, percentage and a number of times.
When the number is calculated by referring to two accounting numbers derived from the
financial statements, it is termed as accounting ratio. For example, if the gross profit of the
business is Rs. 10,000 and the ‘Revenue from Operations’ 10, 000 are Rs. 1,00,000, it can be
said that the gross profit is 10% (10,000/1,00,000) 100 of the ‘Revenue from Operations’.
This ratio is termed as gross profit ratio. Similarly, inventory turnover ratio may be 6 which
implies that inventory turns into ‘Revenue from Operations’ six times in a year.
It needs to be observed that accounting ratios exhibit relationship, if any, between accounting
numbers extracted from financial statements. Ratios are essentially derived numbers and their
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efficacy depends a great deal upon the basic numbers from which they are calculated. Hence,
if the financial statements contain some errors, the derived numbers in terms of ratio analysis
would also present an erroneous scenario. Further, a ratio must be calculated using numbers
which are meaningfully correlated. A ratio calculated by using two unrelated numbers would
hardly serve any purpose. For example, the furniture of the business is Rs. 1, 00,000 and
Purchases are Rs. 3, 00,000. The ratio of purchases to furniture is 3 (3,00,000/1,00,000) but it
hardly has any relevance. The reason is that there is no relationship between these two
aspects.
Types of Ratios
There is a two way classification of ratios:
Figure 3.4
(1) traditional classification, and
(2) functional classification. The traditional classification has been on the basis of financial
statements to which the determinants of ratios belong. On this basis the ratios are classified as
follows:
 ‘Statement of Profit and Loss Ratios: A ratio of two variables from the statement of
profit and loss is known as statement of profit and loss ratio. For example, ratio of
gross profit to revenue from operations is known as gross profit ratio. It is calculated
using both figures from the statement of profit and loss.
63
 Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified
as balance sheet ratios. For example, ratio of current assets to current liabilities known
as current ratio. It is calculated using both figures from balance sheet.
 Composite Ratios: If a ratio is computed with one variable from the statement of
profit and loss and another variable from the balance sheet, it is called composite
ratio. For example, ratio of credit revenue from operations to trade receivables
(known as trade receivables turnover ratio) is calculated using one figure from the
statement of profit and loss (credit revenue from operations) and another figure (trade
receivables) from the balance sheet.
Although accounting ratios are calculated by taking data from financial statements but
classification of ratios on the basis of financial statements is rarely used in practice. It must
be recalled that basic purpose of accounting is to throw light on the financial performance
(profitability) and financial position (its capacity to raise money and invest them wisely) as
well as changes occurring in financial position (possible explanation of changes in the
activity level). As such, the alternative classification (functional classification) based on the
purpose for which a ratio is computed, is the most commonly used classification which is as
follows:
1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability
of the business to pay the amount due to stakeholders as and when it is due is known
as liquidity, and the ratios calculated to measure it are known as ‘Liquidity Ratios’.
These are essentially short-term in nature.
2. Solvency Ratios: Solvency of business is determined by its ability to meet its
contractual obligations towards stakeholders, particularly towards external
stakeholders, and the ratios calculated to measure solvency position are known as
‘Solvency Ratios’. These are essentially long-term in nature.
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for
measuring the efficiency of operations of business based on effective utilization of
resources. Hence, these are also known as ‘Efficiency Ratios’.
4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from
operations or funds (or assets) employed in the business and the ratios calculated to
meet this objective are known as ‘Profitability Ratios’.
Liquidity Ratios
Liquidity ratios are calculated to measure the short-term solvency of the business, i.e. the
firm’s ability to meet its current obligations. These are analyzed by looking at the amounts of
current assets and current liabilities in the balance sheet. The two ratios included in this
category are current ratio and liquidity ratio.
64
Current RATIO
Current ratio is the proportion of current assets to current liabilities. It is expressed as
follows:
Current Ratio = Current Assets: Current Liabilities or Current Assets Current Liabilities
Current assets include current investments, inventories, trade receivables (debtors and bills
receivables), cash and cash equivalents, short-term loans and advances and other current
assets such as prepaid expenses, advance tax and accrued income, etc.
Current liabilities include short-term borrowings, trade payables (creditors and bills
payables), other current liabilities and short-term provisions.
Quick or Liquid RATIO
It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as
Quick ratio = Quick Assets: Current Liabilities or Quick Assets / Current Liabilities
The quick assets are defined as those assets which are quickly convertible into cash. While
calculating quick assets we exclude the inventories at the end and other current assets such as
prepaid expenses, advance tax, etc., from the current assets. Because of exclusion of non-
liquid current assets it is considered better than current ratio as a measure of liquidity position
of the business. It is calculated to serve as a supplementary check on liquidity position of the
business and is therefore, also known as ‘Acid-Test Ratio’.
Debt-Equity RATIO
Debt-Equity Ratio measures the relationship between long-term debt and equity. If debt
component of the total long-term funds employed is small, outsiders feel more secure. From
security point of view, capital structure with less debt and more equity is considered
favorable as it reduces the chances of bankruptcy. Normally, it is considered to be safe if debt
equity ratio is 2: 1. However, it may vary from industry to industry. It is computed as follows:
65
Figure 3.5
Significance: This ratio measures the degree of indebtedness of an enterprise and gives an
idea to the long-term lender regarding extent of security of the debt. As indicated earlier, a
low debt equity ratio reflects more security. A high ratio, on the other hand, is considered
risky as it may put the firm into difficulty in meeting its obligations to outsiders. However,
from the perspective of the owners, greater use of debt (trading on equity) may help in
ensuring higher returns for them if the rate of earnings on capital employed is higher than the
rate of interest payable.
CASH FLOW STATEMENT
Till now you have learnt about the financial statements being primarily inclusive of Position
Statement (showing the financial position of an enterprise as on a particular date) and Income
Statement (showing the result of the operational activities of an enterprise over a particular
period). There is also a third important financial statement known as Cash flow statement,
which shows inflows and outflows of the cash and cash equivalents. This statement is usually
prepared by companies which comes as a tool in the hands of users of financial information
to know about the sources and uses of cash and cash equivalents of an enterprise over a
period of time from various activities of an enterprise. It has gained substantial importance in
the last decade because of its practical utility to the users of financial information.
66
Figure 3.6 Cash flow statement format
Financial Statement of companies are prepared following the accounting standards prescribed
in the companies Act, 2013. Accounting Standards are notified under section 133 of the
Companies Act, 2013 vide Accounting Standards Rules, 2006 and are mandatory in nature.
Companies Act, 2013 also specifies that if the accounting standards are not followed,
financial statements will not be true and fair, which is a quality of financial statement.
Financial Statements are defined in Companies Act, 2013 (Section 2 (40)] and includes Cash
Flow Statement prepared in accordance with Accounting Standard- 3 (AS-3)- Cash Flow
Statement.
A cash flow statement provides information about the historical changes in cash and cash
equivalents of an enterprise by classifying cash flows into operating, investing and financing
activities. It requires that an enterprise should prepare a cash flow statement and should
present it for each accounting period for which financial statements are presented. This
67
chapter discusses this technique and explains the method of preparing a cash flow statement
for an accounting period.
Objectives of Cash Flow Statement

A Cash flow statement shows inflow and outflow of cash and cash equivalents from various
activities of a company during a specific period. The primary objective of cash flow
statement is to provide useful information about cash flows (inflows and outflows) of an
enterprise during a particular period under various heads, i.e., operating activities, investing
activities and financing activities.
This information is useful in providing users of financial statements with a basis to assess the
ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise
to utilize those cash flows. The economic decisions that are taken by users require an
evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing
and certainty of their generation.
Benefits of Cash Flow Statement
Cash flow statement provides the following benefits:
 A cash flow statement when used along with other financial statements provides
information that enables users to evaluate changes in net assets of an enterprise, its
financial structure (including its liquidity and solvency) and its ability to affect the
amounts and timings of cash flows in order to adapt to changing circumstances and
opportunities.
 Cash flow information is useful in assessing the ability of the enterprise to generate
cash and cash equivalents and enables users to develop models to assess and compare
the present value of the future cash flows of different enterprises.
 It also enhances the comparability of the reporting of operating performance by

different enterprises because it eliminates the effects of using different accounting
treatments for the same transactions and events.
 It also helps in balancing its cash inflow and cash outflow, keeping in response to
changing condition. It is also helpful in checking the accuracy of past assessments of
future cash flows and in examining the relationship between profitability and net cash
flow and impact of changing prices.
Cash and Cash Equivalents

As stated earlier, cash flow statement shows inflows and outflows of cash and cash
equivalents from various activities of an enterprise during a particular period. As per AS-3,
‘Cash’ comprises cash in hand and demand deposits with banks, and ‘Cash equivalents’
means short-term highly liquid investments that are readily convertible into known amounts
68
of cash and which are subject to an insignificant risk of changes in value. An investment
normally qualifies as cash equivalents only when it has a short maturity, of say, three months
or less from the date of acquisition. Investments in shares are excluded from cash equivalents
unless they are in substantial cash equivalents. For example, preference shares of a company
acquired shortly before their specific redemption date, provided there is only insignificant
risk of failure of the company to repay the amount at maturity. Similarly, short-term
marketable securities which can be readily converted into cash are treated as cash equivalents
and is liquid able immediately without considerable change in value.
Cash Flows
‘Cash Flows’ implies movement of cash in and out due to some non-cash items. Receipt of
cash from a non-cash item is termed as cash inflow while cash payment in respect of such
items as cash outflow. For example, purchase of machinery by paying cash is cash outflow
while sale proceeds received from sale of machinery is cash inflow. Other examples of cash
flows include collection of cash from trade receivables, payment to trade payables, payment
to employees, receipt of dividend, interest payments, etc.
Cash management includes the investment of excess cash in cash equivalents. Hence,
purchase of marketable securities or short-term investment which constitutes cash equivalents
is not considered while preparing cash flow statement.
Classification of Activities for the Preparation of Cash Flow Statement

You know that various activities of an enterprise result into cash flows (inflows or receipts
and outflows or payments) which is the subject matter of a cash flow statement. As per AS-3,
these activities are to be classified into three categories:
(1) operating, (2) investing, and (3) financing activities so as to show separately the cash
flows generated (or used) by (in) these activities. This helps the users of cash flow statement
to assess the impact of these activities on the financial position of an enterprise and also on its
cash and cash equivalents.
CASH from OPERATING Activities
Operating activities are the activities that constitute the primary or main activities of an
enterprise. For example, for a company manufacturing garments, operating activities are
procurement of raw material, incurrence of manufacturing expenses, sale of garments, etc.
These are the principal revenue generating activities (or the main activities) of the enterprise
and these activities are not investing or financing activities. The amount of cash from
operations’ indicates the internal solvency level of the company, and is regarded as the key
indicator of the extent to which the operations of the enterprise have generated sufficient cash
flows to maintain the operating capability of the enterprise, paying dividends, making of new
investments and repaying of loans without recourse to external source of financing.
69
Cash flows from operating activities are primarily derived from the main activities of the
enterprise. They generally result from the transactions and other events that enter into the
determination of net profit or loss. Examples of cash flows from operating activities are:
Cash Inflows from operating activities
 cash receipts from sale of goods and the rendering of services.
 cash receipts from royalties, fees, commissions and other revenues.
Cash Outflows from operating activities
 Cash payments to suppliers for goods and services.
 Cash payments to and on behalf of the employees.
 Cash payments to an insurance enterprise for premiums and claims, annuities, and
other policy benefits.
 Cash payments of income taxes unless they can be specifically identified with
financing and investing activities.
The net position is shown in case of operating cash flows.
An enterprise may hold securities and loans for dealing or for trading purposes. In either case
they represent Inventory specifically held for resale. Therefore, cash flows arising from the
purchase and sale of dealing or trading securities are classified as operating activities.
Similarly, cash advances and loans made by financial enterprises are usually classified as
operating activities since they relate to main activity of that enterprise.
70
Figure 3.7
Preparation of Cash Flow Statement
As stated earlier cash flow statement provides information about change in the position of
Cash and Cash Equivalents of an enterprise, over an accounting period. The activities
contributing to this change are classified into operating, investing and financing. The
methodology of working out the net cash flow (or use) from all the three activities for an
accounting period has been explained in details and a brief format of Cash Flow Statement
has also been given in Exhibit 6.2. However, while preparing a cash flow statement, full
details of inflows and outflows are given under these heads including the net cash flow (or
use). The aggregate of the net ‘cash flows (or use) is worked out and is shown as ‘Net
Increase/Decrease in cash and Cash Equivalents’ to which the amount of ‘cash and cash
equivalent at the beginning’ is added and thus the amount of ‘cash and cash equivalents at the
end’ is arrived at as shown in Exhibit 6.2. This figure will be the same as the total amount of
cash in hand, cash at bank and cash equivalents (if any) given in the balance sheet (see
Illustrations 7 to 10). Another point that needs to be noted is that when cash flows from
operating activities are worked out by an indirect method and shown as such in the cash flow
statement, the statement itself is termed as ‘Indirect method cash flow statement’. Thus, the
Cash flow statements prepared in Illustrations 7, 8 and 9 falls under this category as the cash
flows from operating activities have been worked out by indirect method. Similarly, if the
cash flows from operating activities are worked by direct method while preparing the cash
71
flow statement, it will be termed as ‘direct method Cash Flow Statement’. Illustration 10
shows both types of Cash Flow Statement. However, unless it is specified clearly as to which
method is to be used, the cash flow statement may preferably be prepared by an indirect
method as is done by most companies in practice.
ILLUSTRATIONS
I.L1 Comparative statement
Convert the following statement of profit and loss into the comparative statement of profit
and loss of BCR Co. Ltd.:
Particulars Note 2013-14 2014-15

No. Rs. Rs.
(i) Revenue from operations 60,00,000 75,00,000
(ii) Other incomes 1,50,000 1,20,000
(iii) Expenses 44,00,000 50,60,000
(iv) Income tax 35% 40%
Solution:
Comparative statement of profit and loss for the year ended March 31, 2014 and 2015:
Particulars 2013-14 2014-15 Absolute Percentage

Increase Increase
(+) or (+)
Decrease or
(–) Decrease
(–)
Rs. Rs. Rs. %
I. Revenue from 60,00,000 75,00,000 15,00,000 25.00
operations
II. Add: Other 1,50,000 1,20,000 (30,000) (20.00)
incomes
III. Total Revenue 61,50,000 76,20,000 14,70,000 23.90
I+II
IV Less: Expenses 44,00,000 50,60,000 6,60,000 15.00
Profit before tax 17,50,000 25,60,000 8,10,000 46.29
V Less: Tax 6,12,500 10,24,000 4,11,500 67.18
Profit after tax 11,37,500 15,36,000 3,98,500 35.03
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I.L 2 Common size income statement
From the following information, prepare a Common size Income Statement for the year
ended March 31, 2014 and 2015:
Particulars 2014-15 2013-14

Rs. Rs.
Net sales 18,00,000 25,00,000
Cost of goods sold 10,00,000 12,00,000
Operating expenses 80,000 1,20,000
Non-operating expenses 12,000 15,000
Depreciation 20,000 40,000
Wages 10,000 20,000
Solution:
Common Size Income Statement for the year ended March 31, 2013 and March 31, 2014
Particulars Absolute Amounts Percentage of Net Sales

2013-14 2014-15 2013-14 2014-15
Rs. Rs. (%) (%)
Net Sales 25,00,000 18,00,000 100 100
(Less) Cost of goods 12,00,000 10,00,000 48 55.56
Sold*
Gross Profit 13,00,000 8,00,000 52 44.44

(Less) Operating 1,20,000 80,000 4.80 4.44
Expenses**
Operating Income 11,80,000 7,20,000 47.20 40

(Less) Non- 15,000 12,000 0.60 0.67
Operating
Expenses
Profit 11,65,000 7,08,000 46.60 39.33
* Wages is the part of cost of goods sold;

** Depreciation is the part of operating expenses.
Example 2
From the following information, prepare Common size statement of profit and loss for the
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year ended March 31, 2014 and March 31, 2015:
Particulars 2013-14 2014-15

Rs. Rs.
Revenue from operations 25,00,000 20,00,000
Other income 3,25,000 2,50,000
Employee benefit expenses 8,25,000 4,50,000
Other expenses 2,00,000 1,00,000
Income tax (% of the profit before tax) 30% 20%
Solution:
Common size statement of Profit and Loss for the year ended March 31, 2014 and March 31,
2015:
Particulars Absolute Amounts Percentage of Net

Revenue from
operations
2013-14 2014-15 2013- 2014-
14 15
Rs. Rs. (%) (%)
Revenue from 25,00,000 20,00,000 100 100
Operations (Add) 3,25,000 2,50,000 13 12.5
Other income
Total revenue 28,25,000 22,50,000 113 112.5
(Less) expenses: 8,25,000 4,50,000 33 22.5
a) Employee benefit
2,00,000 1,00,000 8 5
expenses
b) Other expenses
Profit before tax 18,00,000 17,00,000 72 85

(Less) taxes 5,40,000 3,40,000 21.6 17
Profit after tax 12,60,000 13,60,000 50.4 68
I.L 3 Trend analysis
Calculate the trend percentages from the following figures of sales, stock and profit of X Ltd.,
taking 2010 as the base year and interpret them. (Rs. in lakhs)
Year Sales (Rs.) Stock (Rs.) Profit before

tax
74
(Rs.)
2010 1,881 709 321

2011 2,340 781 435
2012 2,655 816 458
2013 3,021 944 527
2014 3,768 1,154 627
Solution:
Trend Percentages (base year 2010 = 100) (Rs. in lakhs)
Year Sales Trend Stock Trend Profit Trend

Rs. % Rs. % Rs. %
2010 1881 100 709 100 321 100
2011 2340 124 781 110 435 136
2012 2655 141 816 115 458 143
2013 3021 161 944 133 527 164
2014 3768 200 1154 163 627 195
Interpretation:
1. The sales have continuously increased in all the years up to 2014, though in different
proportions. The percentage in 2014 is 200 as compared to 100 in 2010. The increase
in sales is quite satisfactory.
2. The figures of stock have also increased over a period of five years. The increase in
stock is more in 2013 and 2014 as compared to earlier years.
3. Profit has substantially increased. The profits have increased in greater proportion
than sales which implies that the company has been able to reduce their cost of goods
sold and control the operating expenses.
Example 2
From the following data relating to the assets of Balance Sheet of ABC Ltd., for the period
ended March 31, 2011 to March 31, 2014, calculate trend percentages
Particulars 2010- 2011-12 2012-13 2013-

11 14
Cash 100 120 80 140
Debtors 200 250 325 400
Stock 300 400 350 500
75
Other current assets 50 75 125 150
Land 400 500 500 500
Buildings 800 1000 1200 1500
Plant 1000 1000 1200 1500
Solution:
Trend percentage
Asset 20 Tr 20 Tre 20 Tre 20 Tre

s 10 en 11 nd 12 nd 13 nd
- d - % - % - %
11 % 12 13 14
Curre
nt
Asset
s
Cash 10 100 12 120 80 80 14 140
0 0 0
Debto 20 100 25 125 32 162 40 200
rs 0 0 5 .5 0
Stock 30 100 40 133 35 116 50 166
0 0 .33 0 .67 0 .67
Other 50 100 75 150 12 250 15 300
Curre 5 0
nt
Asset
s
65 100 84 130 88 135 1,1 183
0 5 0 .38 90 .08
Non-
curre
nt
Asset
s
Land 40 100 50 125 50 125 50 125
0 0 0 0
Buildi 80 100 1,0 125 1,2 150 1,5 187
ngs 0 00 00 00 .5
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Plant 10 100 1,0 100 1,2 120 1,5 150
00 00 00 00
2,2 100 2,5 113 2,9 131 3,5 159
00 00 .64 00 .82 00 .00
Total 2,8 100 3,3 117 3,7 132 4,6 164
Asset 50 45 .36 80 .63 90 .56
s
Interpretation:
1. The assets have exhibited a continuous increasing trend over the period.
2. The current assets increased much faster than the Non-current assets.
3. Sundry debtors and other current assets and buildings have shown higher growth
I.L 4 Ratio Analysis
Calculate current ratio from the following information’s:
Particulars (Rs.)
Inventories 50,000
Trade receivables 50,000
Advance tax 4,000
Cash and cash equivalents 30,000
Trade payables 1,00,000
Short-term borrowings (bank overdraft) 4,000
Solution:
Example 2
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The current ratio is 2: 1. State giving reasons which of the following transactions would
improve, reduce and not change the current ratio:
(a) Payment of current liability;
(b) Purchased goods on credit;
(c) Sale of a Computer (Book value: Rs. 4,000) for Rs. 3,000 only;
(d) Sale of merchandise (goods) costing Rs. 10,000 for Rs. 11,000;
(e) Payment of unclaimed dividend.
Solution
The given current ratio is 2: 1. Let us assume that current assets are Rs. 50,000 and current
liabilities are Rs. 25,000; Thus, the current ratio is 2: 1. Now we will analyses the effect of
given transactions on current ratio.
(a) Assume that Rs. 10,000 of creditors is paid by cheque. This will reduce the current
assets to Rs. 40,000 and current liabilities to Rs. 15,000. The new ratio will be 2.67: 1 (Rs.
40,000/Rs.15,000). Hence, it has improved.
(b) Assume that goods of Rs. 10,000 are purchased on credit. This will increase the
current assets to Rs. 60,000 and current liabilities to Rs. 35,000. The new ratio will be 1.7:1
(Rs. 60,000/Rs. 35,000). Hence, it has reduced.
(c) Due to sale of a computer (a fixed asset) the current assets will increase to Rs. 53,000
without any change in the current liabilities. The new ratio will be 2.12: 1 (Rs. 53,000/Rs.
25,000). Hence, it has improved.
(d) This transaction will decrease the inventories by Rs. 10,000 and increase the cash by
Rs. 11,000 thereby increasing the current assets by Rs. 1,000 without any change in the
current liabilities. The new ratio will be 2.04: 1 (Rs. 51,000/Rs. 25,000). Hence, it has
improved.
(e) Assume that 5,000 is given by way of unclaimed dividend. It will reduce the current
assets to 45,000 and unclaimed current liabilities by 5,000. The new ratio will be 2:25:1
(45,000/20,000). Hence, it has improved.
Cash Flow statement
From the following information, prepare Cash Flow Statement for Pioneer Ltd.
Balance Sheet of Pioneer Ltd., as on March 31, 2017
Particulars Amount Amount

(Rs.) (Rs.)
78
I. Equity and Liabilities
1. Shareholders’ Funds
a) Share capital 1 7,00,000 5,00,000
b) Reserve and surplus 2 4,20,000 2,50,000
2. Non-current Liabilities
Long-term borrowings: 10% Bank Load 50,000 1,00,000
3. Current Liabilities
a) Trade Payables 45,000 50,000
b) Other current liabilities: outstanding rent 7,000 5,000
c) Short-term provisions 3 50,000 30,000
Total 12,72,000 9,35,000
II. Assets
1. Non-current assets
a) Fixed assets
i) Tangible assets 5,00,000 5,00,000
ii) Intangible assets
b)
Non-current investments
2. Current assets
a) Inventories
b) Trade receivables
c) Cash and cash equivalents
95,000 1,00,000
1,00,000 -
1,30,000 50,000
1,20,000 80,000
3,27,000 2,05,000
Total 12,72,000 9,35,000
Notes to Accounts:
Particulars 31st 31st

March March
2017 2016
(Rs.) (Rs.)
1. Equity share Capital 7,00,000 5,00,000
2. Reserve and Surplus
Surplus: i.e., Balance in Statement of Profit and Loss 4,20,000 2,50,000
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3. Short-term Provision
Provision for Taxation 50,000 30,000

4. Fixed Assets
Tangible assets
(i) Equipment’s 2,30,000 2,00,000
(ii) Furniture 2,70,000 3,00,000
5,00,000 5,00,000
5. Intangible Assets
Patents 95,000 1,00,000
6. Cash and Cash Equivalents
(i) Cash 27,000 5,000

(ii) Bank Balance 3,00,000 2,00,000
3,27,000 2,05,000
Additional Information
During the year, equipment costing Rs. 80,000 was purchased. Loss on sale of equipment
amounted to Rs. 5,000. Depreciation of Rs. 15,000 and Rs. 3,000 charged on equipment’s
and furniture. Loan Rs. 50,000 was repaid on 31.03.2017. Proposed dividend for the year
2015-16 was Rs. 50,000.
Solution:
Particulars (Rs.)
1. Cash flows from Operating Activities:
Net Profit before taxation & extraordinary items 2,70,000
Provision for:
Depreciation on equipment 15,000
Depreciation on furniture 30,000
Patents written-off 5,000
Loss on sale of equipment’s 5,000
Interest on bank load 10,000
Operating Profit before Working capital changes 3,35,000

- Decrease in trade payables (5,000)
80
+ Increase in outstanding rent 2,000
- Increase in trade receivables (40,000)
- Increase in inventories (80,000)
Cash generated from operating activities 2,12,000
(-) Tax paid (30,000)
A. Cash Inflows from Operating Activities 1,82,000
II. Cash flows from Investing Activities
Proceeds from sale of equipment’s 30,000
Purchase of new equipment (80,000)
Purchase of investments (1,00,000)
(1,50,000)
B. Cash used in Investing Activities
III. Cash flows from Financial Activities
Issues of equity share capital 2,00,000
Repayment of bank loan (50,000)
Payment of dividend (50,000)
Payment of Interest on bank load (10,000)
C. Cash Inflows from Financing Activities 90,000
Net increase in cash & cash equipment’s (A+B+C) 1,22,000
+ Cash and Cash Equivalents in the beginning 2,05,000
Cash and Cash Equivalents in the end 3,27,000
Working Notes:
(1) Equipment Account
Dr. Cr.
Particulars J.F. Amount Particulars J.F. Amount

(Rs.) (Rs.)
Balance 2,00,000 Depreciation 15,000
b/d Cash 80,000 (balance figure)
Bank 30,000
Statement of 5,000
Profit & Loss
(Loss on sale) 2,30,000
2,80,000 Balance c/d 2,80,000
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(2) Patents of Rs. 5,000 (i.e., Rs. 1,00,000-Rs. 95,000) were written-off during the year,
and depreciation on furniture was Rs. 30,000. (Rs. 3,00,000-Rs. 2,70,000)
(3) It is assumed that dividend of Rs. 50,000 and tax of Rs. 30,000 provided in 2015-2016
has been paid during the year 2016-17. Hence, proposed dividend and provision for tax
during the year amounts to Rs. 70,000 and Rs. 50,000 respectively.
(1) Rs.
Profit and Loss at the end 4,20,000

(-) Profit and Loss in the beginning (2,50,000)
Net Profit during the year 1,70,000
+ Provision of tax during the year 50,000
+ Proposed dividend 50,000
Net Profit before taxation & extraordinary items 2,70,000
SUMMARY
Major Parts of an Annual Report

An annual report contains basic financial statements, viz., Balance Sheet, Statement of Profit
and Loss and Cash Flow Statement. It also carries management’s discussion of corporate
performance of the year under review for futuristic prospects.
Tools of Financial Analysis

Commonly used tools of financial analysis are: Comparative statements, Common size
statement, trend analysis, ratio analysis, and cash flow analysis.
Comparative Statement
Comparative statement shows changes in all items of financial statements in absolute and
percentage terms over a period of time for a firm or between two firms.
Common Size Statement

Common size statement expresses all items of a financial statement as a percentage of some
common base such as revenue from operations for statement of profit and loss and total assets
for balance sheet.
Ratio Analysis: An important tool of financial statement analysis is ratio analysis.

Accounting ratios represent relationship between two accounting numbers.
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Objective of Ratio Analysis: The objective of ratio analysis is to provide a deeper analysis of
the profitability, liquidity, solvency and activity levels in the business. It is also to identify the
problem areas as well as the strong areas of the business.
Advantages of Ratio Analysis: Ratio analysis offers many advantages including enabling
financial statement analysis, helping understand efficacy of decisions, simplifying complex
figures and establish relationships, being helpful in comparative analysis, identification of
problem areas, enables SWOT analysis, and allows various comparisons
Cash Flow Statement: The Cash Flow Statement helps in ascertaining the liquidity of an
enterprise. Cash Flow Statement is to be prepared and reported by Indian companies
according to AS-3 notified as per Companies Act 2013. The cash flows are categorized into
flows from operating, investing and financing activities. This statement helps the users to
ascertain the amount and certainty of cash flows to be generated by company.
KEYWORDS
• Compensating Balance – excess balances left in a bank account to provide indirect

compensation for loans or services.
• Compound Interest – Interest paid on previously earned interest as well as on the
principal.
• Consolidation – the joining of two or more companies to form a new company.
• Cash Flow Coverage Ratio – the ratio of financial obligations to earnings before
interest, taxes, depreciation and amortization.
• Cash Flow From Operations – a company’s net cash flow resulting directly from its
regular operations.
LEARNING ACTIVITY
1 Following are the balance sheets of Beta Ltd. at March 31, 2014 and 2015:
Particulars March 31, March 31,

2015 (Rs.) 2014 (Rs.)
I. Equity and Liabilities
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Equity share capital 4,00,000 3,00,000
Reserves and surplus 1,50,000 1,00,000
Loan from IDBI 3,00,000 1,00,000
Short-term borrowings 70,000 50,000
Trade payables 60,000 30,000
Short-term provisions 10,000 20,000
Other current liabilities 1,10,000 1,00,000
Total 11,00,000 7,00,000
II. Assets
Fixed assets 4,00,000 2,20,000
Non-current investments 2,25,000 1,00,000
Current investments 80,000 60,000
Stock 1,05,000 90,000
Trade receivables 90,000 60,000
Short-term loans and advances 1,00,000 85,000
Cash and cash equivalents 1,00,000 85,000
Total 11,00,000 7,00,000
You are required to prepare a Comparative Balance Sheet.
2 Anand Ltd., arrived at a net income of Rs. 5,00,000 for the year ended March 31,
2017. Depreciation for the year was Rs. 2,00,000. There was a profit of Rs. 50,000 on assets
sold which was transferred to Statement of Profit and Loss account. Trade Receivables
increased during the year Rs. 40,000 and Trade Payables also increased by Rs. 60,000.
Compute the cash flow from operating activities by the indirect approach.
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UNIT END QUESTIONS
1. Describe the different techniques of financial analysis and explain the limitations of
financial analysis.
2. Explain the usefulness of trend percentages in interpretation of financial performance
of a company.
3. Explain, what is the importance of comparative statements? Illustrate your answer
with particular reference to comparative income statement.
4. Discuss, what are liquidity ratios? Discuss the importance of current and liquid ratio.
5. Describe "Indirect" method of ascertaining Cash Flow from operating activities.
Long descriptive Questions
6. Explain the major Cash Inflows and outflows from investing activities.
7. Explain the major Cash Inflows and outflows from financing activities.
8. Following are the balance sheets of a Vijay & son:
9. .’Cash receipts from sale of goods by a trading company’ will come under which
activity while preparing cash flow statement?
10. Prepare a cash flow statement on the basis of the information given in the balance
sheet of Simco Ltd as at 31st March, 2013 and 2012
85
1. The following groups of ratios are primarily measure risk:
a. liquidity, activity, and profitability

b. liquidity, activity, and inventory
c. liquidity, activity, and debt
d. liquidity, debt and profitability
2. The ................ ratios are primarily measures of return:
a. liquidity
b. activity
c. debt
d. profitability
3. If the net profits earned during the year is Rs. 50,000 and the amount of debtors in the
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beginning and the end of the year is Rs. 10,000 and Rs. 20,000 respectively, then the cash
from operating activities will be equal to Rs. ……………..
a. Rs. 40,000
b. Rs. 60,000
c. Rs. 35000
d. Rs. 65000
4. If the net profits made during the year are Rs. 50,000 and the bills receivables have
decreased by Rs. 10,000 during the year then the cash flow from operating activities will be
equal to Rs.
a. Rs. 40,000
b. Rs. 60,000
c. Rs. 30,000
d. Rs.20000
5. Expenses paid in advance at the end of the year are ......................... the profit made
during the year
a. added to
b. deducted from
c. Negative
d. Debited
6. An increase in accrued income during the particular year is ................... the net profit
a. added to
b. deducted from
c. Multiplied through
d. Divided from
7. As per Accounting Standard-3, Cash Flow is classified into

anOperating activity and investing activities
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b Investing activities and financing activities
c Operating activities and financing activities
d Operating activities, financing activities and investing activities
8. Cash Flow Statement is also known as

a Statement of Changes in Financial Position on Cash basis
b Statement accounting for variation in cash
c Both a and b
d None of these
9. Cash Flow Statement is based upon

a Cash basis of accounting
b Accrual basis of accounting
c Credit basis of accounting
d None of the above
10. Cash flow statement is based upon while Funds Flow Statement recognizes
.
a Cash basis of accounting, accrual basis of accounting
b Accrual basis of accounting, cash basis of accounting
c Both are based on cash basis of accounting
d None of these
Answers
1. c 2. b 3. a 4. a 5. b 6. B 7.d 8.c 9.a 10. a
REFERENCES
 Higgins, Robert C. Analysis for Financial Management. McGraw-Hill, 2000.
 Kristy, James E., and Susan Z. Diamond. Finance without Fear. American
Management Association, 1984.
 Management Accounting Chapter 2. Analysis and Interpretation of Financial
88
Statements 2.5 Concept of Financi.htm

Pvt. Ltd.

89
UNIT 4 CAPITAL BUDGETING
Structure
Learning Objectives
Introduction
Nature of Capital Budgeting
Utility of Capital Budgeting
Investment Proposals and Administrative Aspects
Choosing Among Alternative Proposals

Estimating Cash Flows for Capital Budgeting
Evaluating Investment Proposals
General Principles
Payback Method
Return on Assets (ROA)
Present value method
Internal Rate of Return Method
Tools/ Techniques of capital budgeting
Concept of Cost of capital
Importance of cost control
Classification of Cost of Capital
Measurement of Cost of Capital
Cost of Long Term Debt
Cost of Preference Capital
Cost of Equity Capital
Cost of Retained Earnings
Weighted Cost of Capital
Choice of Weights
Some Misconceptions about Cost of Capital
Summary
Keywords
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Learning Activity
Unit End Questions
References
LEARNING OBJECTIVES
• to explain nature and utility of Capital Budgeting,

• to provide an understanding of the process of evaluation of Investment proposals,
• to discuss various tools of ranking of Investment proposals
• discuss the concept and importance of cost of capital
• distinguish among various classes of cost of capital
• illustrate the computation of cost of long term debt, preferences shares, equity shares
and retained earnings
• discuss and illustrate the various weighting approaches and the weighted average cost
of capital (WACC).
• Narrate misconceptions about cost of capital
INTRODUCTION
Capital budgeting, and investment appraisal, is the planning process used to determine
whether an organization's long term investments such as new machinery, replacement of
machinery, new plants, new products, and research development projects are worth the
funding of cash through the firm's capitalization structure (debt, equity or retained earnings).
It is the process of allocating resources for major capital, or investment, expenditures. One of
the primary goals of capital budgeting investments is to increase the value of the firm to the
shareholders.
NATURE OF CAPITAL BUDGETING
Capital budgeting is a managerial technique of planning capital expenditures whose benefits

are expected to extend beyond one year, such as expenditure on acquisition of new
buildings, improvement of existing buildings, replacement of plant and machinery,
acquisition of new facilities, new machines, etc.
Permanent addition to working capital, R&D expenditure are also regarded as capital
expenditures.
Capital budgeting technique involves matching of expected net cash inflows from the project
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with anticipated cost of the project these two components of capital budgeting technique are
determinant of investment outlay.
UTILITY OF CAPITAL BUDGETING
Capital budgeting is the most potent technique employed in assessing financial viability of
projects and for that matter, allocating prudently the funds among the projects by providing
useful guidelines in identifying useful projects and ranking them in terms of economic
desirability to choose the most promising one. Thus, it helps a firm in strengthening its
financial health and so its competitive position.
Capital budgeting also acts as a planning and control device. As a planning tool, it helps the
managements to determine long-term capital requirements and timings of such requirements.
It also serves as a control device when it is employed to control expenditures.
Capital budgeting as a technique of decision-making suffers from the problem involved in
predicting future cash benefits, cost of capital. Further, it fails to take cognizance of total
consequences of the decision.
INVESTMENT PROPOSALS AND ADMINISTRATIVE ASPECTS
Capital budgeting process involves several steps. The first step in the capital budgeting
process is to assemble a list of proposed new investments, together with the data necessary to
appraise them. Although practices vary from firm to firm, proposals dealing with asset
acquisitions are frequently grouped according to the following four categories:
1. Replacements of existing/old projects.
2. Expansion: additional capacity in existing product lines.
3. Growth: new product lines.
4. Other (for example, pollution control equipment)
Other important aspects of capital budgeting involve administrative matters. Approvals are
typically required at higher levels within the organization as we move away from
replacement decisions and as the sums involved increase.
One of the most important functions of the board of directors is to approve the major outlays
in a capital budgeting program as well as the total capital budget for each planning period.
Such decisions are crucial for the future well-being of the firm.
The planning horizon for capital budgeting programs varies with the nature of the industry.
When sales can be forecast with a high degree of reliability for 10 to 20 years, the
planning period is likely to be correspondingly long; electric utilities are an example of such
92
an industry. Also, when the product-technology developments in the industry require an 8-to-
10-year cycle to develop a new major product, as in certain segments of the aerospace
industry, a correspondingly long planning period is necessary.
After a capital budget has been adopted, funding must be scheduled. Characteristically, the
finance department is responsible for scheduling and acquiring funds to meet scheduled
requirements. The finance department is also primarily responsible for cooperating with the
operating divisions to compile systematic records on the uses of funds and the installation of
equipment purchased. Effective capital budgeting programs require such information as the
basis for periodic review and evaluation of capital expenditure decisions - the feedback and
control phase of capital budgeting, often called the post-audit review.
The foregoing represents a brief overview of the administrative aspects of capital budgeting;
the analytical problems involved are considered in the following paragraphs.
CHOOSING AMONG ALTERNATIVE PROPOSALS
In most firms, there are more proposals for projects than the firm is able or willing to finance.
Some proposals are good, others are poor, and methods must be developed for distinguishing
between the good and the poor.
Essentially, the end product is a ranking of the proposals and a cutoff point for determining
how far down the ranked list to go
In part, proposals are eliminated because some are mutually exclusive. Mutually exclusive
proposals are alternative methods of doing the same job. If one piece of equipment is
chosen, other will not be required. Thus, if there is a need to improve the materials
handling system in a chemical plant, the job may be done either by conveyer belts or by
forklift trucks. The selection of one method makes it unnecessary to use the others: They are
mutually exclusive items.
Independent projects are those that are being considered for different kinds of tasks that need
to be accomplished. For example, in addition to the materials handling system, the chemical
firm may need equipment to package the end product. The work would require a packaging
machine, and the purchase of equipment for this purpose would be independent of the
equipment purchased for materials handling. The firm may undertake any or all independent
projects.
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Finally, projects may be contingent. For example, there may be only one way to build a
football stadium but two ways of housing it (in a metal structure or a geodesic dome).
Because the stadium and its housing are contingent, the analysis requires that we consider
them together. Hence, we would want to compare the stadium within a metal structure with
the alternative of the stadium within a geodesic dome.
To distinguish among the many proposals that compete for the allocation of the firm’s capital
funds, a ranking procedure must be developed. This procedure requires calculating the
estimated cash flows from the use of equipment and then translating them into a measure of
their effect on shareholders’ wealth.
First, we turn our attention to the problem of estimating cash flows for capital budgeting
purposes.
ESTIMATING CASH FLOWS FOR CAPITAL BUDGETING
Cash flows for capital budgeting purposes are defined as the after-tax cash flows for an all-
equity financed firm. Algebraically, this definition is equivalent to earnings before interest
and taxes, EBIT, less the taxes the firm would pay if it had no debt, T (EBIT), plus noncash
depreciation charges, W dep.
W Cash flow = W EBIT - T (W EBIT) + W depreciation
Note that this definition of cash flows is unaffected by the firm’s financing decision, for
example the amount of debt which it uses. Consequently, the investment decision and the
financing decision are kept separate when we use this definition of cash flows for capital
budgeting purposes.
We focus on how the firm’s cash flows will be changed. Table 5.1 provides an example of a
pro-forma income statement which can be used to illustrate a cash flow calculation.
To arrive at the change in after-tax cash flows created by the project, we start with increased
revenues, WR, then subtract out all items which are expansible for tax purposes (WVC +
WFCC + Wdep). The result is taxable income, assuming the firm has no debt. Next, we
subtract the change in taxes and add back the change in depreciation because depreciation is
not a cash outflow.
The appropriate algebraic expression is:

W Cash flow = (WR - WVC - WFCC - Weep) - T (W R - WVC - WFCC -W dep) + Wdep.
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Description Symbol Amount
Change in sales revenue WR Rs.145,000
Change in variable operating cost W VC -90,000
Change in fixed cash costs W FCC -10,000
Change in depreciation W dep -15,000
Change in earnings before interest and W 30,000
taxes EBIT
Change in interest expense WrD -5,000
Change in earnings before tax W EBT 25,000
Change in taxes (@T=40%) W tax -10,000
Change in net income W NI 15,000
Pro-forma Income Statement

This equation can be simplified as follows:
WCash flow = (1–T) (WR – WVC – WFCC – WDep) + WDep
Note that the term in brackets is the same as the change in earnings before interest and taxes,
WEBIT; hence, the equation becomes:
Wash flow = (1-T) WEBIT + Weep.
Substituting in the numbers from Table 5.1, we have:
Wash flow = (1 - .4) (Rs.145,000 - Rs.90,000 - Rs.10,000 - Rs.15,000) + Rs.15,000
= .6 (Rs.30,000) + Rs.15,000
= Rs.33,000
The procedure described above starts with revenues at the top of the income statement and
then works down to obtain the definition of cash flows for capital budgeting purposes.
Alternately, one can start at the bottom of the income statement, with changes in net income
(WNI) and build upward to arrive at the same definition. Sometimes this approach is easier to
use. The algebraic expression for the change in cash flows is
W Cashflow – W NI + W dep + (1 – T) Wr D
EVALUATING INVESTMENT PROPOSALS
The point of capital budgeting - indeed, the point of all financial analysis - is to make
decisions that will maximize the value of the firm. The capital budgeting process is designed
to answer two questions:
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(1) Which of several mutually exclusive investments should be selected?
(2) How many projects, in total, should be accepted?
Among the many methods used for evaluating investment proposals, five are discussed here.
1. Payback method (or payback period): Number of years required to return the original
investment.
2. Return on assets (ROA) or return on investment (ROI): An average rate of return on
assets employed.
3. Net present value (NPV) method: Present value of expected future cash flows
discounted at the appropriate cost of capital, minus the cost of the investment.
4. Internal rate of return (IRR) method: Interest rate which equates the present value of
future cash flows to the investment outlay.
5. Profitability Index (PI): It shows the relative profitability of any project, or the present
value of benefits per rupee of costs.
General Principles
When comparing various capital budgeting criteria, it is useful to establish some guidelines.
What are the properties of an ideal criterion? The optimal decision rule should have four
characteristics:
1. It will select from a group of mutually exclusive projects the one which maximizes
shareholders’ wealth.
2. It will appropriately consider all cash flows.
3. It will discount the cash flows at the appropriate market-determined opportunity cost
of capital.
4. It will allow managers to consider each project independently from all others. This
has come to be known as the value additivity principle.
The value additivity principle implies that if we know the value of separate projects accepted
by management, then simply adding their values, V’ will give us the value of the firm. If
there are N projects, then the value of the firm will be:
This is a particularly important point because it means that projects can be considered on
their own merit without the necessity of looking at them in an infinite variety of combinations
with other projects.
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The cash flows for four mutually exclusive projects. They all same life, five years, and they
all require the same investment outlay, Rs.1,500. Once accepted, no project can be abandoned
without incurring the outflows indicated. For example, Project A has negative cash flows
during its fourth and fifth years. Once the project is accepted these expected cash outflows
must be incurred. An example of a project of this type is a nuclear power plant.
Decommissioning costs at the end of the economic life of the facility can be as large as the
initial construction costs and they must be taken into account.
Cash flow
Year A B C D PVIF@10%
0 - - - - 1.000
1,500 1,500 1,500 1,500
1 150 0 150 300 .909
2 1,350 0 300 450 .826
3 150 450 450 750 .751
4 -150 1,050 600 750 .683
5 -600 1,950 1,875 900 .621
Table 4.2: Cash Flows of Four Mutually Exclusive Projects

The last column of Table 5.2 shows the appropriate discount factor for the present value of
cash flows, assuming that the appropriate opportunity cost of capital is 10 percent. Since all
four projects are assumed to have the same risk, they can be discounted at the same interest
rate.
Now we turn our attention to the actual implementation of the five above- mentioned capital
budgeting techniques (1) the payback method, (2) the return on assets, (3) the net present
value, (4) the internal rate of return, (5) Profitability Index. We shall see that only one
technique - the net present value method - satisfies all four of the desirable properties for
capital budgeting criteria.
Payback Method
The payback period is the number of years required to recover the initial capital outlay on a
project. The payback periods for the four projects in Table 5.2 are given below.
Project A, 2-year payback Project B, 4-year payback Project C, 4-year payback Project D, 3-
year payback.
If management were adhering strictly to the payback method, then Project A would be chosen
as the best among the four mutually exclusive alternatives. Even a casual look at the
numbers indicates that this would be a bad decision. The difficulty with the payback method
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is that it does not consider all cash flows and it fails to discount them. Failure to consider all
cash flows results in ignoring the large negative cash flows which occur in the last two years
of Project A. Failure to discount them means that management would be indifferent between
the following two cash flow patterns:
Cash Flows
Year G G*
0 -1,000 -1,000
1 100 900
2 900 100
Because they have the same payback period. Yet no one with a positive opportunity cost of
funds would choose Project G because Project G* returns cash much faster.
The payback method also violates the value additivity principle. Consider the following
example. Projects 1 and 2 are mutually exclusive but Project 3 is independent. Hence, it is
possible to undertake Projects 1 and 3 in combination, 2 and 3 in combination, or any of the
projects in isolation.
The only arguments in favor of using the payback method is that it is easy to use, but with the
advent of pocket calculators and computers, we feel that other more correct capital budgeting
techniques are just as easy to use
Return on Assets (ROA)
The return on assets (ROA) which is also sometimes called the return on investment (ROI) is
an average rate of return technique. It is computed by averaging the expected cash flows over
the life of a project and then dividing the average annual cash flow by the initial
investment outlay. For example, the ROA for Project B in Table 5.2 is computed from the
following definition:
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The ROA’s for the four projects are
 Project A, - 8%
 Project B, 26%
 Project C, 25%
 Project D, 22%
The ROA criterion chooses Project B as best. The major problem with ROA is that it
does not take the time value of money into account. We would have obtained exactly the
same ROA for Project B, even if the order of cash flows had been reversed with Rs.1,950
received now, Rs.1,050 at the end of Year 1, Rs.450 at the end of Year 2 and -Rs.1,500 at the
end Year 5. But no one primitive opportunity cost of capital would be indifferent between the
alternatives. The opposite ordering of cash flows would always be preferred.
Present value method
Another method based on discounted cash flow approach employed to evaluate financial
viability of investment projects is the present value method, which involves discounting of
streams of future cash earnings to present value at required rate of return to the firm (cost of
capital). For ranking projects under this method, net present value is computed. Project with
highest positive net present value is accorded the highest priority.
The equation for calculating the net present value of a project is:
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Here CF1, CF2, and so forth represent the net cash flows; k is the firm’s cost of capital; I0 is
the initial cost of the project; and n is the project’s expected life.
The net present value of Project C in Table 5.2 is calculated below by multiplying each cash
flow by the appropriate discount factor (PVIF), assuming that the cost of capital, k, is 10 per
cent.
Year Cash Flow X PVIF = PV

0 -1,500 1.000 -1,500.00
1 150 .909 136.35
2 300 .826 247.80
3 450 .751 337.95
4 600 .683 409.80
5 1,875 .621 1,164.38
NPV =
796.28
The net present value of all four projects in Table 5.2 are:
Project A NPV = Rs. –610.95.
Project B NPV = Rs. 766.05.

Project C NPV = Rs. 796.28.
Project D NPV = Rs. 778.80
If these projects were independent instead of mutually exclusive, we would reject A and
accept B, C, and D. Why? Since they are mutually exclusive, we select the project with the
greatest NPV, Project C. The NPV of the project is exactly the same as the increase in
shareholders’ wealth. This fact makes it the correct decision rule for capital budgeting
purposes. The NPV rule also meets the other three general principles required for an optimal
capital budgeting criterion. It takes all cash flows into account. All cash flows are discounted
at the appropriate market-determined opportunity cost of capital in order to determine their
present values. Also, the NPV rule obeys the value additivity principle.
The net present value of a project is exactly the same as the increase in shareholders’ wealth.
To see why, start by assuming a project has zero net present value. In this case, the project
returns enough cash flow to do three things:
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1. To pay off all interest payments to creditors who have lent money to finance the
project.
2. To pay all expected returns (dividends and capital gains) to shareholders who have
put up equity for the project, and
3. To pay off the original principal, I0, which was invested in the project.
Thus, a zero net present value project is one which earns a fair return to compensate both debt
holders and equity holders, each according to the returns which they expect for the risk they
take. A positive NPV project earns more than the required rate of return, and equity holders
receive all excess cash flows because debt holders have a fixed claim on the firm.
Consequently, equity holders’ wealth increases by exactly the NPV of the project. It is this
direct link between shareholders’ wealth and the NPV definition which makes the net
present value criterion so important in decision making.
Internal Rate of Return Method
The internal rate of return (IRR) is defined as the interest rate that equates the present value
of the expected future cash flows, or receipts, to the initial cost outlay. The equation for
calculating the internal rate of return is:
Here we know the value of Io and also the values of CF1, CF2, CFn, but we do not
know the value of IRR. Thus, we have an equation with one unknown, and we can solve for
the value of IRR. Some value of IRR will cause the sum of the discounted receipts to equal
the initial cost of the project, making the equation equal to zero, and that value of IRR is
defined as the internal rate of return.
The internal rate of return may be found by trial and error. First, compute the present value of
the cash flows from an investment, using an arbitrarily selected interest rate - for example, 10
percent. Then compare the present value so obtained with the investment’s cost. If the
present value is higher than the cost figure, try a higher interest rate and go through the
procedure again. Conversely, if the present value is lower than the cost, lower the interest rate
and repeat the process. Continue until the present value of the flows from the investment is
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approximately equal to its cost. The interest rate that brings about this equality is defined as
the internal rate of return.
Table 4.3 shows computation for the IRR for Project D in Table 4,2 and Figure4.1 graphs the
relationship between the discount rate and the NPV of the project
Figure 4.1
In Figure 4.1 the NPV of Project D’s cash flows decreases as the discount rate is increased. If
the discount rate is zero, there is no time value of money and the NPV of a project is simply
the sum of its cash flows.For Project D, the NPV equals Rs.1, 650 when the discount rate is
zero. At the opposite extreme, if the discount rate is infinite, then the future cash flows are
valueless and the NPV of Project D is its current cash flow, –Rs.1,500. Somewhere between
these two extremes is a discount rate which makes the NPV equal to zero. In Figure 5.1, we
see that the IRR for Project D is 25.4 per cent. The IRR’s for each of the four projects in
Table 1 are given below
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Project A IRR = - 200%
Project B IRR = 20.9%

Project C IRR = 22.8%
Project D IRR = 25.4%
If we use the IRR criterion and the projects are independent, we accept any project which has
an IRR greater than the opportunity cost of capital, which is10 percent. Therefore, we would
accept Projects B, C, and D. However, since these projects are mutually exclusive, the IRR
rule leads us to accept Project D as best
Profitability Index (PI)
Another method that is used to evaluate projects is the profitability index (PI), or the
benefit/cost ratio, as it is sometimes called:
Present value methods had the merit of simplicity in as much as it helps the management in
choosing the most profitable proposal. Further, while evaluating and ranking projects it
focuses on one of the primary objectives of a firm, i.e., increasing value of the firm.
However, main drawback of this approach is that it does not take into consideration size of
investment outlay and net cash benefits together while ranking projects. This may at times
lead to faulty decisions.
Profitability Index (PI) method has come to be employed to overcome the above drawback
and to ensure rational investment decision by establishing relationship between the present
values of the net cash inflows and net investment outlay.
The equation to compute ‘PI’ of a project is:
Here CIFt represents the expected cash inflows, or benefits, and COFt represents the
expected cash outflows, or costs. The PI shows the relative profitability of any project, or the
present value of benefits per rupee costs. The PI for Project C, based on a 10 percent cost of
capital is:
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Similarly:
Project A PI = 0.59
Project B PI = 1.51
Project D PI = 1.52
A project is acceptable if its PI is greater than 1.0, and the higher the PI, the higher the project
ranking. Mathematically, the NPV, the IRR, and the PI methods must always reach the same
accept/reject decisions for independent projects: If a project’s NPV is positive, its IRR must
exceed k and its PI must be greater than 1.0. However, NPV, IRR, and PI can give
different rankings for pairs of projects. This can lead to conflicts between the three methods
when mutually exclusive projects are being compared.
TOOLS/ TECHNIQUES OF CAPITAL BUDGETING
The above discussion leads us to conclude that IRR, NPV and PI methods will result in the
same decision, except in certain cases involving mutually exclusive projects or non-normal
cash flows. The question that arises which capital budgeting techniques do firm actually use
in practice. Lawrence Gitmanand John Forester conducted a survey to help answer this
question.
Gitman and Forester received 103 usable responses from a survey sent to 268 major
companies known to make large capital expenditures. They found that the responsibility for
capital budgeting analysis generally rests with the finance department. The respondents also
stated that defining projects and estimating their cash flows were the most difficult and the
most critical steps in the capital budgeting process.
Table – 5.4 summarizes the capital budgeting methods used by the respondent firms. The
results indicate a strong preference for discounted cash flow (DCF) capital budgeting
techniques, that is, NPV, IRR, and PI, with the dominant method being IRR. However, the
heavy use of ROA and payback as primary ranking techniques indicates that not all U.S.
firms were technologically up to part in an economic sense.
Method Number Percent Number Percent

IRR 60 53.6% 13 14.0%
ROA 28 25.0 13 14.0
NPV 11 9.8 24 25.8
Payback period 10 8.9 41 44.0
PI 3 2.7 2 2.2
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Total 112 100.0% 93 100.0%
It may also be noted that almost all the respondents used at least two methods in their
analysis, and as evidenced by the 112 primary methods from 103 respondents, some firms use
more than one primary method. Although the questionnaire did not bring this point out, we
suspect that many of the analysts of firms which use the IRR as the primary method
recognize its drawbacks, yet use it anyway because it is easy to explain to non-financial
executives but use NPV as a check on IRR when evaluating mutually exclusive or non-
normal projects. It is also doubtful the payback method can be used as a liquidity and/ or
risk indicator, hence to help choose among competing projects whose NPVs and/or IRRs are
close together. One interesting, and encouraging note is that when compared with earlier
surveys, Gitman and Forester found that the discounted cash flow methods are gaining in
usage.
As regards the use of assessment methods employed by Indian corporates, study of 100
medium and large scale companies conducted in 1994, reveals that Indian Companies have
started using discounting techniques more than non- discounting approaches. Although some
companies are still using payback period approach, it is the net present value technique which
is used quite widely, particularly by companies which have high sales volume and large-paid-
up capital. Small and new companies are still relying on traditional approach like pay-back
period.
CONCEPT OF COST OF CAPITAL
The cost of capital is an important financial concept. It links the company's long- term
decisions with the wealth of the shareholders as determined in the market place. Whenever, a
business organization raises funds, it has to keep in mind its cost. Hence computation of cost
of capital is very important and finance managers must have a close look on it. In this unit,
we shall discuss the concept, classification, and importance of cost of capital the process of
computing cost of capital of individual components, weighted cost of capital, importance of
cost of capital and a few misconceptions.
The term cost of capital refers to the minimum rate of return which a firm must earn on its
investments so that the market value of the company's equity shares does not fall
Hampton, John defines the term as "the rate of return the firm requires from investment in
order to increase the value of the firm in the market place". The following are the basic
characteristics of cost of capital:
i) Cost of capital is a rate of return; it is not a cost as such.
ii) This return, however, is calculated on the basis of actual cost of different components
of capital.
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iii) A firm's cost of capital represents minimum rate of return that will result in at least
maintaining (If not increasing) the value of its equity shares.
iv) It is related to long term capital funds.
v) Cost of capital consists of three components:
a) Return at Zero Risk Level. (r0)
b) Premium for Business Risk (b)
c) Premium for Financial Risk (f)
vi) The cost of capital may be put in the form of the following equation: K = ro + b + f
Where
K = Cost of Capital
ro = Return at Zero Risk Level b = Premium for Business Risk f = Premium for Financial
Risk.
Importance of cost control
The determination of the firm's cost of capital is important from the point of view of the
following:
i) It is the basis of appraising new capital expenditure proposals. This gives the
acceptance / rejection criterion for capital expenditure projects.
ii) The finance manager must raise capital from different sources in a way that it
optimizes the risk and cost factors. The source of funds which have less cost involve high
risk. Cost of capital helps the managers in determining the optimal capital structure.
iii) It is the basis for evaluating the financial performance of top management.
iv) It helps in formulating appropriate dividend policy.
v) It also helps the organization in developing an appropriate working capital policy.
Classification of Cost of Capital
There is no fixed base of classification of cost of capital. It varies according to need, process
and purpose. It may be classified as follows:
i) Explicit Cost and Implicit Cost: Explicit cost is the discount rate that equates the present
value of the funds received by the firm net of underwriting costs, with the present value of
expected cash outflows. Thus, it is `the rate of return of the cash flows of financing
opportunity’. On the other hand, the implicit cost is the rate of return associated with the best
investment opportunity for the firm and its shareholders that will be foregone if the project
presently under consideration by the firm were accepted. In the other words, explicit cost
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relates to raising of funds and implicit costs relate to usage of funds.
ii) Average Cost and Marginal Cost: The average cost is the weighted average of the costs of
each components of funds. After ascertaining costs of each source of capital, appropriate
weights are assigned to each component of capital. Marginal cost of capital is the weighted
average cost of new funds raised by the firms.
iii) Future Cost and Historical Cost: In financial decision making, the relevant costs are future
costs. Future cost i.e. expected cost of funds to finance the projects is ascertained with the
help of historical costs.
iv) Specific Cost and Combined Cost: The costs of individual components of capital are
specific costs of capital. The combined cost of capital is the average cost of capital as it is
inclusive of cost of capital from all sources. In capital budgeting decisions, combined cost of
capital is used for accepting / rejecting the proposals
MEASUREMENT OF COST OF CAPITAL
There are four basic sources of long term funds for a business firm : (i) Long-term Debt and
Debentures (ii) Preferences share capital, (iii) Equity share capital, (iv) Retained Earnings.
Through all of these sources may not be tapped by the firm for funding its activities, each
firm will have some of these sources in its capital structure.
The specific cost of each source of funds is the after-tax cost of financing. It can be before-
tax, provided the basis is the same for all the sources of finance being considered for
calculating the cost of capital. The procedure for determining the costs of debt, procedure for
determining the costs of debt, preferences and equity capital as well as retained earnings is
discussed in the following sub-sections.
Cost of Long Term Debt
Debt may be issued at par, or at premium or at of discount. It may be perpetual or

redeemable. The technique of computation of cost in each case has been explained in the
following paragraphs.
(a) The formula for computing the Cost of Long Term debt at par is
Kd = (1 – T) R
where
Kd = Cost pf long term debt T = Marginal Tax Rate
R = Debenture Interest Rate
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For example, if a company has issued 10% debentures and the tax rate is 50%, the cost of
debt will be
(1 - .5) 10 = 5%
(a) In case the debentures are issued at premium or discount, the cost of debt
should be calculated on the basis of net proceeds realized. The formula will
be as follows :
Cost of Preference Capital
The preference share represents a special type of ownership interest in the firm. Preference
shareholders must receive their stated dividends prior to the distribution of any earnings to
the equity shareholders. In this respect preference shares are very much like bonds or
debentures with fixed interest payment. The cost of preference shares can be estimated by
dividing the preference dividend per share by the current price per share, as the dividend can
be considered a continuous level payment.
For example, a company is planning to issue 9% preference shares expected to sell at Rs. 85
per share. The costs of issuing and selling the shares are expected to be Rs. 3 per share.
The first step in finding out the cost of the preference capital is to determine the rupee
amount of preference dividends, which are stated as 9% of the share of Rs. 85 per share. Thus
9% of Rs. 85 is Rs. 7.65. After deducting the floatation costs, the net proceeds are Rs. 82 per
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share.
Thus the cost of preference capital:
Now, the companies can issue only redeemable preference shares. Cost of capital for such
shares is that discount rate which equates the funds available from the issue of preference
shares with the present values of all dividends and repayment of preference share capital.
This present value method for cost of preference share capital is similar to that used for cost
of debt capital, the only difference is that in place of `interest’ stated dividend on preference
share is used.
Cost of Equity Capital
“Cost of equity capital is the cost of the estimated stream of net capital outlays desired from
equity sources” E.W. Walker.
James C. Van Horne defines the cost of equity capital can be thought of as the rate of
discount that equates the present value of all expected future dividends per share, as
perceived by investors.
The cost of equity capital is the most difficult to measure. A few problems in this regard are
as follows:
i. The cost of equity is not the out of pocket cost of using equity capital.
ii. The cost of equity is based upon the stream of future dividends as expected by
shareholders (very difficult to estimate).
iii. The relationship between market price with earnings is known. Dividends also affect
the market value (which one is to be considered).
The following are the approaches to computation of cost of equity capital:
1. E / P Ratio Method: Cost of equity capital is measured by earning price ratio.
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Symbolically
Eo (current earnings per share)
* 100
Po (current market price per share) the limitations of this method are:
• Earnings do not represent real expectations of shareholders.
• Earnings per share is not constant.
• Which earnings-current earnings or average earnings (It is not clear).
The method is useful in the following circumstances:

• The firm does not have debt capital.
• All the earnings are paid to the shareholders.
• There is no growth in earnings.
2. E / P Ratio + Growth Rate Method: This method considers growth in earnings. A

period of 3 years is usually being taken into account for growth. The formula will be as
follows:
Where (1 + b) 3 = Growth factor where b is the growth rate as a percentage and estimated for
a period of three years.
3. D / P Ratio Method: Cost of equity capital is measured by dividends price ratio.

Symbolically
The following are the assumptions:

i) The risk remains unchanged.
ii) The investors give importance to dividend.
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iii) The investors purchase the shares at par value.
Under this method, the future dividend stream of a firm as expected by the investors are
estimated. The current price of the share is used to determine shareholders’ expected rate of
return. Thus, if Ke is the risk-adjusted rate of return expected by investors, the
Present value of future dividends, discounted by Ke would be equal to the price of the share.
Thus,
Given the current price p and values for future dividends `Dt’, one can calculate Ke by using
IRR procedure. If the firm has maintained some regular r pattern of dividends in the past, it is
not unreasonable to expect that the same pattern will prevail. If a firm is playing a dividend of
20% on a share with a par value of Rs. 10 as a level perpetual dividend, and its market price
is Rs. 20, then
4. D / P + Growth Rate Method: The method is comparatively more realistic as i) it

considers future growth in dividends, ii) it considers the capital appreciation.
Thus
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5. Realized Yield Method: One of the difficulties in using D / P Ratios and E / P Ratios for
finding out Ke is to estimate the rate of expected return. Hence, this method depends on the
rate of return actually earned by the shareholders. The most recent five to ten years are taken
and the rate of return is calculated for the investor who purchased the shares at the beginning
of the study period, held it to the present and sold it at the current prices. This is also the
realized yield by the investor. This yield is supposed to indicate the cost of equity share on
the assumption that the investor earns what he expects to earn. The limiting factors to the
usefulness of this method are the additional conditions that the investors expectation do not
undergo change during the study period, no significant change in the level of dividend rates
occurs, and the attitude of the investors towards the risk remain the same. As these conditions
are rarely fulfilled, the yield method has severe limitations. In addition, the yield often differs
depending on the time period chosen.
6. Security’s Beta Method: An investor is concerned with the risk of his entire portfolio, and
that the relevant risk of a particular security is the effect that the security has on the entire
portfolio. By “diversified portfolio” we mean that each investor’s portfolio is representative if
the market as a whole and that the portfolio Beta is 1.0. A security’s Beta indicate how
closely the security’s returns move with from a diversified portfolio. A beta of 1.0 for a given
security means that, if the total value of securities in the market moves up by 10 percent, the
stock’s price will also move up, on the average by 10 percent. If security has a beta of 2.0, its
price will, on the whole, rises or falls by 20 percent when the market rises or falls by 10
percent. A share with –0.5 percent beta will rise by 10 percent, when the market falls by 20
percent.
A beta of any portfolio of securities is the weighted average of the betas of the securities,
where the weights are the proportions of investments in each security. Adding a high beta
(beta greater than 1.0) security to a diversified portfolio increase the portfolio’s risk, and
adding a low beta (beta less than zero) security to a diversified security reduces the
portfolio’s risk.
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How is beta determined? The beta co-efficient for a security (or asset) can be found by
examining security’s historical returns relative to the return of the market. As it is, not
feasible to take all securities, a sample of securities is used. The Capital Asset Pricing Model
(CAPM) uses these betas co-efficient to estimate the required rate of return on the securities.
The CAPM, specifies that the required rate on the share depends upon its beta. The
relationship is:
Ke = riskless rate + risk premium x beta
where, Ke = expected rate of return.
The current rate on government securities can be used as a riskless rate. The difference
between the long-run average rate of returns between shares and government securities may
represent the risk premium. During 1926-1981, this was estimated in USA to be 6 percent.
Beta co-efficient are provided by the published date or can be independently estimated.
The beta for Pan Am’s stock was estimated by Value Line to be 0.95 in 1984. Long-term
government bond rates were about 12 percent in November 1984. Thus the required rate of
return on Pan Am’s stock in November 1984 was –
Required Rate = 12% + 6% * 0.95 = 17.7 %
The use of beta to measure the cost of equity capital is definitely a better approach. The major
reason is that the method incorporates risk analysis, which other methods do not. However,
its application remains limited perhaps because it is tedious to calculate Beta value.
Cost of Retained Earnings
Some authors do not consider it necessary to calculate separately cost of retained earnings.
They say that the cost of retained earnings is included in the cost of equity share capital. They
say that the existing share price is used to determine cost of equity capital and this price
includes the impact of dividends and retained earnings. There are authorities who also
suggest that cost of retained earnings is to be determined separately. Two alternative
approaches are there:
i) One is to regard cost of equity capital as the cost of retained earnings.
ii) The concept of external yields as suggested by Ezra Soloman. It assures investment of
retained earnings in another firm. Symbolically
Cost of Retained Earnings =
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D1
( --------- + G ) ( 1 – TR ) (1-B)
Po
= Ke ( 1 – TR) ( 1 – B )
where
Ke = Cost of equity capital based on dividends growth method TR = Shareholder’s Tax Rate
B= Percentage Brokerage Cost
WEIGHTED COST OF CAPITAL
Weighted cost of capital is also called as composite cost of capital, overall cost of capital,
weighted marginal cost of capital, combined cost of debt and equity etc. It comprises the
costs of various components of financing. These components are weighted according to their
relative proportions in the total capital.
Choice of Weights
The weights to be employed can be book value, market values, historic or target. Book value
weights are based on the accounting values to assess the proportion of each type of capital in
the firm’s structure. Market value weights measure the proportion of each type of financing at
its market value. Market value weights are preferred because they approximate the current
value of various instruments of finance employed by the company.
Historic weights can be book or market weights based on actual data. Such weights however
would represent actual rather than desired proportions of various types of capital in the
capital structure. Target weights, which can also be based on book or market values, reflect
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the desired capital structure proportions. If the firm’s historic capital structure is not much
different from `optimal’ or desired capital structure, the cost of capital in both the cases is
mostly similar. However, from a strictly theoretical point of view, the target market value
weighting scheme should be preferred.
Marginal weights are determined on the basis of financing mix in additional new capital to be
raised for r investments. The new capital to be raised is marginal capital. The propositions of
new capital raised will be the marginal weights.
SOME MISCONCEPTIONS ABOUT COST OF CAPITAL
The cost of capital is a central concept in financial management linking the investment and
financing decisions. A few misconceptions in this regard are as follows:
i. The concept of cost of capital is academic and impractical.
ii. It is equal to the dividend rate.
iii. Retained earnings are either cost free or cost significantly less than external equity.
iv. Depreciation has no cost.
v. The cost of capital can be defined in terms of an accounting based manner.
vi. If a project is heavily financed by debt, its weighted average cost of capital is low.
SUMMARY
For any economy/company there are many avenues of investments, but one can’t go and
invest in all of these avenues. This gives rise to problem of selection of a particular project
out of the many available. Here capital budgeting techniques play an important role in
deciding which project to select & which to reject. Capital budgeting technique involves
matching of expected net cash inflows from the project with anticipated cost of the project.
Capital budgeting techniques are broadly classified in two categories. Discounted and non-
discounted the major difference between these two is that informer the future cash flows are
discounted at appropriate discount rate (usually cost of capital) to get net present value of
future cash flows.
The cost of capital is the minimum acceptable rate of return on new investments. The basic
factors underlying the cost of capital for a firm are the degree of risk associated with the firm,
the taxes it must pay, and the supply of and demand of various types of financing. The term
cost of capital refers to the minimum rate of return a firm must earn on its investments so that
the market value of the company's equity shares does not fall.
In estimating the cost of capital, it is assumed that, (1) the firms are acquiring assets which do
not change their business risk, and (2) these acquisions are financed in such a way as to leave
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the financial risk unchanged. In order to estimate the cost of capital, we must estimate rates of
return required by investors in the firm's securities, including borrowings, and average those
rates according to the market values of the various securities currently outstanding.
While the cost of debt and preference capital is the contractual interest / dividend rate
(adjusted for taxes), the cost of equity capital is difficult to estimate.
Broadly, there are six approaches to estimate the cost of equity, namely, the E / P method, E /
P + Growth method, D / P method, D / P + Growth method, realized yield method and using
the Beta co-efficient of the share. Weighted cost of capital is computed by assigning book
weights or market weights.
The cost of capital is the minimum acceptable rate of return on new investments. The basic
factors underlying the cost of capital for a firm are the degree of risk associated with the firm,
the taxes it must pay, and the supply of and demand of various types of financing. The term
cost of capital refers to the minimum rate of return a firm must earn on its investments so that
the market value of the company's equity shares does not fall.
In estimating the cost of capital, it is assumed that, (1) the firms are acquiring assets which do
not change their business risk, and (2) these acquisions are financed in such a way as to leave
the financial risk unchanged. In order to estimate the cost of capital, we must estimate rates of
return required by investors in the firm's securities, including borrowings, and average those
rates according to the market values of the various securities currently outstanding.
While the cost of debt and preference capital is the contractual interest / dividend rate
(adjusted for taxes), the cost of equity capital is difficult to estimate.
Broadly, there are six approaches to estimate the cost of equity, namely, the E / P method, E /
P + Growth method, D / P method, D / P + Growth method, realized yield method and using
the Beta co-efficient of the share. Weighted cost of capital is computed by assigning book
weights or market weights.
KEYWORDS
• Capital Budget – a company’s plan for capital expenditures (acquisition of fixed

assets).
• Capital Expenditures – money used to acquire or improve fixed assets.
• Cost of Capital is the minimum rate of return that will maintain the value of the firm's
equity shares.
• Marginal Weights are determined on the basis of financing mix of additional capital.
• Cost of Equity Capital is the discount rate which equates present value of all expected
dividends in future with net proceeds per share / current market price.
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• Business Risk is a possibility when the firm will not be able to operate successfully in
the market.
• Financial Risk is the possibility when the firm will not earn sufficient profits to make
payment of interest on loans and / or to pay dividends.
LEARNING ACTIVITY
1. The current dividend paid by the company is Rs. 5 per share, the market price of the equity
share is Rs. 100 and the growth rate of dividend is expected to remain constant at 10%. Find
out the cost of capital.
2. Contact Finance Managers of five PSUs and five Indian Companies to find out the existing
capital budgeting evaluation methods used by them.
UNIT END QUESTIONS
1. Explain, what are the most critical problems that arise in calculating a rate of return for a
prospective investment?
2. Discuss, why is the cost of capital the minimum acceptable rate of return on an
investment?
3. Discuss, how is the Cost of Debt Capital ascertained? Give examples.
4. Discuss, how will you calculate the Cost of Preferences Share Capital?
Long Questions
1. Are there conditions under which a firm might be better off if it chose a machine with a
rapid payback rather than one with the largest rate of return?
2. Company X uses the payback method in evaluating investment proposals and is
considering new equipment whose additional net after-tax earnings will be Rs.150 a year.
The equipment costs Rs.500, and its expected life is ten years (straight-line depreciation).
The company uses a three-year payback as its criterion. Should the equipment be purchased
under the above assumptions?
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1. Capital Budgeting is a part of:
a. Working Capital Management
b. Marketing Management
c. Capital Structure
d. Investment Decision
2. Capital Budgeting deals with:

a. Long-term Decisions
b. Short-term Decisions
c. Both (a) and (b)
d. Neither (a) nor (b)
3. Which of the following is not used in Capital Budgeting?

a. Time Value of Money
b. Sensitivity Analysis
c. Net Assets Method
d. Cash Flows
4. Capital Budgeting Decisions are:

a. Irreversible
b. Unimportant
c. Reversible
d. All of these
5. Which of the following is not incorporated in Capital Budgeting?

a. Tax-Effect
b. Time Value of Money
c. Required Rate of Return
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d. Rate of Cash Discount
6. The key sources of value (earning an excess return) for a company can be attributed
primarily to .
a. competitive advantage and access to capital
b. quality management and industry attractiveness
c. access to capital and quality management
d. industry attractiveness and competitive advantage
7. The overall (weighted average) cost of capital is composed of a weighted average of

.
a. the cost of common equity and the cost of debt
b. the cost of common equity and the cost of preferred stock
c. the cost of preferred stock and the cost of debt
d. the cost of common equity, the cost of preferred stock, and the cost of debt
8. What is the overall (weighted average) cost of capital in the following situation? The firm
has $10 million in long-term debt, $2 million in preferred stock, and $8 million in common
equity -- all at market values. The before-tax cost for debt, preferred stock, and common
equity forms of capital are 8%, 9%, and 15%, respectively. Assume a 40% tax rate.
a. 6.40%
b. 6.54%
c. 9.30%
d. 10.90%
9. For which of the following costs is it generally necessary to apply a tax adjustment to a
yield measure?
a. Cost of debt.
b. Cost of preferred stock.
c. Cost of common equity.
d. Cost of retained earnings.
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10. Which of the following is not a recognized approach for determining the cost of equity?
a. Dividend discount model approach.
b. Before-tax cost of preferred stock plus risk premium approach.
c. Capital-asset pricing model approach.
d. Before-tax cost of debt plus risk premium approach.
Answers
1. d 2. a 3. c 4. c 5. D 6.d 7.d 8.c 9.a 10.d
REFERENCES
 Upadhyay, K.M. “Financial Management, Kalyani Publishers, New Delhi.
 Schall, Lawrence D and Haley Charles W., Introduction to Financial Management,

McGraw Hill Book Company, New York, London, New Delhi, Fourth (International
Students') Edition.
 Van Horne James W., Financial Management and Policy, Prentice Hall Inc.
Englewood Cliffs, New Jersey.
 Khan, M.Y. and Jain P.K. “Financial Management - Text and Problems”, Tata
McGraw Hills, New Delhi.
 Chandra, P., Fundamentals of Financial Management, Tata McGraw Hill, New Delhi.
Maheshwari, S.N., Financial Management - Principles and Practices, Sultan Chand &
Sons, New Delhi.
 Singh, J.K. “Financial Management - Text and Problems” Dhanpat Rai & Co. Delhi.
Srivastava, R.M., “Financial Management”, Pragati Prakashan, Meerut.
 Kulkarni, P.V. & Satya Prasad, B.G., “Financial Management – A conceptual

approach”, Himalaya Publishing House, Mumbai.

Pvt. Ltd.

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UNIT 5 CURRENT ASSETS MANAGEMENT
Structure
Learning Objectives
Introduction
Significance of Working Capital
Operating Cycle
Concepts of Working Capital
Gross Working Capital

Net Working Capital
Fluctuating Working Capital
Components of Working Capital
Importance of Working Capital Management
Determinants of Working Capital Needs
Approaches to Managing Working Capital
The Conventional Approach
The Operating Cycle Approach
Measuring Working Capital
Working Capital Management under Inflation
Determining Optimal Cash Balance
Management of Cash Flows
Speeding up Collections
Recovering Dues
Controlling Disbursements
Investment Criteria
Inventory Management
Benefits and Costs of Holding Inventories:
Costs of Holding Inventories:
Objectives of Inventory Management:
Receivable Management
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Working Capital Financing
Summary
Keywords
Learning Activity
Unit End Questions
References
LEARNING OBJECTIVES

• concepts and components of working capital
• significance of and need for working capital
• determinants of the size of working capital
• criteria for efficiency in managing working capital
• concepts and factors of inventory management
• Explain about receivable management
INTRODUCTION
The ageing analysis of your current assets including stock, debtors etc. is of large importance,
since it is directly linked to the liquidity position of the company. You have more space to
business and more chances of profitability, when you are successful in reducing your money
in hands of your associates.
We have a strong analytical team which is trained in credit management. The debtor- creditor
position will be analyzed periodically and insights on the ideal Current ratio position will be
given to the management. We will intimate your team, when the optimum credit ratio is
crossed or when the stock in hand position goes below the margin.
Current asset management includes management of cash, cash equivalents, accounts
receivable and prepaid expenses. Direct us can help you to maintain a good current asset
position by effective debtors and creditors’ management. Direct us current assets
management program focuses mainly on accelerating of the payments due to the company
through continuous follow ups and thereby reduces the time of debt realization considerably.
Effective financial management is the outcome, among other things, of proper management
of investment of funds in business. Funds can be invested for permanent or long-term
purposes such as acquisition of fixed assets, diversification and expansion of business,
renovation or modernization of plants & machinery, and research & development.
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Funds are also needed for short-term purposes, that is, for current operations of the business.
For example, if you are managing a manufacturing unit you will have to arrange for
procurement of raw material, payment of wages to your workmen and for meeting routine
expenses. All the goods, which are manufactured in a given time period may not be sold in
that period. Hence, some goods remain in stock, e.g., raw material, semi-finished
(manufacturing -in-process) goods and finished marketable goods. Funds are thus blocked in
different types of inventory. Again, the whole of the stock of finished goods may not be sold
against ready cash; some of it may be sold on credit. The credit sales also involve blocking of
funds with debtors till cash is received or the bills are cleared.
Working Capital refers to firm's investment in short-term assets, viz. cash, short-term
securities, accounts receivable (debtors) and inventories of raw materials, work-in- process
and finished goods. It can also be regarded as that portion of the firm's total capital, which is
employed in short-term operations. It refers to all aspects of current assets and current
liabilities. In simple words, we can say that working capital is the investment needed for
carrying out day-to-day operations of the business smoothly. The management of working
capital is no less important than the management of long-term financial investment.
SIGNIFICANCE OF WORKING CAPITAL
You will hardly find a running business firm, which does not require some amount of
working capital. Even a fully equipped manufacturing firm is sure to collapse without
(a) an adequate supply of raw materials to process, (b) cash to meet the wage bill, (c) the
capacity to wait for the market for its finished products, and (d) the ability to grant credit to
its customers. Similarly, a commercial enterprise is virtually good for nothing without
merchandise to sell. Working capital, thus, is the life-blood of a business. As a matter of fact,
any organization, whether profit-oriented or otherwise, will not be able to carry on day-to-day
activities without adequate working capital.
OPERATING CYCLE
The time between purchase of inventory items (raw material or merchandise) and their
conversion into cash is known as operating cycle or working capital cycle. The successive
events which are typically involved in an operating cycle are depicted in Figure 16.1. A
perusal of the operating cycle would reveal that the funds invested in operations are re-cycled
back into cash. The cycle, of course, takes some time to complete. The longer the period of
this conversion the longer is the operating cycle. A standard operating cycle may be for any
time period but does not generally exceed a financial year. Obviously, the shorter the
operating cycle, the larger will be the turnover of funds invested for various purposes. The
channels of the investment are called current assets. Sometimes the available funds may be in
excess of the needs for investment in these assets, e.g., inventory, receivables and minimum
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essential cash balance. Any surplus may be invested in government securities rather than
being retained as idle cash balance.
Figure 5.1
CONCEPTS OF WORKING CAPITAL
There are two concepts of working capital, namely Gross concept and Net concept.
Gross Working Capital
According to this concept; working capital refers to the firm’s investment in current assets.
The amount of current liabilities is not deducted from the total of current assets. This concept
views Working Capital and aggregate of Current Assets as two inter-changeable terms. This
concept is also referred to as `Current Capital' or ‘Circulating Capital'.
The proponents of the gross working capital concept advocate this for the following reasons:
a. Profits are earned with the help of assets, which are partly fixed and partly current. To
a certain degree, similarity can be observed in fixed and current assets so far as both
are partly financed by borrowed funds, and are expected to yield earnings over and
above the interest costs. Logic then demands that the aggregate of current assets
should be taken to mean the working capital.
b. Management is more concerned with the total current assets as they constitute the
total funds available for operating purposes than with the sources from which the
funds come.
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c. An increase in the overall investment in the enterprise also brings about an increase in
the working capital.
Net Working Capital
The 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 creditor’s dues, bills payable, bank overdraft and
outstanding expenses. Net working capital can be positive or negative. A negative net
working capital occurs when current liabilities are in excess of current assets.
"Whenever working capital is mentioned it brings to mind current assets and current
liabilities with a general understanding that working capital is the difference between the
two".
‘Net working capital’ is a qualitative concept, which indicates the liquidity position of the
firm and the extent to which working capital needs may be financed by permanent sources of
funds. This needs some explanation.
Current assets should be sufficiently in excess of current liabilities to constitute a margin or
buffer for obligations maturing within the ordinary operating cycle of a business. A weak
liquidity position poses a threat to the solvency of the company and makes it unsafe.
Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore,
prompt and timely action should be taken by management to improve and correct the
imbalance in the liquidity position of the firm.
The net working capital concept also covers the question of a judicious mix of long- term and
short-term funds for financing current assets. Every firm has a minimum amount of net
working capital, which is permanent. Therefore, this portion of the working capital should be
financed with permanent sources of funds such as owners' capital, debentures, long-term
debt, preference capital and retained earnings: Management must decide the extent to which
current assets should be financed with equity capital and/or borrowed capital.
Several economists uphold the net working capital concept. In support of their stand, they
state that:
1. In the long run what matters is the surplus of current assets over current liabilities.
2. It is this concept which helps creditors and investors to judge the financial soundness of
the enterprise.
3. It is the excess of current assets over current liabilities, which can be relied upon to meet
contingencies since this amount is not liable to be returned.
4. It helps to ascertain the correct comparative financial position of companies having the
same amount of current assets.
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It may be stated that gross and net concepts of working capital are two important facets of
working capital management. Both the concepts have operational significance for the
management and therefore neither can be ignored. While the net concept of working capital
emphasizes the qualitative aspect, the gross concept underscores the quantitative aspect.
KINDS OF WORKING CAPITAL

Ordinarily, working capital is classified into two categories:
• Fixed, Regular or Permanent Working Capital; and
• Variable, Fluctuating, Seasonal, Temporary or Special Working Capital
Fixed Working Capital

The need for current assets is associated with the operating cycle, which, as you know, is a
continuous process. As such, the need for current assets is felt constantly. The magnitude of
investment in current assets however may not always be the same. The need for investment in
current assets may increase or decrease over a period of time according to the level of
production. Nevertheless, there is always a certain minimum level of current assets, which is
essential for the firm to carry on its business irrespective of the level of operations. This is the
irreducible minimum amount necessary for maintaining the circulation of the current assets.
This minimum level of investment in current assets is permanently locked up in business and
is therefore referred to as permanent or fixed or regular working capital. It is permanent in the
same way as investment in the firm's fixed assets is.
Fluctuating Working Capital
Depending upon the changes in production and sales, the need for working capital, over and
above the permanent working capital, will fluctuate. The need for working capital may also
vary on account of seasonal changes or abnormal or unanticipated conditions. For example, a
rise in the price level may lead to an increase in the amount of funds invested in stock of raw
materials as well as finished goods. Additional doses of working capital may be required to
face cutthroat competition in the market or other contingencies like strikes and lockouts. Any
special advertising campaigns organized for increasing sales or other promotional activities
may have to be financed by additional working capital. The extra working capital needed to
support the changing business activities is called the fluctuating (variable, seasonal,
temporary or special) working capital.
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Figure 5.2
As seen in Figure, that fixed working capital is stable over time, whereas variable working
capital is fluctuating-sometimes increasing and sometimes decreasing. The permanent
working capital line, however, may not always be horizontal. For a growing firm, permanent
working capital may also keep on increasing over time as has been shown in figure above.
Both these kinds of working capital - permanent and temporary-are required to facilitate
production and sales through the operating cycle, but temporary working capital is arranged
by the firm to meet liquidity requirements that are expected to be temporary.
COMPONENTS OF WORKING CAPITAL
You have already noted that working capital has two components: Current assets and Current
liabilities. Current assets comprise several items. The typical items are:
i) Cash to meet expenses as and when they occur.
ii) Accounts Receivables or sundry trade debtors
iii) Inventory of:
a) Raw materials, stores, supplies and spares,
b) Work-in-process, and
c) Finished goods
Advance payments towards expenses or purchases, and another short-term advances which
are recoverable.
Temporary investment of surplus funds which could be converted into cash whenever
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needed.
A part of the need for funds to finance the current assets may be met from supply of. goods
on credit, and deferment, on account of custom, usage or arrangement, of payment for
expenses. The remaining part of the need for working capital may be met from short-term
borrowing from financiers like banks. These items are collectively called current liabilities.
Typical items of current liabilities are:
1. Goods purchased on credit
2. Expenses incurred in the course of the business of the organization (e.g., wages or
salaries, rent, electricity bills, interest etc.) which are not yet paid for.
3. Temporary or short term borrowings from banks, financial institutions or other parties
4. Advances received from parties against goods to be sold or delivered, or as short term
deposits.
5. Other current liabilities such as tax and dividends payable. Some of the major
components of current assets are explained here in brief:
Cash: All of us know that the basic input to start any business is cash. Cash is initially
required for acquiring fixed assets like plants and machinery which enables a firm to produce
products and generate cash by selling them. Cash is also required and invested in working
capital. Investments in working capital is required, as firms have to store certain quantity of
raw materials and finished goods and also for providing credit terms to the customers.
A minimum level of cash helps in the conduct of everyday ordinary business such as making
of purchases and sales as well as for meeting the unexpected payments, developments and
other contingencies. As discussed earlier cash invested at the beginning of-the operating
cycle gets released at the end of the cycle to fund fresh investments. However, additional
cash is required by the firm when it needs to buy more fixed assets, increase the level of
operations or for bringing out change in working capital cycle such as extending credit period
to the customers.
The demand for cash is affected by several factors, some of them are within the control of the
managers and some are outside their control. It is not possible to operate the business without
holding cash but at the same time holding it without a purpose also costs a firm either directly
in the form of interest or loss of income that could be earned out of the cash.
In the context of working capital management, cash management refers to optimizing the
benefit and cost associated with holding cash. The objective of cash management is best
achieved by speeding up the working capital cycle, particularly the collection process and
investing surplus cash in short term assets in most profitable avenues.
We will be subsequently discussing certain issues like the management of cash flows and
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determination of optimal cash balance, etc. (in this unit).
Accounts Receivable: Firms rather prefer to sell for cash than on credit, but competitive
pressures force most firms to offer credit. Today the use of credit in the purchase of goods
and services is so common that it is taken for granted. Selling goods or providing services on
credit basis leads to accounts receivable. When consumers expect credit, business units in
turn expect credit from their suppliers to match their investment in credit extended to
consumers. The granting of credit from one business firm to another for purchase of goods
and services is popularly known as trade credit.
Though commercial banks provide a significant part of requirements for working capital,
trade credit continues to be a major source of funds for firms and accounts receivable that
result from granting trade credit are major investment for the firm.
Both direct and indirect costs are associated with carrying receivables, but it has an important
benefit for increasing sales. Excessive levels of accounts receivables result in decline of cash
flows and many results in bad debts which in turn may reduce the profit of the firm.
Therefore, it is very important to monitor and manage receivables carefully and regularly. We
would be dealing with this topic in MS-41: Working Capital Management.
Inventory: Three things will come to your mind when you think of a manufacturing unit -
machines, men and materials. Men using machines and tools convert the materials into
finished goods. The success of any business unit depends on the extent to which these are
efficiently managed. Inventory is an asset to the organization like other components of
current assets.
Inventory constitutes a very significant part of working capital or current assets in
manufacturing organization. It is essential to control inventories (physical/quantity control
and value control) as these are significant elements in the costing process constituting
sometimes more than 60% of the current assets.
Inventory holding is desirable because it meets several objectives and needs but an excessive
inventory is undesirable because it costs a lot to firms.
Inventory which consists of raw material components and other consumables, work in
process and finished goods, is an important component of `current assets'. There are several
factors like nature of industry, availability of material, technology, business practices, price
fluctuation, etc. that determines the amount of inventory holding. Holding inventory ensures
smooth production process, price stability and immediate delivery to customers. Since
inventory is like any other form of assets, holding inventory has a cost. The cost includes
opportunity cost of funds blocked in inventory, storage cost, stock out cost, etc. The benefits
that come from holding inventory should exceed the cost to justify a particular level of
inventory.
Marketable Securities: Cash and marketable securities are normally treated as one item in any
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analysis of current assets although these are not the same as cash they can be converted to
cash at a very short notice. Holding cash in excess of immediate requirement means the firm
is missing out an opportunity income. Excess cash is normally invested in marketable
securities, which serves two purposes namely, provide liquidity and, also earn a return.
IMPORTANCE OF WORKING CAPITAL MANAGEMENT
Because of its close relationship with day-to-day operations of a business, a study of working
capital and its management is of major importance to internal, as well as external analysts. It
is being increasingly realized that inadequacy or mismanagement of working capital is the
leading cause of business failures. We must not lose sight of the fact that management of
working capital is an integral part of the overall financial management and, ultimately, of the
overall corporate management. Working capital management thus throws a challenge and
should be a welcome opportunity for a financial manager who is ready to play a pivotal role
in his organization.
Neglect of management of working capital may result in technical insolvency and even
liquidation of a business unit. With receivables and inventories tending to grow and with
increasing demand for bank credit in the wake of strict regulation of credit in India by the
Central Bank, managers need to develop a long-term perspective for managing working
capital. Inefficient working capital management may cause either inadequate or excessive
working capital, which is dangerous.
A firm may have to face the following adverse consequences from inadequate working
capital:
Growth may be stunted. It may become difficult for the firm to undertake profitable projects
due to non-availability of funds.
1. Implementation of operating plans may become difficult and consequently the firm's
profit goals may not be achieved.
2. Operating inefficiencies may creep in due to difficulties in meeting even day to day
commitments.
3. Fixed assets may not be efficiently utilized due to lack of working funds, thus
lowering the rate of return on investments in the process.
4. Attractive credit opportunities may have to be lost due to paucity of working capital.
5. The firm loses its reputation when it is not in a position to honor its short-term
obligations. As a result, the firm is likely to face tight credit terms.
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On the other hand, excessive working capital may pose the following dangers:
1 Excess of working capital may result in unnecessary accumulation of inventories,
increasing the chances of inventory mishandling, waste, and theft.
2 It may provide an undue incentive for adopting too liberal a credit policy and
slackening of collection of receivables, causing a higher incidence of bad debts. This has an
adverse effect on profits.
3 Excessive working capital may make management complacent, leading eventually to
managerial inefficiency.
4 It may encourage the tendency to accumulate inventories for making speculative
profits, causing a liberal dividend policy, which becomes difficult to maintain when the firm
is unable to make speculative profits.
An enlightened management, therefore, should maintain the right amount of working capital
on a continuous basis. Financial and statistical techniques can be helpful in predicting the
quantum of working capital needed at different points of time.
DETERMINANTS OF WORKING CAPITAL NEEDS
There are no set rules or formulas to determine the working capital requirements of a firm.
The corporate management has to consider a number of factors to determine the level of
working capital. The amount of working capital that a firm would need is affected not only
by the factors associated with the firm itself but is also affected by economic, monetary and
general business environment. Among the various factors the following are important ones.
Nature and Size of Business
The working capital needs of a firm are basically influenced by the nature of its business.
Trading and financial firms generally have a low investment in fixed assets, but require a
large investment in working capital. Retail stores, for example, must carry large stocks of a
variety of merchandise to satisfy the varied demand of their customers. Some manufacturing
businesses' like tobacco, and construction firms also have to invest substantially in working
capital but only a nominal amount in fixed assets. In contrast, public utilities have a limited
need for working capital and have to invest abundantly in fixed assets. Their working capital
requirements are nominal because they have cash sales only and they supply services, not
products. Thus, the amount of funds tied up with debtors or in stocks is either nil or very
small. The working capital needs of most of the manufacturing concerns fall between the two
extreme requirements of trading firms and public utilities.
The size of business also has an important impact on its working capital needs. Size may be
measured in terms of the scale of operations. A firm with larger scale of operations will need
more working capital than a small firm. The hazards and contingencies inherent in a
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particular type of business also have an influence in deciding the magnitude of working
capital in terms of keeping liquid resources.
Manufacturing Cycle
The manufacturing cycle starts with the purchase of raw materials and is completed with the
production of finished goods. If the manufacturing cycle involves a longer period the need for
working capital will be more, because an extended manufacturing time span means a larger
tie-up of funds in inventories. Any delay at any stage of manufacturing process will result in
accumulation of work-in-process and will enhance the requirement of working capital. You
may have observed that firms making heavy machinery or other such products, involving
long manufacturing cycle, attempt to minimize their investment in inventories (and thereby in
working capital) by seeking advance or periodic payments from customers.
Business Fluctuations
Seasonal and cyclical fluctuations in demand for a product affect the working capital
requirement considerably, especially the temporary working capital requirements of the firm.
An upward swing in the economy leads to increased sales, resulting in an increase in the
firm's investment in inventory and receivables or book debts. On the other hand, a decline in
the economy may register a fall in sales and, consequently, a fall in the levels of stocks and
book debts.
Seasonal fluctuations may also create production problems. Increase in production level may
be expensive during peak periods. A firm may follow a policy of steady production in all
seasons to utilize its resources to the fullest extent. This will mean accumulation of
inventories in off-season and their quick disposal in peak season. Therefore, financial
arrangements for seasonal working capital requirement should be made in advance. The
financial plan should be flexible enough to take care of any seasonal fluctuations.
Production Policy
If a firm follows steady production policy, even when the demand is seasonal, inventory will
accumulate during off-season periods and there will be higher inventory costs and risks. If the
costs and risks of maintaining a constant production schedule are high, the firm may adopt
the policy of varying its production schedule in accordance with the changes in demand.
Firms whose physical facilities can be utilized for manufacturing a variety of products can
have the advantage of diversified activities. Such firms manufacture their main products
during the season and other products during off-season. Thus, production policies may differ
from firm to firm, depending upon the circumstances. Accordingly, the need for working
capital will also vary.
Turnover of Circulating Capital
The speed with which the operating cycle completes its round (i.e., cash → raw materials →
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finished product → accounts receivables → cash) plays a decisive role in influencing the
working capital needs. (Refer to Figure 1(.1 on operating cycle).
Credit Terms
The credit policy of the firm affects the size of working capital by influencing the level of
book debts. Though the credit terms granted to customers to a great extent depend upon the
norms and practices of the industry or trade to which the firm belongs; yet it may endeavor to
shape its credit policy within such constraints. A long collection period will generally mean
tying of larger funds in book debts. Slack collection procedures may even increase the
chances of bad debts.
The working capital requirements of a firm are also affected by credit terms granted by its
creditors. A firm enjoying liberal credit terms will need less working capital.
Growth and Expansion Activities
As a company grows, logically, larger amount of working capital will be needed, though it is
difficult to state any firm rules regarding the relationship between growth in the volume of a
firm's business and its working capital needs. The fact to recognize is that the need for
increased working capital funds may precede the growth in business activities, rather than
following it. The shift in composition of working capital in a company may be observed with
changes in economic circumstances and corporate practices. Growing industries require more
working capital than those that are static.
Operating Efficiency
Operating efficiency means optimum utilization of resources. The firm can minimize its need
for working capital by efficiently controlling its operating costs. With increased operating
efficiency the use of working capital is improved and pace of cash cycle is accelerated. Better
utilization of resources improves profitability and helps in relieving the pressure on working
capital.
Price Level Changes
Generally, rising price level requires a higher investment in working capital. With increasing
prices the same levels of current assets need enhanced investment. However, firms which can
immediately revise prices of their products upwards may not face a severe working capital
problem in periods of rising levels. The effects of increasing price level may, however, be felt
differently by different firms due to variations in individual prices. It is possible that some
companies may not be affected by the rising prices, whereas others may be badly hit by it.
Other Factors
There are some other factors, which affect the determination of the need for working capital.
A high net profit margin contributes towards the working capital pool. The net profit is a
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source of working capital to the extent it has been earned in cash. The cash inflow can be
calculated by adjusting non-cash items such as depreciation, outstanding expenses, losses
written off, etc., from the net profit, (as discussed in Unit 6).
The firm's appropriation policy, that is, the policy to retain or distribute profits also has a
bearing on working capital. Payment of dividend consumes cash resources and thus reduces
the firms working capital to that extent. If the profits are retained in the business, the firm's
working capital position will be strengthened.
In general, working capital needs also depend upon the means of transport and
communication. If they are not well developed, the industries will have to keep huge stocks
of raw materials, spares, finished goods, etc. at places of production, as well as at distribution
outlets.
APPROACHES TO MANAGING WORKINGCAPITAL
Two approaches are generally followed for the management of working capital: (i) the
conventional approach, and (ii) the operating cycle approach.
The Conventional Approach
This approach implies managing the individual components of working capital (i.e.
inventory, receivables, payables, etc.) efficiently and economically so that there are neither
idle funds nor paucity of funds. Techniques have been evolved for the management of each of
these components. In India, more emphasis is given to the man- agreement of debtors because
they generally constitute the largest share of the investment in working capital. On the other
hand, inventory control has not yet been practiced on a wide scale perhaps due to scarcity of
goods (or commodities) and ever rising prices.
The Operating Cycle Approach
This approach views working capital as a function of the volume of operating expenses.
Under this approach the working capital is determined by the duration of the operating cycle
and the operating expenses needed for completing the cycle. The duration of the operating
cycle is the number of days involved in the various stages, commencing with acquisition of
raw materials to the realization of proceeds from debtors. The credit period allowed by
creditors will have to be set off in the process. The optimum level of working capital will be
the requirement of operating expenses for an operating cycle, calculated on the basis of
operating expenses required for a year.
In India, most of the organizations use to follow the conventional approach earlier, but now
the practice is shifting in favor of the operating cycle approach. The banks usually apply this
approach while granting credit facilities to their clients.
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MEASURING WORKING CAPITAL
The factors discussed in the preceding section influence the quantum of working capital in a
business enterprise. How to determine or measure the amount of working capital that an
enterprise would need was discussed to some extent in Unit 6 dealing with funds flow
analysis. Let us attempt to determine the amount of working capital needed by taking up an
illustration.
WORKING CAPITAL MANAGEMENT UNDERINFLATION
It is desirable to check the increasing demand for capital, for maintaining the existing level of
activity. Such a control acquires even more significance in times of inflation. In order to
control working capital needs in periods of inflation, the following measures may be applied.
Greater disciplines on all segments of the production front may be attempted as under:
a) The possibility of using substitute raw materials without affecting quality must be
explored in all seriousness. Research activities in this regard may be undertaken, with
financial assistance provided by the Government and the corporate sector, if any.
b) Attempts must be made to increase the productivity of the work force by proper
motivational strategies. Before going in for any incentive scheme, the cost involved must be
weighed against the benefit to be derived. Though wages in accounting are considered a
variable cost, they have tended to become partly fixed in nature due to the influence of
various legislative measures adopted by the Central or State Governments in recent times.
Increased productivity results in an increase in value added, and this has the effect of
reducing labor' cost per unit.
The managed costs should be properly scrutinized in terms of their costs and benefits. Such
costs include office decorating expenses, advertising, managerial salaries and payments, etc.
Managed costs are more, or less fixed costs and once committed they are difficult to retreat.
In order to minimize the cost impact of such items, the maximum possible use of facilities
already created must be ensured. Further the management should be vigilant in sanctioning
any new expenditure belonging to this cost
The increasing pressure to augment working capital will, to some extent, be neutralized if the
span of the operating cycle can be reduced. Greater turnover with shorter intervals and
quicker realization of debtors will go a long way in easing the situation.
Only when there is a pressure on working capital does the management become conscious of
the existence of slow-moving and obsolete stock. The management tends to adopt ad hoc
measures, which are grossly inadequate. Therefore, a clear-cut policy regarding the disposal
of slow-moving and obsolete stocks must be formulated and adhered to. In addition to this,
there should be an efficient management information system reflecting the stock position
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from various standpoints.
The payment to creditors in time leads to building up of good reputation and consequently it
increases the bargaining power of the firm regarding period of credit for payment and other
conditions. Projections of cash flows should be made to see that cash inflows and outflows
match with each other. If they do not, either some payments have to be postponed or purchase
of some avoidable items has to be deferred.
DETERMINING OPTIMAL CASH BALANCE
Holding of excessive cash is a non-profitable proposition, as idle cash does not earn any
income. Similarly shortage of cash may deprive the business unit of availing the benefits of
cash discounts, and of taking advantage of other favorable opportunities.
It may even lead to loss of credit-worthiness on account of default in paying liabilities when
the same become due. Hence, every organization, irrespective of its size and nature, has to
determine the appropriate or optimum cash balance that it would need. Nature has to
determine the appropriate or optimum cash balance that it would need.
A firm's cash balance, generally, may not be constant over time. It would therefore be
worthwhile to investigate the maximum, minimum and average cash needs over a designated
time period.
You are aware that cash is needed for various transactions in the organization. Maintenance
of a cash balance however has an opportunity cost in the following ways:
A)Cash can be invested in acquiring assets such as Inventory, or for purchasing securities.
Opportunities for such investments may have to be lost if a certain minimum cash balance is
not held.
b) Holding of cash means that it cannot be used to offset financial risks from the short-term
debts.
c) Excessive reliance on internally generated liquidity can isolate the firm from the short-term
financial market.
Now the financial manager should understand the benefits and the opportunity costs for
holding cash. Thereafter, he must proceed to work out a model for determining the optimal
amount of cash. First of all a critical minimum cash balance should be conceived below
which the firm will incur definite and measurable costs. Apart from risk aversion the
existence of the minimum balance is justified by institutional requirements such as credit
ratings, checking accounts, lines of credit.
The violation of maintaining a minimum cash balance will create shortage costs which will
be determined by the actions of creditors on account of postponing their payments or non-
availing of cash discounts.
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At any point of time a firm's (ending) cash balance can be represented as follows: Ending
balance = Beginning Balance + Receipts –Disbursements
If receipts and disbursements are equal for any unit of time, no problem is involved.
Ordinarily, however, receipts may be more than disbursements or vice versa. Hence, the
ending balance will keep on fluctuating. In actual practice receipts and disbursements do
vary, particularly in case of firms having seasonal activities.
Suppose, the receipts and disbursements are not synchronized but the variation is predictable,
then the main problem will be that of minimizing total costs. In case you set the balance too
low you will incur high transaction costs. If you set the balance too high you will lose
interest, which you can earn by investing cash in marketable securities. The determination of
optimal cash balance under these conditions of known certainty is similar to the inventory
problem: The costs of too little cash (transaction costs) can be balanced against the costs of
too much cash (opportunity costs). Figure clarifies this position.
It is seldom that receipts and disbursements are completely predictable. For a moment let, us
take one extreme case where receipts and disbursements are completely random: A model
can be developed using the Control Theory and fix maximum and minimum optimal balances
as illustrated in Figure 16.5
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Figure 5.3
You can observe from Figure 16.5 that the fluctuating cash balance is on account of random
receipts and disbursements. At time to the balance touches the upper control point. At this
point the excess of cash is invested in marketable securities. The balance falls to zero point at
time t2 and at this stage marketable securities have to be sold to create cash balances. These
two control points lay only the maximum and minimum balance. We can conclude that where
cash flows (receipts and disbursements) are uncertain the principle will be: the greater the
variability the higher the minimum cash balance.
MANAGEMENT OF CASH FLOWS
The cash flows could be properly and effectively managed by:
Speeding up Collections
In order to minimize the size of cash holding, the time gap between sale of goods and their
cash collection should be reduced and the flow be controlled. Normally, certain factors
creating time lags are beyond the control of management. Yet, in order to improve the
efficiency, attention should be paid to the following.
All cash collected should be directly deposited in one account. If there are more than one
collection centres, all cash receipts should be remitted to the main account with. Top speed.
Compared to a single collection centre, the aggregate requirement for cash will be more when
there are several centres. Concentration of collections at one place will thus permit the firm to
store its cash more efficiently.
The time lag between the dispatch of cheque by the customer and its credit to our account
with the bank should be reduced. Some firms with large collection transactions introduce lock
box system. In this system the post boxes are hired at different centres where cash/cheques
can be dropped in. The local banker can daily collect the same from the lockers. The
collecting bank is paid service charges. In order to minimize time, banks may be asked to
devise methods for speeding up the collection of cash.
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Recovering Dues
After sale of goods on credit, either on account of convention or for promoting sales,
receivables are created. It may however be useful to reduce the amount blocked in
receivables by seeing to it that they do not become overdue accounts. Incentive in the form of
discounts for early payment may be given. More important than anything else is a constant
follow-up action for the recovery of dues. This will improve position of cash balance.
Controlling Disbursements
Needless to assert that speeding up of collections helps conversion of receivables into cash
and thus reduces the financing requirements of the firm. Similar kind of benefit can be
derived by delaying disbursements. Trade credit is a costless source of funds for it allows us
to pay the creditors only after the period of credit agreed upon. The dues can be withheld till
the last date. This will reduce the requirement for holding large cash balance. Some firms
may like to take advantage of cheque book float which is the time gap between the date of
issue of a cheque and the actual when it is presented for payment directly or through the
bank.
Investment of Idle Cash Balances Two other important aspects in cash management are how
to determine appropriate cash balance and how to invest temporarily idle cash in interest
earning assets or securities. The first part relating to the theory of determining appropriate
cash balance has already been discussed earlier. Now we shall discuss the investment of idle
cash balance on temporary basis.
Cash by itself yields no income. If we know that some cash will be in excess of our need for a
short period of time, we must invest it for earning income without depriving ourselves of the
benefit of liquidity of funds. While doing this, we must weigh the advantages of carrying
extra cash (i.e. more than the normal requirement) and the disadvantages of not carrying it.
The carrying of extra cash may be necessitated due to its requirement in future, whether
predictable or unpredictable. The experience indicates that cash flows cannot be predicted
with complete accuracy. Competition, technological changes, unexpected failure of products,
strikes and variations in economic conditions make it difficult to predict cash needs
accurately.
Investment Criteria
When it is realized that the excess cash will remain idle, it should be invested in such a way
that it would generate income and at the same time ensure quick re-conversion of investment
in cash. While choosing the channels for investment of any idle cash balance for a short
period, it should be seen that (i) the investment is free from default risk, that is, the risk
involved due to the possibility of default in timely payment of interest and repayment of
principal amount; (ii) the investment shall mature in short span of time; and (iii) the
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investment has adequate marketability. Marketability refers to the ease with which an asset
can be converted back into cash. Marketability has two dimensions -price and time-which are
inter-related. If an asset can be sold quickly in large amounts at a price determinable in
advance the asset will be regarded as highly marketable and highly liquid. The assets which
largely satisfy the aforesaid criteria are: Government Securities, Bankers' Acceptances and
Commercial Paper.
INVENTORY MANAGEMENT
What is inventory? Inventory refers to those goods which are held for eventual sale by the
business enterprise. In other words, inventories are stocks of the product a firm is
manufacturing for sale and components that make up the product. Thus, inventories form a
link between the production and sale of the product.
The forms of inventories existing in a manufacturing enterprise can be classified into three
categories:
(i) Raw Materials:
These are those goods which have been purchased and stored for future productions. These
are the goods which have not yet been committed to production at all.
(ii) Work-in-Progress:
These are the goods which have been committed to production but the finished goods have
not yet been produced. In other words, work-in-progress inventories refer to ‘semi-
manufactured products.’
(iii) Finished Goods:

These are the goods after production process is complete. Say, these are final products of the
production process ready for sale. In case of a wholesaler or retailer, inventories are generally
referred to as ‘merchandise inventory’.
Some firms also maintain a fourth kind of inventory, namely, supplies. Examples of supplies
are office and plant cleaning materials, oil, fuel, light bulbs and the like. These items are
necessary for production process. In practice, these supplies form a small part of total
inventory involving small investment. Therefore, a highly sophisticated technique of
inventory management is not needed for these.
The size of above mentioned three types of inventories to be maintained will vary from one
business firm to another depending upon the varying nature of their businesses. For example,
while a manufacturing firm will have all three types of inventories, a retailer or a wholesaler
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business, due to its distinct nature of business, will have only finished goods as its
inventories. In case of them, there will be, therefore, no inventories of raw materials as well
as work-in- progress.
Benefits and Costs of Holding Inventories:
Holding inventories bears certain advantages for the enterprise.

The important advantages but not confined to the following only are as follows:
1. Avoiding Losses of Sales:

By holding inventories, a firm can avoid sales losses on account of non-supply of goods at
times demanded by its customers.
2. Reducing Ordering Costs:
Ordering costs, i.e., the costs associated with individual orders such as typing, approving,
mailing, etc. can be reduced, to a great extent, if the firm places large orders rather than
several small orders.
3. Achieving Efficient Production Run:
Holding sufficient inventories also ensures efficient production run. In other words, supply of
sufficient inventories protects against shortage of raw materials that may at times interrupt
production operation.
Costs of Holding Inventories:
However, holding inventories is not an unmixed blessing. In other words, it is not that
everything is good with holding inventories. It is said that every noble acquisition is attended
with risks; he who fears to encounter the one must not expect to obtain the other. This is true
of inventories also. There are certain costs also associated with holding inventories. Hence, it
is necessary for a firm to take these costs into consideration while planning for inventories.
These are broadly classified into three categories:
1. Material Costs:
These include costs which are associated with placing of orders to purchase raw materials and
components. Clerical and administrative salaries, rent for the space occupied, postage,
telegrams, bills, stationery, etc. are the examples of ordering costs. The more the orders, the
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more will be the ordering costs and vice versa.
2. Carrying Costs:
These include costs involved in holding or carrying inventories like insurance charges for
covering risks, rent for the floor space occupied, wages to laborers, wastages, obsolescence or
deterioration, thefts, pilferages, etc. These also include opportunity costs. This means had the
money blocked in inventories been invested elsewhere in the business, it would have earned a
certain return. Hence, the loss of such return may be considered as an ‘opportunity cost’.
The above facts underline the need for inventory management, i.e., to decide the optimum
volume of inventories in the firm/enterprise during the period.
Objectives of Inventory Management:
There are two main objectives of inventory management:

1. Making Adequate Availability of Inventories:
The main objective of inventory management is to ensure the availability of inventories as
per requirements all the times. This is because both shortage and surplus of inventories prove
costly to the organization. In case of shortage of availability in inventories, the manufacturing
wheel comes to a grinding halt. The consequence is either less production or no production.
The either case results in less sale to less revenue to less profit or more loss. On the other
hand, surplus in inventories means lying inventories idle for some time implying cash
blocked in inventories. Speaking alternatively, this also means that had the organization
invested money blocked in inventories invested elsewhere in the business, it would have
earned a certain return to the organization. Not only that, it would have also reduced the
carrying cost of inventories and, in turn, increased profits to that extent.
2. Minimizing Costs and Investments in Inventories:
Closely related to the above objective is to minimize both costs as well as volume of
investment in inventories in the organization. This is achieved mainly by ensuring required
volume of inventories in the organization all the times.
This benefits organization mainly in two ways. One, cash is not blocked in idle inventories
which can be invested elsewhere to earn some return. Second, it will reduce the carrying
costs which, in turn, will increase profits. In lump sum, inventory management, if done
properly, can bring down costs and increase the revenue of a firm.
RECEIVABLE MANAGEMENT
Trade Credit is a prominent and all pervasive force in the present day competitive
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industrialenvironment. This is because, it is highly difficult to a manufacturer to pay cash
across the counter, whatever be his liquidity in meeting the debts. In the words of Pandey1,
“A firm is said to have granted trade credit when it sells its products or services and does not
receive cash immediately”. Trade credit is an essential marketing tool which acts as a bridge
for the movement of goods from the stage of production to distribution. It acts as a device to
protect firm’s sales from its competitors and also attracts potential customer, who otherwise
finds it difficult to make cash purchases.
Trade credit creates receivables, which the firm is expected to collect in the near future. Thus,
the book debt or receivables, arising out of credit has three dimensions2. First, it embraces an
element of risk which needs to be assessed, since cash sales are totally riskless. Second, it is
based on economic values. To the buyer, the economic value in goods or services is passed
on immediately at the time of sale while the seller expects an equivalent value to be received
at a later date. Third, it implies futurity.
The payment for value received, arises at a future date. But, creation of receivables block the
firm’s funds for the period between the date of sale and the date of receipt of payment which
is to be financed out of working capital funds. This necessitates the firm to arrange funds
from banks and other sources. Thus, receivables represent investment, which constitutes a
substantial portion of current assets of manufacturing firm. Thus, it needs careful analysis and
proper management. Receivables, in the strict accounting sense, include (i) book debts or
accounts, (ii) notes and bills and (iii) accrued receivables only. However, in broader sense,
the term receivables is used to include further (iv) any pre-payment made against purchase
and expenses contract and (v) advance to subsidiaries, employees and officers3 .
The quantum of book debts depends upon the volume of credit sales and collection policy.
The greater the volume of credit sales and larger the credit period allowed, the more is the
investment in trade debtors. Sometimes, the customers, at the time of credit sales, may be
asked to sign notes or bills promising therein to pay a specified date the amount extended to
them as credit. Again, sale of durable goods on hire purchase basis gives rise to accrued
receivables for those installments that become due for payment.
Pre-payment arise when payment is made in advance of receipt of goods and services. As
pre-payments represent items to be consumed during the course of business, it is different
from typical receivables. Insurance premium, rent, etc., are pre-payments of this nature. Pre-
paid tax is also considered an asset as it chargeable to a later period. Advances and loans to
employees and officers of the company are also current assets. They are, however, good
assets only to the extent that the responsibility of the employees or the officers can be relied
upon. In the present chapter, the term ‘receivables’ has been used in its broader sense, that is,
to include trade debtors and loans and advances in its purview. In order to evaluate the
performance of receivables management in select cement companies, an attempt has been
made to analyze the size, composition and efficiency of receivables during the study period.
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Composition of Receivables
A vital tool for evaluating the management of receivables is study of their composition. It
helps to reveal the point where receivables concentrated most. Receivables in any
organization comprise the total of sundry debtors and loans and advances. It is desirable to
keep minimum investment in loans and advances because to that extent firm’s funds are
blocked up which would have been otherwise used profitably. In other words, investment in
loans and advances has high opportunity cost. Investment in debtors, on the other hand, is
inevitable in the competitive environment. Further, increasing investment in debtors may
increase the sales which in turn may increase profit. The table 7.6 shows the composition of
receivables in select cement companies which reveals that first two years of the study period
i.e., 2003-04 and 2004-05, the proportion of sundry debtors dominated the total receivables
and later on loans and advances predominated the structure of receivables in the industry. On
an average, the proportion of debtors was 42.76 per cent and loans and advances was 57.24
per cent in the industry.
CREDIT POLICY
Designing credit policy is the first step in receivables management. In designing credit
policy, the management can follow two broad approaches. Firstly, the policy can be designed
under the assumption of unlimited production/sales and funds available for investment in
receivables. If credit policy is designed under this assumption and subsequently some
constraints are experienced on sales or funds available for receivables, then managers have to
restrict the credit at the time of implementing the credit policy. But this may cause certain
difficulties to customers because of deviation from the announced credit policy. For example,
if a company announces that credit will be unlimited to certain categories of customers
based on unlimited funds assumption and subsequently refuse to grant credit due to limited
funds available for investment in receivables, it will create hardship to the customer. Under
the second approach, the credit policy could be designed keeping in mind the limitations on
production/sales volume and funds available for investment in receivables. This is aimed to
achieve optimum utilization of production capacity and funds available for receivables. It
also ensures consistency of credit policy.
The credit policy consists of the following components:

• Credit Period
• Discount
• Credit Eligibility
• Credit Limit
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Credit Period
Decision on credit period is determined by several factors. It is important to check the credit
period given by other firms in the industry. It would be difficult to sustain by adopting a
completely different credit policy as compared to that of industry. For example, if the
industry practice is 30 days of credit period, a firm which offers 120 days credit would
certainly attract more business but the cost associated with managing longer credit period
also increases simultaneously. On the other hand, if the firm reduces the credit period to 10
days, it would certainly reduce the cost of carrying receivables but volume would also decline
because many customers would prefer other firms, which offer 30 days credit. In other
words, granting trade credit is an aspect of price.
The time that the buyer gets before payment is due, is one of the dimensions of the product
(like quality, service, etc.) which determine the attractiveness of the product. Like other
aspects of price, the firm’s terms of credit affect its volume. All other things being equal,
longer credit period and more liberal credit-granting policies increase sales, while shorter
credit period and more stringent credit- granting policies decrease sales. These policies also
affect the level and timing of certain costs. Evaluation of credit policy changes must
compare with the changes in sales and additional revenues generated by the sales as a
result of this policy change and costs effects. While additional volume and revenue
associated with such additional volume are clear and measurable, the cost effects require
further analysis.
Cost of Extending Credit Period

Lengthening credit period delays the cash inflows. For example, suppose a firm increases the
credit period from 30 days to 90 days. Customers, old as well as new, will now pay at the end
of 90 days and the cash inflows from these sales would occur further into the future. That
means, the firm has to delay in settling its dues to others or resort to short-term borrowing if
the payments cannot be delayed. The interest cost of short-term borrowing arises mainly on
account of extending the credit period.
Discount
When a firm pursues aggressive credit policy, it affects cash flows in the form of delayed
collection and bad debts. Discounts are offered to the customers, who purchased the goods on
credit, as an incentive to give up the credit period and pay much earlier. For example,
suppose the terms of credit is “3/10 net 60”. It means if the customer, who gets 60 days credit
period can pay within 10 days from the date of purchase and get a discount of 3% on the
value of order.
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Since the customer uses the opportunity cost of funds and availability of cash in taking
decision, the cash discount should be set attractive. The discount quantum should be greater
than interest rate of short-term borrowings.
Credit Eligibility
Having designed credit period and discount rate, the next logical step is to define the
customers, who are eligible for the credit terms. The credit-granting decision is critical for
the seller since credit-granting has economic value to buyers and buyers decision on purchase
is directly affected by this policy. For instance, if the credit eligibility terms reject a particular
customer and requires the customer to make cash purchase, the customer may not buy the
product from the company and may look forward to someone who is agreeable to grant
credit. Nevertheless, it may not be desirable to grant credit to all customers. It may
instead analyze each potential buyer before deciding whether to grant credit or not based on
the attributes of that particular buyer. While the earlier two terms of credit policy viz. credit
period and discount rate are not changed frequently in order to maintain consistency in the
policy, credit eligibility is periodically reviewed. For instance, an entry of new customer
would warrant a review of credit eligibility of existing customers.
The decision whether a particular customer is eligible for credit terms generally involves a
detailed analysis of some of the attributes of the customer. Credit analysts normally group
the attributes in order to assess the credit worthiness of customers. One traditional way of
organizing the information is by characterizing the applicant along five dimensions namely,
Capital, Character, Collateral, Capacity and Conditions. These five dimensions are also
popularly called Five Cs of credit analysis.
Capital: The term capital here refers to financial position of the applicant firm. It requires
an analysis of financial strength and weakness of the firm in relation to other firms in the
industry to assess the credit worthiness of the firm.
Financial information is normally derived from the financial statements of the firm and
analyzed through ratio analysis. The liquidity ratios like current ratio, debt- service coverage
ratio, etc. are often used to get a preliminary idea on the financial strength of the firm. Further
analysis includes trend analysis and comparison with the other industry norm or other firms
in the industry.
Character: A prospective customer may have high liquidity but delay payment to their
suppliers. The character thus relates to willingness to pay the debts.
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Some relevant questions relating to character are:
• What is the applicant’s history of payments to the trade?
• Has the firm defaulted to other trade suppliers?
• Does the applicant’s management make a good-faith effort to honor debts as they
become due?
Information on these areas are useful to assess the applicant’s character.
Collateral: If a debt is supported by collateral, then the debt enjoys lower risk because in the
event of default, the debt holder can liquidate the collateral to recover the dues. The
collateral causes hardship to other debt holders. Thus, the analysts should look into both the
availability of collateral for the debt and the amount of collateral the firm has given to others.
In computing the liquidity of the firm, the analysts should remove the assets used for
collateral and take into account only the free assets. The credit worthiness improves if the
customer is willing to offer collateral assets or the value of collateral asset backed loan is
low.
Capacity: The capacity has two dimension - management’s capacity to run the business and
applicant firm’s plant capacity. The future of the firm depends on the management’s ability
to meet the challenges. Similarly, the facility should exist to exploit the opportunity. Since
the assessment of capacity is a
judgement on the part of analysts, a lot of care should be taken in assessing this feature.
Conditions: These are the economic conditions in the applicant’s industry and in the economy
in general. Scope for failure and default is high when the industry and economy are in
contraction phase. Credit policy is required to be modified when the conditions are not
favorable. The policy changes include liberal discount for payment within a stipulated period
and imposing lower credit limit
The information collected under five Cs can be analyzed in general to decide whether the
customer is eligible for credit or fit into a statistical model to get an unbiased credit rating of
the customer. Discussion on credit evaluation model is presented in the next section.
Credit Limit
If a customer falls within the desired limit of credit worthiness, the next issue is fixing the
credit amount. This is something similar to banks fixing overdraft limit for the account
holders. If a customer is new, normally the credit limit is fixed at the lowest level
initially and expanded over the period based on the performance of the customer in meeting
the liability. Credit limit may undergo a change depending on the changes in the credit
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worthiness of the customer and changes in the performance of customer’s industry.
MONITORING RECEIVABLES
Managing receivables does not end with granting of credit as dictated by the credit policy. It
is necessary to ensure that customers make payment as per the credit term and in the event of
any deviation, corrective actions are required.
Thus, monitoring the payment behavior of the customers assumes importance. There are
several possible reasons for customers to deviate from the payment terms. Three of these
possible reasons and their implications in credit management are discussed below:
Changing Customer Business Characteristics: The customers, who have earlier agreed to
make payment within a certain period of time, may deviate from their acceptance and delay
the payment. For example, economic slowdown or slowdown in the industry of the
customers’ business may force the customers to delay the payment. In fact, the bills payable
become discretionary cash outflow item in economic recession. Thus, a close watch on the
performance of customer’s industry is required.
Inaccurate Policy Forecasts: A wide deviation from the credit terms and actual flow of cash
flows show inaccurate forecast and defective credit policy. It is quite possible that a firm
uses defective credit rating model or wrongly assesses the credit variable. For example, it is
quite possible to overestimate the collateral value and then lend more credit. If this is the
reason for wide deviation, it requires updating the model or training the employees.
Improper Policy Implementation: Often wide deviation is noticed in practice while

implementing credit policy. This may not be intentional but frequently in the form of
accommodating special requests of the customers. For example, a customer may not be
eligible for credit or higher credit as per the model in force. The customer may personally see
the concerned manager and request her/him to relax the credit restriction. If there is no policy
in place to deal with these types of request and ad hoc decisions are made, then wide
deviation is possible. Often these deviations become costly for the firm. Intervention of top
officials and ad hoc decisions are cited as major reasons for widespread defaults in many
public financial institutions. Thus, it is necessary to ensure that policies are implemented in
letter and spirit.
Monitoring provides signals of deviation from expectations. There are several monitoring
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techniques available to the credit managers. The monitoring system begins with aggregate
analysis and then move down to account-specific analysis.
Investments in Receivables: The decision to supply on credit basis leads to investments in

receivables. Credit policy is designed in such a way that investment needs of receivables are
optimized i.e. return is greater than cost associated with investments. Credit monitoring starts
with an assessment of investment in receivables as a percentage of total assets. The
investments in receivables are then compared with the budget. Any deviation from budgeted
value shows delay in collection or managers deviating from the credit policy. For example, if
a firm based on credit policy worked out that investments in receivables is 12%, the actual
value for the last three months is around 18%, there are two possible reasons. Firstly, some
of the customers are not paying and thus, the receivables value has gone up. Secondly, the
managers would be giving more credit than the prescribed limit or extend the credit period. In
either case, it requires an investigation and explanation from managers for the increased
investment in receivables.
Collection Period: Receivables can be related to sales in different ways. The simplest form of
analysis is comparing sales and receivables for different periods to know the trend. While
this analysis gives a reasonable understanding on how the receivables have moved over the
period, it fails to give an implication of the changes in the trend. For example, if sales and
receivables of two periods are Rs. 90 lakhs, 120 lakhs and Rs.120 lakhs, Rs.140 lakhs
respectively, the figures show (i) the sales value has gone up during the period, and (ii)
receivables have also gone up along with sales. A shaper focus on changes in the trend can be
obtained by computing the collection period of the two periods. The collection period is
computed as follows:
Credit sales per day is computed by dividing the total credit sale of the period by the number
of days of the period. If the sales value given above are related to quarterly sales value, then
sales per day for the two quarters are Rs. 1 lakh (Rs.90 lakhs/90 days) and Rs. 1.33 lakh
(Rs.120 lakhs/90 days) respectively.
The collection period for the two quarters are
Period 1: 120/1 = 120 days Period 2: 140/1.33 =105 days
The collection period shows a decline and thus improved performance, which was not visible
earlier in simple comparison. If the sales value for the second period is Rs. 100 lakhs instead
of 120 lakhs, then average credit sales per day is Rs.1.11 lakh and collection period is 126
days. The collection performance in this case has marginally come down. The
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collectionperiod of manufacturing companies in BSE-30 index (Sensex) for the last five years
is given in Table 5.2. The Table shows the average collection period for companies such as
Hindustan Petroleum, Nestle, Hindustan Lever, Bajaj Auto, Gujarat Ambuja Cements, ACC,
and Colgate are low whereas BHEL, L&T, Telco, Tesco, Grasim, etc., have experienced
longer days for collection.
If customers are granted different credit periods, then customers of similar nature are to be
grouped separately and then sales, receivables and collection period relating to each group of
customers are to be computed separately. Otherwise, it will give a distorted figure. In
addition to comparing collection period of one period with other periods, they are also
compared with credit terms. Any abnormal deviation warrants customer-wise analysis. That
is, all these three values for two periods can be computed for each customer to know the
trends in collection period of different customers. Such an analysis will help to narrow down
the customers who take longer time for paying the dues.
COLLECTING RECEIVABLES
The analysis explained earlier are useful to know the trend of collection and identify
customers, who are not paying on due dates. This should enable the management to take
appropriate action to collect the dues, which is the main objective of receivables
management. Collecting receivables begins with timely mailing of invoices. There are several
procedures available to credit managers, who must judiciously decide when, where and to
what extent pressure should be applied to delinquent customers. Management of collection
activity should be based on careful comparison of likely benefits and costs.
Inexpensive procedures include periodical mailing of duplicate bills reminding the customers
that the account is not settled or sending a formal letter informing nonpayment of bill and
requesting the customer to pay immediately. Written follow-up on an overdue account is
referred to as dunning. If a customer fails to respond to these reminders, then expensive
procedures are initiated. Personal telephone calls and reminder through registered post are
initially tried. Even if these steps fail to deliver the desired results, a personal visit by the
credit manager or representative to sort out the issue would be useful. If the credit manager
realizes that the customer is willfully defaulting or is in deep trouble and hence unlikely to
pay the dues, a formal legal action is initiated either to recover the dues or file a
liquidation petition before the court to recover the dues. It is difficult to prescribe exactly as
to which and when these collection procedures should be adopted. If collection policy is
strict, then it would reduce the outstanding receivables but at the same time frightened many
potential customers from doing business. On the other hand, a liberal collection policy would
invite many willful defaulters to do business with the company.
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The above discussion assumes that the firm takes the responsibility of collection. Two
alternatives are available to firms in collecting the receivables. The first one called factoring
enables the firm to transfer the receivables to factoring agent, who takes the responsibility of
collection. Some factoring agents takes the credit risk (i.e. the factoring agents bear the loss
on account of bad debts) and others accept factoring without credit risk. In India, we have
factoring subsidiaries of Canara Bank, SBI, etc. and Exim Bank does the factoring service
relating to export bills. The second one is called receivables securitization. Securitization is
somewhat similar to factoring but here the securitizing agent sells the units of receivables to
investors in the market. Though the concept of securitization is popular in finance related
receivables like housing loans, credit cards receivables, lease rentals, etc., the concept is
slowly spreading to other types of receivables. A few securitization deals have already been
completed in India and the market will witness more such transactions in the near future.
WORKING CAPITAL FINANCING
Working capital financing is done by various modes such as trade credit, cash credit/bank
overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter of
credit, factoring, commercial paper, inter-corporate deposits etc.
The arrangement of working capital financing forms a major part of the day to day activities
of a finance manager. It is a very crucial activity and requires continuous attention because
working capital is the money which keeps the day to day business operations smooth.
Without appropriate and sufficient working capital financing, a firm may get into troubles.
Insufficient working capital may result in nonpayment of certain dues on time. Inappropriate
mode of financing would result in loss of interest which directly hits the profits of the firm.
Types of Working Capital Financing / Loans
Trade Credit
This is simply the credit period which is extended by the creditor of the business. Trade credit
is extended based on the creditworthiness of the firm which is reflected by its earning
records, liquidity position, and records of payment. Working Capital Financing Just like other
sources of working capital financing, trade credit also comes with a cost after the free credit
period. Normally, it is a costly source as a means of financing business working capital.
Cash Credit / Bank Overdraft
Cash credit or bank overdraft is the most useful and appropriate type of working capital
financing extensively used by all small and big businesses. It is a facility offered by
commercial banks whereby the borrower is sanctioned a particular amount which can be
utilized for making his business payments. The borrower has to make sure that he does not
cross the sanctioned limit. The best part is that the interest is charged to the extent the money
is used and not on the sanctioned amount which motivates him to keep depositing the amount
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as soon as possible to save on interest cost. Without a doubt, this is a cost-effective working
capital financing.
Working Capital Loans
Working capital loans are as good as term loan for a short period. These loans may be repaid
in installments or a lump sum at the end. The borrower should take such loans for financing
permanent working capital needs. The cost of interest would not allow using such loans for
temporary working capital.
SUMMARY
An enterprise needs funds to operate profitably. The working capital of a business reflects the
short-term uses of funds. Apart from the investment in the long-term assets such as buildings,
plant and equipment, funds are also needed for meeting day to day operating expenses and for
amounts held in current assets. Within the time span of one year there is a continuing cycle or
turnover of these assets. Cash is used, to acquire stock, which on being sold results in an
inflow of cash, either immediately or after a time lag in case the sales are on credit. The rate
of turnover of current assets in relation to total sales of a given time period is of critical
importance to the total funds employed in those assets.
The amount needed to be invested in current assets is affected by many factors and may
fluctuate over a period of time. Manufacturing cycle, production policies, credit terms,
growth and expansion needs, and inventory turnover are some of the important factors
influencing the determination of working capital. Inflation magnifies the need for working
capital. The constant rise in the cost of inputs, if not accompanied with corresponding
increase in output prices puts an additional strain on the management. However, by taking
several measures on production front and by keeping a strict watch on managed costs and
expediting collection of credit sales, etc. the management can contain or at least minimize the
upward thrusts for additional working capital.
The management should ensure the adequacy and efficiency in the utilization of working
capital. For this purpose various ratios can be periodically computed and compared against
the norms established in this regard.
For efficient management of working capital, management of cash is as important as the
management of other items of current assets like receivables and inventories. Too little cash
may place the firm in an illiquid position, which may force the creditors and other claimants
to stop transacting with the firm. Too much cash results in funds lying idle, thereby lowering
the overall return on capital employed below the acceptable level. An adequate amount of
cash is always needed for meeting any unforeseen contingencies and also liabilities as well as
day-to-day operating expenses of the business.
The use of credit in the purchase of goods and services is so common that it is taken for
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granted. Selling goods or providing services on credit basis lead to accounts receivables.
Though a lot of discussion is going on in the Indian industry on how to cut down the
investments in inventories through concepts such as Just-in-Time (JIT), MRP, etc.,
investments in receivables have gone up and firms are demanding more credit from banks
and specialized institutions to deal with receivables. Since investment in receivables has a
cost, managing receivables assumes importance. Receivables management starts with
designing appropriate credit policy. Credit policy involves fixing credit period, discount to be
offered in the event of early payment, conditions to be fulfilled to grant credit and fixing
credit limit for different types of customers. It is essential for the operating managers to
strictly follow the credit policy in evaluating credit proposals and granting credit. To evaluate
the credit proposal, it is necessary to know the credit worthiness of the customers. Credit
worthiness is assessed by collecting information about the customers and then fitting the
values into credit evaluation models. There are number of credit evaluation models which
range from simple decision tree analysis to sophisticated multivariate statistical models. The
firm has to develop a suitable model, test the model with historical data to validate the model
and use it for credit evaluation. Models also need to be periodically updated. Once the credit
is granted, then it should be monitored for collection.
Different methodologies are available to get a macro picture on collection efficiency. Micro
analysis in the form of individual customer analysis is done wherever there is a deviation
from the expectation. It is equally important in dealing with delinquent customers. There are
several options, simple reminders to legal action, available before the credit managers in
dealing with such default accounts and appropriate method is to be selected with an objective
of benefit exceeding cost. The use of credit policy and credit analysis is not restricted to
the operational managers in dealing with day-to-day activities of the firm. In the competitive
world, credit policy and analysis provide a lot of strategic inputs.
Credit policy of an organization is in line with the desired strategy that the organization wants
to pursue to gain certain competitive advantages.
KEYWORDS
•Terms of Credit: These refer to eligibility conditions and payment details for granting credit
by the company to a customer.
•Creditworthiness: Capacity of the customer to meet payment obligations.
•Business Analysis: An examination of risk factors influencing business prospects in terms of
competition, demand and supply position, structure of industry, cost structure, labor relations,
etc.
•Financial Analysis: An examination of financial performance and ability of a business unit
to generate income.
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•Fundamental Analysis: Refers to capital adequacy asset quality, liquidity management and
interest over tax sensitivity
•Collection Period: Indicates the time taken by the collection department in collecting its
book debts. Credit limit: Is the limit up to which credit is granted
•Decision Tree: Is a model indicating decision points and chance events for taking a decision.
•Credit Scoring System: A system which attempts to rank customers as good, bad or average
by a scoring mechanism.
•Business Analysis: An examination of risk factors influencing business prospects in terms of
competition, demand and supply position, structure of industry, cost structure, labor relations,
etc.
LEARNING ACTIVITY
1. How does the decision on granting credits affect the finance of the company?
2. List some of the major items of operating expenses in your organization such as
wages and salaries of staff.
UNIT END QUESTIONS
1. Explain important components of receivables management system?
2. Explain, why do we need a credit policy? How do you evaluate credit policy?
3. Do you know, how you assess the credit worthiness of customers?
4. Explain important components of receivables management system?
Long Questions
5. Discuss, why do we need a credit policy? How do you evaluate credit policy?
6. Do you know how do you assess the credit worthiness of customers?
7. On June 30, after all, monthly postings had been completed, the Accounts Receivable
control account in the general ledger had a debit balance of $291,160; the Accounts Payable
control account had a credit balance of $78,734.
8. The July transactions recorded in the special journals are summarized below. No
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entries affecting accounts receivable and accounts payable were recorded in the general
journal for July.
1. Sales journal 2. Total sales 3. $168,420
4. Purchases 5. Total
6. $52,705
journal purchases
8. Accounts
7. Cash receipts
receivable 9. $127,330
journal
column total
11. Accounts
10. Cash payments
payable 12. $48,446
journal
column total
Required:
1. What is the balance of the Accounts Receivable control account after the monthly postings
on July 31?
2. What is the balance of the Accounts Payable control account after the monthly postings on
July 31?
3. To what account(s) is the column total of $168,420 in the sales journal posted?
4. To what account(s) is the accounts receivable column total of $127,330 in the cash receipts
journal posted?
9. Discuss a few important financial ratios and analysis used in managing receivables.

1. What are the aspects of working capital management?
a. Inventory management
b. Receivable management
c. Cash management
d. All of these
2. function includes a firm’s attempts to balance cash inflows and outflows.

a. Finance
b. Liquidity
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c. Investment
d. Dividend
3. Firms which are capital intensive rely on .

a. Equity
b. Short term debt
c. Debt
d. Retained earnings
4. Hirer is entitled to claim .

a. Depreciation
b. Salvage value
c. HP payments
d. None of above
5. Which of the following is not an advantage of trade credit?

a. Easy availability
b. Flexibility
c. Informality
d. Buyout financing
6. From the point of view of the lessee, a lease is a:

a. Working capital decision,
b. Financing decision,
c. Buy or make decision,
d. Investment decision
7. 143. For a lesser, a lease is a

a. Investment decision,
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b. Financing decision,
c. Dividend decision
d. None of these
8. 144. Which of the following is not true for a "Lease decision for the lessee?
a. Helps in project selection
b. Helps in project financing
c. Helps in project location
d. All of these
9. 145. Risk-Return trade off implies

a. Minimization of Risk,
b. Maximization of Risk,
c. Ignorance of Risk
d. Optimization of Risk
10. Basic objective of diversification is

a. Increasing Return,
b. Maximizing Return,
c. Decreasing Risk,
d. Maximizing Risk.
Answers
1. d 2. b 3. c 4. a 5. D 6.b 7.a 8.b 9.d 10.c
REFERENCES
 Van Home, James C., 2002. Financial Management and Policy, Prentice-Hall of
India: New Delhi (Part V).
 Khan M.Y., Jain P.K., 2002. Cost Accounting and Financial Management, Tata
McGraw Hill (Chapters 11-16).
 Kulkarni, P.V., Sathya Prasad B.G., 1999. Financial Management, Himalaya
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Publishing: Bombay.
 Kuchhal, S.C., 1985. Financial Management, Chaitanya Publishing: Allahabad

(Chapter 9 & 10).

Pvt. Ltd.

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UNIT 6 FINANCIAL DECISIONS- I
Structure
Learning Objectives
Introduction
Operating Leverage
Meaning
Computation of Operating Leverage
Behaviour Of Operating Leverage

Applications
Financial Leverage
Meaning
Computation of Financial Leverage
Behaviour
Applications
Composite Leverage
Combined Leverage
Ebit - Eps Analysis
Importance of Leverages
Capital Structure
Measures of Capital Structure
Designing Capital structure
Traditional Approach
Net Income (NI) Approach
Net Operating Income (NOI) Approach
Modigliani and Miller Approach
Summary
Keywords
Learning Activity
Unit End Questions
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References
LEARNING OBJECTIVES

• Explain the concepts of financial leverage, operating leverage and total leverage
• explain the computation process of leverages
• assess the behavior and applications of leverages
• analysis the relationship between EBIT and EPS
• discuss the importance of leverages
• Illustrate various practical problems of leverage
INTRODUCTION
In the arena of financing decisions, the capital structure decision assumes greater
significance. As it deals with debt equity composition of the organization, the resultant risk
and return for shareholders is of utmost concern for finance managers. If the borrowed funds
are more than owners’ funds, it results in increase in shareholders’ earnings. At the same
time, it also increases the risk of the organization. In a situation where the proportion of the
equity funds is more than the proportion of the borrowed funds, the return as well as risk of
the shareholders will be very low. This underlines the importance of having an optimal
capital structure where risk and return to shareholders be matched. The effect of capital
structure where risk and return to shareholders may judiciously help the finance managers to
decide their short term and long-term strategies. The behavior and application of leverage
help sin examining the whole issue in right perspective.
Concept and Types of Leverages
The dictionary meaning of the term leverage refers to: an increased means for
accomplishing some purpose”. It helps us in lifting heavy objects by the magnification of
force when a lever is applied to a function.
James Horne has defined “leverage as the employment of an asset or funds for which the firm
pays a fixed cost or fixed return.”
Christy and Roder defines “leverage as the tendency for profits to change at a faster rate than
sales.”
A few essential characteristics of leverage are as follows:
(a) Leverage is applied to the employment of an asset or funds.
(b) Profits tend to change at a faster rate than sales.
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(c) There is risk return relationship which is basically found in the same direction.
(d) If higher is the leverage, higher will be the risk and higher will be the expected
returns.
A brief review of various types of leverage is as follows:
Return on Investment Leverage is an index of operational efficiency. It is calculated as
follows:
EBIT
Total Assets
Asset Leverage is the part of ROI leverage. It is like assets turnover. It is calculated as
follows:
Sales
---------------
Total Assets
A firm with a relatively high turnover is said to have a high degree of asset leverage.
Operating Leverage is related to fixed cost. It indicates the impact of changes in sales on
operating income. It is calculated as follows:
Contribution
---------------
EBIT
Financial Leverage depends upon the ratio of debt and preferred stock together to common
shares. It is calculated with the help of EBIT and EBT as below:
EBIT
---------------
EBT
Combined Leverage is the multiplication of operating leverage and financial leverage.
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OPERATING LEVERAGE
It takes place when a change in revenue produces a greater change in EBIT. It is related to
fixed costs. A firm with relatively high fixed costs uses much of its marginal contribution to
cover fixed costs.
Meaning
It refers to heavy usage of fixed assets. A few definitions are as follows:

“The use of fixed operating costs to magnify a change in profits relative to a given change in
Sales”
Walker & Petty
“If a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a high
degree of operating leverage.
E F Brigham
It is a function of three factors:
 Fixed costs
 Contribution
 Volume of Sales
A few specific characteristics of operating leverage are as follows:
 It affects assets side of Balance sheet
 It is related to composition of fixed assets
 It is related in fluctuation sin business risk
 It affects capital structure and return on total assets.
COMPUTATION OFOL
The operating leverage can be calculated by the following formula
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Where contribution means sales minus variables costs EBIT means contribution minus fixed
costs.
If contribution is more than fixed cost, it is favorable financial leverage. In case of vice-versa,
it is unfavorable financial leverage.
Behaviour of Operating Leverage
The behavior of operating leverage may be measured by the degree of operating leverage.
The degree of operating leverage is the percentage change in the profits resulting from a
percentage change in the sales. It may be put in the form of the following formula:
If a firm has a high degree of operating leverage, small change in sales will have large effect
on operating income. Similarly, the operating profits of such a firm will suffer loss as
compared to decrease in its sales.
There will not be any operating leverage, if there are no fixed costs.
Applications
The operating leverage indicates the impact of change in sales on operating income. If a firm
has a high degree of operating leverage, small change in sales will have large effect on
operating income. A few areas of application are as follows:
Operating leverage has an important role in capital budgeting decisions. Infect, this concept
was originally developed for use in capital budgeting.
Longtermprofitplanningisalsopossiblebylookingatquantamoffixedcost investment and its
possible effects.
Generally, a high degree of operating leverage increases the risk of a firm. For deciding
capital structure in favor of debt, the impact of further increase in risk will influence capital
structure decision.
FINANCIAL LEVERAGE
It refers to usage of debt in capital structure. It is the use of fixed cost capital (debt) in the
total capitalization of the firm. Fixed cost capital includes loans, debentures and preferences
share capital.
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MEANING
Financial leverage is expressed as the firm’s ability to use fixed financial cost in such a
manner so as to have magnifying impact on the EPS due to any change in EBIT (Earnings
before Interest and Taxes). In other words, financial leverageisaprocessofusingdebt capital
toincreasetheirturnonequity.
According to Guthman “Financial leverage is the ability of the firm to use fixed financial
changes to magnify the effect of changes in EBIT on the firms EPS.
The following are the essentials of financial leverage:
(1) It relates to liabilities side of balance sheet
(2) It is related to capital structure
(3) It is related to financial risk
(4) It affects earning after tax and earnings per share
(5) It may be favorable or unfavorable. Unfavorable leverage occurs when the firm does
not earn as much as the funds cost.
Computation of Financial Leverage
The financial leverage can be calculated by the following formula:
Where EBIT refers to earnings before interest and tax and EBT refers to earnings before tax
but after interest
Some authorities have used the term financial leverage in the context of establishing
relationship between EBIT and EPS. The financial leverage shows the percentage change in
EPS in relation to percentage change in EBIT.
BEHAVIOUR
The behavior of financial leverage may be measured by the degree of financial leverage. The
degree of financial leverage may be in the form of the following equation:
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APPLICATIONS
Financial leverage is useful in

(i) Capital structure planning
(ii) Profit Planning
Financial leverage helps the finance managers while devising the capital structure of the
company. A high financial leverage means high fixed financial costs and high financial
risk. Increase in fixed financial costs may force the company into liquidation.
COMPOSITE LEVERAGE
Both operating and financial leverage magnify the returns. There is combined effect of these
leverages on income. Both the leverages are closely concerned with the firm's capacity to
meet its fixed costs (both operating and financial). In case both the leverages are combined,
the result obtained will disclose the effect of change in sales over change taxable profit.
COMBINED LEVERAGE
The degree of operating leverage may be combined with the degree of financial leverage. In
fact, degree of operating leverage (DOL) is viewed as the first-stage leverage and degree of
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financial leverage (DFL) as the second-stage leverage. Since financial leverage measures the
effect of changes in EBIT on earnings avail-able to equity shareholders, it may be calculated
by using the following formula
The use of this formula may be illustrated before demonstrating the implications of
combining DOL and DFL. The data of Table 13.3 for the leverage factors of 20% debt and
80% debt may be utilized to show the effect of an increase of EBIT from Rs. 25 lakhs to Rs.
50 lakhs. The following calculations may be noticed:
DFL (80%) the degree of financial leverage at 80% debt.

DFL (20%) the degree of financial leverage at 20% debt.
The Figures 2.92 and 1.14 can be easily understood. The former implies that when the debt
ratio (or the leverage factor) is 80%, a 10% increase in EBIT produces a 29.2% (10 x 2.92)
increase in net income available to equity shareholders. At a leverage factor of 20%, a 10%
increase in EBIT brings about only an 11.4% (I 0 x 1.14) increase in net income or earnings
available to equity shareholders. You may conclude that a high degree of leverage brings
about a higher magnification of equity earnings.
In the absence of debt, the degree of financial leverage (DFL) will be 1.00 (i.e. unity). The
use of debt will lead to DFL above 1.00 or 100%. The DFL may be viewed as a
multiplication factor, and when this multiplication factor is 1.00, there is no magnification in
net income or return on equity, or in earnings per share.
A combination of operating and financial leverage measures the degree of magnification in
Net Income (NI), Return on Equity (ROE), and Earnings per Share (BPS) for a given increase
in sales. When the use of operating and financial leverage is considerable, small changes in
sales will produce wide fluctuations in NI, ROE and EPS.
The Degree of Combined Leverage (DCL) may be measured by using the following formula:
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You may note that a number of combinations of DOL and DFL may produce the same DCL.
And if management has a target DCL, changes in DOL or DFL may be made to attain the
targeted DCL. For instance, if the firm has a high degree of operating leverage clue to the
nature of its operations, the degree of financial leverage may be suitably lowered so as not to
lower the targeted combined leverage and vice versa.
EBIT – EPS ANALYSIS
This is a method to study the effect of leverage. It involves the comparisons of alternative
methods of financing under various alternative financing proposals. A firm may raise funds in
either of the following alternatives:
(i) Exclusive use of equity capital
(ii) Exclusive use of debt
(iii) Various combinations of debt and equity
(iv) Various combinations of debt, equity and preferences capital
IMPORTANCE OFLEVERAGES
Leverages have the magnifying effect. Operating leverage magnifies EBIT with respect to
contribution while financial leverage magnifies EPS with respect to EBIT. Financial leverage
enhances the EPS without an additional investment. By having judicious assets mix and
financing mix, EPS may be increased. A few areas identified in this regard are as follows:
Investment in fixed assets (Operating leverage)
Capital structure planning (Financial leverage)
Profit planning (Combined leverage) Monitoring business and financial risk
Maximizing the value of share Improving EPS
Judicious mixture of operating leverage and financial leverage.
A firm with high operating leverage should not have a high financial leverage. Similarly, a
firm having low operating leverage will stand to gain by having a high financial leverage. If
both leverages are increased, the possibility of bearing more risk will increase.
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CAPITAL STRUCTURE
The capital structure is the particular combination of debt and equity used by a company to
finance its overall operations and growth. Debt comes in the form of bond issues or loans,
while equity may come in the form of common stock, preferred stock, or retained earnings.
Short-term debt is also considered to be part of the capital structure.
Both debt and equity can be found on the balance sheet. Company assets, also listed on the
balance sheet, are purchased with this debt and equity. Capital structure can be a mixture of a
company's long-term debt, short-term debt, common stock, and preferred stock. A company's
proportion of short-term debt versus long-term debt is considered when analyzing its capital
structure.
When analysts refer to capital structure, they are most likely referring to a firm's debt-to-
equity (D/E) ratio, which provides insight into how risky a company's borrowing practices
are. Usually, a company that is heavily financed by debt has a more aggressive capital
structure and therefore poses greater risk to investors. This risk, however, may be the primary
source of the firm's growth.
Debt is one of the two main ways a company can raise money in the capital markets.
Companies benefit from debt because of its tax advantages; interest payments made as a
result of borrowing funds may be tax deductible. Debt also allows a company or business to
retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant
and easy to access.
Equity allows outside investors to take partial ownership in the company. Equity is more
expensive than debt, especially when interest rates are low. However, unlike debt, equity
does not need to be paid back. This is a benefit to the company in the case of declining
earnings. On the other hand, equity represents a claim by the owner on the future earnings of
the company.
Measures of Capital Structure
Companies that use more debt than equity to finance their assets and fund operating activities
have a high leverage ratio and an aggressive capital structure. A company that pays for assets
with more equity than debt has a low leverage ratio and a conservative capital structure. That
said, a high leverage ratio and an aggressive capital structure can also lead to higher growth
rates, whereas a conservative capital structure can lead to lower growth rates.
DESIGNING CAPITAL STRUCTURE
Capital structure is the major part of the firm‘s financial decision which affects the value of
the firm and it leads to change EBIT and market value of the shares.
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Capital structure is the major part of the firm‘s financial decision which affects the value of
the firm and it leads to change EBIT and market value of the shares. There is a relations hip
among the capital structure, cost of capital and value of the firm. The aim of effective capital
structure is to maximize the value of the firm and to reduce the cost of capital.
There are two major theories explaining the relations hip between capital structure, cost of
capital and value of the fir m.
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as inter mediate approach. According to the traditional approach, mix of debt and
equity capital can increase the value of the firm by reducing overall cost of capital up to
certain level of debt. Traditional approach states that the Ko decreases only within the
responsible limit of financial leverage and when reaching the minimum level, it starts
increasing with financial leverage.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and
convenient manner:
 There are only two sources of funds used by a firm; debt and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance re ma ins constant.
 The operating profits (EBIT) are not expected to grow.
 The business risk remains constant.
 The firm has a perpetual life.
 The investors behave rationally.
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Net Income (NI) Approach
Net income approach suggested by the Durand. According to this approach, the capital
structure decision is relevant to the valuation of the firm. In other words, a change in the
capital structure leads to a corresponding change in the overall cost of capital as well as the
total value of the firm.
According to this approach, use more debt finance to reduce the overall cost of capital and
increase the value of fir m.
Net income approach is based on the following three important assumptions:
 There are no corporate taxes.
 The cost debt is less than the cost of equity.
 The use of debt does not change the risk perception of the investor.
where
V = S+B
V = Value of fir m
S = Market value of equity

B = Market value of debt
Market value of the equity can be ascertained by the following formula:
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S =NI/ Ke
where
NI = Earnings available to equity shareholder
Ke = Cost of equity/equity capitalization rate
Format for calculating value of the firm on the basis of NI approach.
Net Operating Income (NOI) Approach
Figure 6.1
Another modern theory of capital structure, suggested by Durand. This is just the opposite of
the Net Income approach. According to this approach, Capital Structure decision is irrelevant
to the valuation of the firm. The market value of the firm is not at all affected by the capital
structure changes.
According to this approach, the change in capital structure will not lead to any change in the
total value of the firm and market price of shares as well as the overall cost of capital.
NI approach is based on the following important assumptions;
 The overall cost of capital remains constant;
 There are no corporate taxes;
 The market capitalizes the value of the firm as a whole;
Value of the firm (V) can be calculated with the help of the following formula
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V = E BIT /K0
Modigliani and Miller Approach
Modigliani and Miller approach states that the financing decision of a firm does not affect the
market value of a firm in a perfect capital market. In other words MM approach maintains
that the average cost of capital does not change with change in the debt weighted equity mix
or capital structures of the fir m.
Modigliani and Miller approach is based on the following important assumptions:
• There is a perfect capital market.
• There are no retained earnings.
• There are no corporate taxes.
• The investors act rationally.
• The dividend payout ratio is 100%.
• The business consists of the same level of business risk.
SUMMARY
Leverage refers to the use of an asset or source of funds which involves fixed costs or fixed
returns. Leverages can be operating, financial and combined. Operating leverage uses fixed
operating costs to magnify the effects of changes in sales on the operating profits. Operating
leverage may be favorable or unfavorable. High operating leverage is good when sales
increase. Financial leverage affects financial risk of the firm. In financial leverage, the source
of fund which wants fixed refund so that more than proportionate change in EPS may be
reflected. Combined leverage is the multiplication of financial and operating leverage. In
order to keep the risk under control, low financial leverage be kept along with high degree of
operating leverage. EBIT – EPS analysis may help the financial managers to choose the
optimum capital structure.
KEYWORDS
• Leverage: is the employment of an asset or funds for which the firm pays a fixed cost
or fixed return.
• Operating Leverage: is the use of fixed operating costs to magnify a change in profits
relative to a given change in sales.
• Financial Leverage: is the tendency of residual income to vary disproportionately with
operating profit.
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• Combined Leverage: expresses the relationship between revenue on account of sales
and the taxable income.
• ROI Leverage: is the ratio of EBIT and total assets.
• Trading on Equity: Financial leverage is also sometimes called on trading on equity.
• EPS: Earnings per share is calculated by dividing earnings available to equity
shareholders with number of equity shares.
LEARNING ACTIVITY
1. Illustrate the concept of operating leverage.
2. State the applications of operating leverage in the changed socio-economic Indian scenario
UNIT END QUESTIONS
1. Discuss your understanding about leverage? What are the different types of leverages?
2. Explain, what is operating leverage? How is it different from financial leverage? Illustrate.
3. Discuss, what is combined leverage? Explain its significance. Illustrate EBIT – EPS
Analysis
4. State the applications of operating and financial leverage.
Long questions
5. Explain the significance of operating leverage? Discuss its effect on risk. When does
financial leverage become favorable? Discuss its impact on risk.
6. The following are the details:
A Company BCompany
Sales 10,00,000 6,00,000
Variable cost 4,00,000 2,40,000
Fixed cost 2,40,000 1,80,000
Interest 1,00,000 1,00,000
Calculate the following:
a) Degree of operating leverage and financial leverage of both the firms.
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b) Comment on the risk position.

1. Other things being constant,' if Firm A has more Operating leverage than Firm B, then a
given percentage decline in sales will cause a larger percentage decline for Firm A than for
Firm B in
a. EBIT
b. Net Income
c. Both (a) and (b)
d. Neither (a) nor (b)
2. One of the components of a firm's financial structure that is not a component of its capital
structure is:
a. debentures
b. reserves
c. convertible preference
d. shares
3. Operating leverage =
a. Contribution x Earnings before Interest and tax

b. Contribution / Earnings before interest and tax
c. Earnings before interest and tax / Contribution
d. Earnings before interest and tax + Contribution
4. - Earnings per share =

a. Number of Equity shares / (Profit after tax – Preference dividend)
b. (Profit after tax – Preference dividend) / Number of Equity shares
c. (Profit after tax + Preference dividend) / Number of Equity shares
d. Number of Equity shares / (Profit after tax + Preference dividend)
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5. Price earnings ratio =
a. Market Price per share / Earnings per share
b. Earnings per share / Market Price per share
c. Market Price per share x No. of shares) / Earnings per share
d. Market Price per share / (Earnings per share x No. of shares).
6. Scrutiny of financial transactions is called

a. Budgeting
b. Auditing
c. Programming
d. Accounting
7. The presence of fixed costs in the total cost structure of a firm results into
a. Financial Leverage
b. Operating Leverage
c. Super Leverage
d. None of these
8. A view that dividend policy of a firm has a bearing on share valuation advocated by James
E. Walter is based on which one of the following assumptions.
a. Retained earnings is only source of financing
b. Cost of capital does not remain constant

c. Return of investment function
d. All of these
9. The term "capital structure" refers to:

a. long-term debt, preferred stock, and common stock equity.
b. current assets and current liabilities.
c. total assets minus liabilities.
d. shareholders' equity.
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10. A critical assumption of the net operating income (NOI) approach to valuation is:
a. that debt and equity levels remain unchanged.
b. that dividends increase at a constant rate.
c. that ko remains constant regardless of changes in leverage.
d. that interest expense and taxes are included in the calculation.
Answers
1. c 2. d 3. b 4. c 5. A 6.b 7.b 8.a 9.a 10.c
REFERENCES
 Singh J.K. "Financial Management" Dhanpat Rai & Co. Pvt. Ltd.; Delhi - 110006
Van Horne, J.C. " Financial Management and Policy, Prentice Hall of India, New
Delhi.
 Khan, M Y & Jain P.K., "Financial Management - Text and Problems" Tata McGraw
Hill, Mumbai.
 Kulkarni, P.V. & Satya Prasad "Financial Management”, Himalaya Publishing House,
Mumbai.
 Upadhyay, K.M. " Financial Management" Kalyani Publishers, Ludhiana.

Maheshwari, S.N. "Financial Management - Principles and Practice”, Sultan Chand &
Sons, Delhi.

Pvt. Ltd.

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UNIT 7 FINANCIAL DECISIONS- II
Structure
Learning Objectives
Introduction
Long term financing
Importance of long-term finance
Objectives of Long-term Financing
Sources ofLong-Term Finance

Long Term Sources of Finance / Funds Medium Term Sources of Finance / Funds Short
Term Sources of Finance / Funds
Long-Term Sources of Finance
Short term financing
Types of Short Term Financing
Example of Short Term Finance
Advantages of Short Term Loans
Disadvantages of Short Term Loans
Capital Structure
Capital Structure Components
Capital Structure Theories
Net Income Approach
Net Operating Income Approach
Modigliani and Miller Approach (Mm Approach)
Summary
Keywords
Learning Activity
Unit end questions
Suggested Reading
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LEARNING OBJECTIVES
After studying this unit, you should be able to
• List the concepts of financing

• Explain about and difference of short term and long term financing
• State about capital structure theories and there assumptions
INTRODUCTION
Long-term finance can be defined as any financial instrument with maturity exceeding one
year (such as bank loans, bonds, leasing and other forms of debt finance), and public and
private equity instruments. Maturity refers to the length of time between origination of a
financial claim (loan, bond, or other financial instrument) and the final payment date, at
which point the remaining principal and interest are due to be paid. Equity, which has no final
repayment date of a principal, can be seen as an instrument with nonfinite maturity. The one
year cut-off maturity corresponds to the definition of fixed investment in national accounts.
The Group of 20, by comparison, uses a maturity of five years more adapted to investment
horizons in financial markets (G-20 2013). Depending on data availability and the focus, the
report uses one of these two definitions to characterize the extent of long-term finance.
Moreover, because there is no consensus on the precise definition of long-term finance,
wherever possible, rather than use a specific definition of long-term finance, the report
provides granular data showing as many maturity buckets and comparisons as possible.
LONG TERM FINANCING
The Sources of Long Term Finance are those sources from where the funds are raised for a
longer period of time, usually more than a year. Long term financing is required for
modernization, expansion, diversification and development of business operations.
Generally, the companies resort to the sources of long-term finance when they have an
inadequate cash balance and need capital to carry out its operation for a longer period of time.
Importance of long-term finance
Extending the maturity structure of finance is often considered to be at the core of sustainable
financial development. Long-term finance contributes to faster growth, greater welfare,
shared prosperity, and enduring stability in two important ways: by reducing rollover risks for
borrowers, thereby lengthening the horizon of investments and improving performance, and
by increasing the availability of long-term financial instruments, thereby allowing households
and firms to address their life-cycle challenges (Demirgüç-Kunt and Maksimovic 1998, 1999;
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Caprio and Demirgüç-Kunt 1998; de la Torre, Ize, and Schmukler, 2012).
The term of the financing reflects the risk-sharing contract between providers and users of
finance. Long-term finance shifts risk to the providers because they have to bear the
fluctuations in the probability of default and other changing conditions in financial markets,
such as interest rate risk. Often providers require a premium as part of the compensation for
the higher risk this type of financing implies. On the other hand, short-term finance shifts
risk to users as it forces them to roll over financing constantly.
The amount of long-term finance that is optimal for the economy as a whole is not clear. In
well-functioning markets, borrowers and lenders will enter short- or long-term contracts
depending on their financing needs and how they agree to share the risk involved at different
maturities. What matters for the economic efficiency of the financing arrangements is that
borrowers have access to financial instruments that allow them to match the time horizons of
their investment opportunities with the time horizons of their financing, conditional on
economic risks and volatility in the economy (for which long-term financing may provide a
partial insurance mechanism). At the same time, savers would need to be compensated for the
extra risk they might take.
Objectives of Long-term Financing
• To purchase new asset or equipment

• To finance the permanent part of the working capital
• To enhance the cash flow in the firm
• To invest in R&D operations
• To construct or build new construction projects
• To develop a new product
• To design marketing strategies or increase facilities
• To expand business operations
• The long term financing could be done internally, i.e. within the organization or
externally, i.e. from outside the organization.
SOURCES OF LONG TERM FINANCE
Sources of finance for business are equity, debt, debentures, retained earnings, term loans,
working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds
are used in different situations. They are classified based on time period, ownership and
control, and their source of generation. It is ideal to evaluate each source of capital before
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opting for it.
Sources of capital are the most explorable area especially for the entrepreneurs who are about
to start a new business. It is perhaps the toughest part of all the efforts. There are various
capital sources, we can classify on the basis of different parameters.
Having known that there are many alternatives to finance or capital, a company can choose
from. Choosing the right source and the right mix of finance is a key challenge for every
finance manager. The process of selecting the right source of finance involves in-depth
analysis of each and every source of fund. For analyzing and comparing the sources, it needs
the understanding of all the characteristics of the financing sources. There are many
characteristics on the basis of which sources of finance are classified.
On the basis of a time period, sources are classified as long-term, medium term, and short
term. Ownership and control classify sources of finance into owned and borrowed capital.
Internal sources and external sources are the two sources of generation of capital. All the
sources have different characteristics to suit different types of requirements. Let’s understand
them in a little depth.
Figure 7.1
According to Time Period
Sources of financing a business are classified based on the time period for which the money
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is required. The time period is commonly classified into the following three:
Long-term financing means capital requirements for a period of more than 5 years to 10, 15,
20 years or maybe more depending on other factors. Capital expenditures in fixed assets like
plant and machinery, land and building, etc. of business are funded using long-term sources
of finance. Part of working capital which permanently stays with the business is also financed
with long-term sources of funds. Long-term financing sources can be in the form of any of
them:
Sources of finance for business are equity, debt, debentures, retained earnings, term loans,
working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds
are used in different situations. They are classified based on time period, ownership and
control, and their source of generation. It is ideal to evaluate each source of capital before
opting for it.
Sources of capital are the most explorable area especially for the entrepreneurs who are about
to start a new business. It is perhaps the toughest part of all the efforts. There are various
capital sources, we can classify on the basis of different parameters.
Having known that there are many alternatives to finance or capital, a company can choose
from. Choosing the right source and the right mix of finance is a key challenge for every
finance manager. The process of selecting the right source of finance involves in-depth
analysis of each and every source of fund. For analyzing and comparing the sources, it needs
the understanding of all the characteristics of the financing sources. There are many
characteristics on the basis of which sources of finance are classified.
On the basis of a time period, sources are classified as long-term, medium term, and short
term. Ownership and control classify sources of finance into owned and borrowed capital.
Internal sources and external sources are the two sources of generation of capital. All the
sources have different characteristics to suit different types of requirements. Let’s understand
them in a little depth.
LONG TERM SOURCES OF FINANCE / FUNDS MEDIUM TERM

SOURCES OF FINANCE / FUNDS SHORT TERM SOURCES OF
FINANCE / FUNDS
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LONG-TERM SOURCES OF FINANCE
Long-term financing means capital requirements for a period of more than 5 years to 10, 15,
20 years or maybe more depending on other factors. Capital expenditures in fixed assets like
plant and machinery, land and building, etc. of business are funded using long-term sources
of finance. Part of working capital which permanently stays with the business is also financed
with long-term sources of funds. Long-term financing sources can be in the form of any of
them:
• Share Capital or Equity Shares
• Preference Capital or Preference Shares
• Retained Earnings or Internal Accruals
• Debenture / Bonds
• Term Loans from Financial Institutes, Government, and Commercial Banks
• Venture Funding
• Asset Securitization
• International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR, etc.
Medium Term Sources of Finance
Medium term financing means financing for a period of 3 to 5 years and is used generally for
two reasons. One, when long-term capital is not available for the time being and second when
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deferred revenue expenditures like advertisements are made which are to be written off over a
period of 3 to 5 years. Medium term financing sources can in the form of one of them:
Preference Capital or Preference Shares
Debenture / Bonds
Medium Term Loans from
Financial Institutes
Government, and
Commercial Banks
Lease Finance
Hire Purchase Finance
Short Term Sources of Finance

Short term financing means financing for a period of less than 1 year. The need for short-term
finance arises to finance the current assets of a business like an inventory of raw material and
finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also
named as working capital financing. Short term finances are available in the form of:
Trade Credit
Short Term Loans like Working Capital Loans from Commercial Banks
Fixed Deposits for a period of 1 year or less
Advances received from customers
Creditors
Payables
Factoring Services
Bill Discounting etc.
(1) Equity-Shares:
Equity Shares, also known as ordinary shares, represent the ownership capital in a company.
The holders of these shares are the legal owners of the company. They have unrestricted
claim on income and assets of the company and possess all the voting power in the company.
In fact, the foremost objective of a company is to maximize the value of its equity shares.
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Being the owners of the company, they bear the risk of ownership also. They are entitled to
dividends after paying the preference dividends. The rate of dividend on these shares is not
fixed and depends upon the availability of divisible profits and the intention of the directors.
They may be paid a higher rate of dividend in times of prosperity and also run the risk of no
dividends in the period of adversity. Similarly, when the company is wound up, they can
exercise their claim on those assets which are left after the payment of all other claims
including that of preference shareholders.
Advantages of Equity / Ordinary Shares:

(A) Advantages to the Company:
Equity shares offer the following advantages to the company:
(i) Permanent Source of Funds – Equity capital is a permanent capital, and is available for use
as long as the company continues. The management is free to utilize such capital and is not
bound to refund it.
(ii) Increase in the Borrowing Capacity – The equity capital increases the company’s
shareholder’s funds. Lenders normally lend in proportion to the amount of shareholder’s
funds. Higher amount of shareholder’s funds provides higher safety to the lenders.
(iii) Not Bound to Pay Dividend – A company is not legally bound to pay dividend to its
equity shareholders. The payment of dividend depends on the availability of divisible profits
and the discretion of directors. A company can reinvest whole of its income, if it so desires.
(iv) No Need to Mortgage the Assets – The company need not mortgage its assets to secure
equity capital. Hence, if the company desires to raise further finance from other sources, it
can easily do so by mortgaging its assets.
(B) Advantages to Investors:

(i) Right to Control – Equity shareholders are the real owners of the company. They have the
right to elect the directors as well as vote in the meetings of the company.
(ii) Increase in Rate of Dividends – In case of higher profits in the company, these
shareholders are handsomely rewarded in the form of higher dividends.
(iii) Increase in Market Value – Usually a portion of the profits is ploughed back into the
business which results in enhanced earning power of the company and increase in the market
value of its shares.
(iv) Bonus Shares – Equity shareholders have a claim on the residual income of the company.
This residual income is either directly distributed to them in the form of dividend or
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indirectly in the form of bonus shares.
(v) Right Shares – Equity shareholders are entitled to get right shares whenever the company
issues new shares. The subscription price at which the right shares are offered to them is
generally much below the share’s current market price.
(vi) Easy to Sell – In comparison to investment in fixed properties, the investment in equity
shares is much liquid because the shares can be sold in the market whenever needed.
Disadvantages of Equity Shares:
(A) Disadvantages to the Company:

(i) High Cost of Funds – Equity shares have a higher cost for two reasons. Firstly, as
compared to interest, dividends cannot be deducted from the income of the company while
calculating taxes. Dividends are paid out of post-tax profits. Secondly, equity shares have
high floatation cost in terms of underwriting, brokerage and other issue expenses in
comparison to other securities.
(ii) No Advantage of Trading on Equity – If a Company issues only equity shares, it will be
deprived of the benefits of trading on equity. For availing the benefit of trading on equity, it
is essential to issue debentures or preference shares with fixed yields lower than the earning
rate of the company.
(iii) Manipulation by a Group of Shareholders – Shares of a company can be purchased and
sold in the stock market. Hence, a group of shareholders may control the company by
purchasing shares and they may use such control for their personal advantage at the cost of
company’s interests.
(B) Disadvantages to Investors:

(i) Irregular Dividend – Dividend paid on equity shares is neither regular nor at a fixed rate.
In case of lower profits, the company can reduce or suspend payment of dividend. In case of
higher profits too, the company is not legally bound to distribute dividends. Entire profits
may be ploughed back for expansion and development of the company.
(ii) Fall in the Market Value of Shares – If the company does not earn sufficient profits, the
shareholders have to bear the loss because of fall in the market value of shares.
(iii) No Real Control over the Company – There are a number of shareholders and most of
them are scattered and unorganized. Hence they are unable to exercise effective and real
control over the company.
(iv) Ownership Dilution – If the new shares are issued to the public, it may dilute the
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ownership and control of the existing shareholders. The control of the company may change
to new shareholders who may reap the benefits of the company’s prosperity and progress.
(v) Loss on Liquidation – In case of liquidation, equity shareholders have to bear the
maximum risk. Out of the realized value of assets, first the claims of creditors and then
preference shareholders are satisfied, and the remaining balance, if any, is paid to equity
shareholders. In most of the cases, equity shareholders do not get anything in case of
liquidation.
To conclude, equity shares are the most convenient and popular source of long-term finance
for a company. For new company recourse to equity share financing is most desirable
because the management is under no legal obligation to pay dividends to shareholders and the
management can retain its earnings entirely for their investment in the enterprise.
However, for obtaining further finance in case of any existing company, the management
should, as far as possible, avoid issuing equity shares. From investor’s point of view, equity
shares are riskier as there is uncertainty regarding dividend and capital gains. Investors who
desire to invest in safe securities with a regular and fixed income have no attraction for such
shares. On the contrary, the investors who are more ambitious and ready to bear risk in
consideration of higher returns prefer these shares.
(2) Preference Shares:

Preference share capital is another source of long-term financing for a company. As the name
suggests, these shares carry preferential rights over equity shares both regarding the payment
of dividend and the return of capital. These shares carry a fixed rate of dividend and such
dividend must be paid in full before the payment of any dividend on equity shares. Similarly,
at the time of liquidation, the whole of preference capital must be paid before any payment is
made to equity shareholders.
(3) Ploughing Back of Profits:

A new company can raise finance only from external sources such as shares, debentures,
loans etc. But, an existing company can also generate finance through its internal sources,
i.e., retained earnings or ploughing back of profits. When a company does not distribute
whole of its profits as dividend but reinvests a part of it in the business, it is known as
ploughing back of profits or retention of earnings. This method of financing is also known as
self-financing or internal financing.
Ploughing back of profits is made by transferring a part of after-tax profits to various reserves
such as General Reserve, Reserve Fund, Replacement Fund, Dividend Equalization Fund etc.
Such retained earnings may be utilized to fulfil the long-term, medium-term and short-term
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financial requirements of the firm.
Advantages:
(i) Economical Method – It is very economical method of financing.
(ii) A Cushion to Absorb the Shocks of the Business – A concern with large reserves can
easily absorb the shocks of trade cycles and the uncertainty of market.
(iii) Helpful in Following a Balanced Dividend Policy – Such a company can follow the
policy of paying regular and balanced dividends because it can use retained earnings for
paying dividends in the years when there are inadequate profits.
(iv) Helpful in Making the Company Self-Dependent – Ploughing back of profits makes the
company self-dependent because it has not to depend upon outsiders such as banks, financial
institutions, debentures etc.
(v) Increase in the Credit Worthiness of the Company – Since the company need not depend
upon outside sources for its financial needs; it increases the credit worthiness of the company.
(vi) Helpful in the Repayment of Long-Term Liabilities – It enables the company to repay its
long-term loans and debentures and thus relieves the company from the burden of fixed
interest payments.
(B) Disadvantages or Dangers of Excessive Ploughing Back:

(i) Misuse of Retained Earnings – It is not necessary that the management may always use the
retained earnings to the advantage of shareholders. They may invest the funds in unprofitable
areas or may invest in other concerns under the same management, bringing little gain to the
shareholders.
(ii) Over-Capitalization – Retained earnings are used for the issue of bonus shares which may
result to over-capitalization without any corresponding increase in its earnings.
(iii) Creation of Monopolies – Continuous ploughing back of profits over a long time may
lead a company to grow into a monopoly. This is more likely to occur when other companies
find it difficult to procure finance from the market whereas an existing concern continues to
grow through its retained earnings.
(iv) Manipulation in the Value of Shares – Ploughing back of profits provides the
management an opportunity to manipulate the market value of its shares. In the name of
ploughing back of profits, they may declare lower dividends and when the share values fall in
the market, they may purchase them at reduced prices. Later, they may increase the rate of
dividend out of past profits and may sell their shares at a profit.
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(v) Dissatisfaction among the Shareholders – Excessive ploughing back of profits may create
dissatisfaction among the shareholders since the rate of dividend is quite low in relation to the
earnings of the company.
(vi) Hindrance in the Free Flow of Capital – According to Prof. Pigou,” Excessive ploughing
back entails social waste, because money is not made available to those who can use it to the
best advantage of the community, but is retained by those who have earned it.”
Despite the above disadvantages, the ploughing back of profits is a popular source of long-
term finance and is widely used by most of the companies.
(4) Debentures:
Debentures are one of the frequently used methods by which a company raises long-term
funds. Funds acquired by issue of debentures represent loans taken by the company and are
also known as ‘debt capital’. A debenture is a certificate issued by a company under its seal
acknowledging a debt due by it to its holders. In USA there is a distinction between
debentures and bonds. There, the term bond refers to an instrument which is secured on the
assets of the company whereas the debentures refer to unsecured instruments.
But, in India no such distinction is made between bonds and debentures and the two terms are
used as synonymous. According to Section 2 (30) of the Companies Act, 2013, “the term
debenture includes debenture stock, bonds and any other securities of a company whether
constituting a charge on the assets of the company or not.”
(5) Loans from Financial Institutions:
Financial Institutions are another important source of long-term finance. In India, a number
of special financial institutions have been established by the Government at the national level
and state level to provide medium-term and long-term loans to the industrial undertakings.
Financial institutions established at the national level include Industrial Development Bank of
India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment
Corporation of India (ICICI), Industrial Reconstruction Corporation of India (IRCI), Unit
Trust of India (UTI), Life Insurance Corporation of India (LIC), General Insurance
Corporation (GIC) etc.
Financial institutions established at the state level include State Financial Corporations
(SFCs) and State Industrial Development Corporations (SIDCs). For example, In Haryana,
Haryana State Financial Corporation (HFC) and Haryana State Industrial Development
Corporation (HSIDC) have been established.
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Characteristics of Loans from Financial Institutions:
(i) Maturity – Maturity period of term loans provided by Financial Institutions ranges
between 6 to 10 years.
(ii) Direct Negotiation – Terms and conditions of such loans are directly negotiated between
the borrower and the financial institution providing the loan.
(iii) Security – Such loans are always secured. While the assets financed by loans serve as
primary security, all the present as well as the future immovable assets of the borrower
constitute secondary security.
(iv) Restrictive Covenants – To protect their interests the financial institutions impose a
number of restrictive terms and conditions. These are called covenants. These covenants may
be in respect of maintaining a minimum current ratio, not to create further charge on assets,
not to sell fixed assets without the lender’s approval, restrain on taking additional loan,
reduction in debt-equity ratio by issuing additional shares etc.
Financial Institutions may also restrict the payment of dividend, salaries and perks of
managerial staff. Covenants may also include the appointment of nominee director by
financial institutions to safeguard their interests.
(v) Convertibility – Financial institutions usually insist on the option of converting their loans
into equity shares of the company,
(vi) Repayment Schedule – Such loans have to be repaid according to predetermined
schedule. The common practice in India is the repayment of principal in equal instalments
and payment of interest on the outstanding loan.
Advantages and Disadvantages of Loans from Financial Institutions:

Such loans offer all the advantages and disadvantages of debenture financing. An additional
disadvantage from borrower’s viewpoint is that the loan contracts contain certain restrictive
covenants which restrict the managerial freedom. The right of lenders to appoint nominee
directors on the board of the borrowing company may further restrict the managerial freedom.
(6) Lease Financing:
Lease is a contract between the owner of an asset and the user of such asset. Owner of the
asset is called ‘Lessor’ and the user is called ‘Lessee’. Under the lease contract, the owner of
the asset surrenders the right to use the asset to another party for an agreed period of time for
an agreed consideration called the lease rental. The lessee pays a fixed rental to the lessor at
the beginning or at the end of a month, quarter, half year, or year. At the end of the period of
lease contract, the asset reverts back to the lessor, who is the legal owner of the asset.
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As the legal owner, it is the lessor (and not the lessee), who will be entitled to claim
depreciation on the leased asset. At the end of lease period, the lessee is usually given an
option to buy or further renew the lease contract for a definite period.
Leasing is, thus, a device of long term source of finance. Lessee gets the right to use the asset
without buying them. His position is akin to that of a person who uses the asset with
borrowed money. The real position of lessor is not renting of asset but lending of finance and
hence lease financing is, in effect, a contract of lending money. The lessee is free to choose
the asset according to his requirements and the lessor is actually the financier.
Advantages of Leasing:
(A) Advantages to the Lessee:

(i) Additional Source of Finance – Leasing facilitates the use of assets without making any
immediate payment. Thus the scarce financial resources of the business may be preserved for
other purposes.
(ii) Simplicity – Borrowing from banks and financial institutions involve time consuming and
complicated procedures whereas a leasing contract is simple to negotiate and free from
cumbersome procedures.
(iii) Free from Restrictive Covenants – Lease financing is free from restrictive covenants
whereas the financial institutions often put a number of restrictions on borrowers, such as,
conversion of loan into equity, appoint nominee directors, restrictions on payment of
dividend, and so on.
(iv) Flexibility in Fixing the Rentals – Lease rentals are fixed in such a way that the lessee is
able to pay them from the cash flows generated from his business operations. Thus flexibility
is not available in case of loans from financial institutions where the loans are repaid in
instalments resulting in heavy burden in the earlier years of a project, whereas the project
may actually generate substantial cash flows in later years.
(v) Safety from the Risk of Obsolescence – In a lease contract, the lessor being the owner of
the leased asset bears the risk of obsolescence. Lessee is free to cancel the lease in case of
change of technology.
(vi) Benefit of Maintenance – Lessee gets the benefit of maintenance and specialized services
provided by the lessor. For example, computer manufacturers who lease out computers
provide such services.
(vii) No Effect on Debt-Equity Ratio – Lease is considered a ‘hidden form of debt’ because
neither the leased asset nor the lease liability is depicted on the balance sheet. Lease
financing, therefore, does not affect the debt raising capacity of the enterprise.
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(viii) Tax Benefits – Lease rentals can be adjusted in such a way that the lessee can reduce his
tax liability.
(B) Advantages to the Lessor:
(i) Fully Secured – The lessor’s interests are fully secured because he is the owner of the
leased asset and can take possession of the asset in case the lessee defaults.
(ii) Tax Benefits – The lessor is entitled to claim the depreciation of leased asset and thus
reduces his tax liability.
(iii) High Profitability – Leasing business is highly profitable to the lessor because the rate of
return is more than what the lessor pays on his borrowings.
Limitations of Leasing:
(i) Costly Source of Finance – Lease financing is a costly source of finance for the lessee
because lease rentals include a profit margin for the lessor as also the cost of risk of
obsolescence.
(ii) Restrictions on the Use of Asset – Leasing contracts usually impose certain restrictions on
the use of the asset or require compulsory insurance, and so on. In addition, the lessee is not
free to make alterations to the leased asset.
(iii) Consequences of Default – Since the lessee is not the owner of the leased asset, the lessor
may take over the possession of the same, in case of default in payment of lease rentals,
(iv) Excessive Penalties – Sometimes, lessee has to pay excessive penalties if he terminates
the lease before the expiry of lease period,
(v) Not Entitled to Tax-Benefits – Lessee is not entitled to certain tax benefits like
depreciation and investment allowance because he is not the owner of the asset.
SHORT TERM FINANCING
Short term financing means the financing of business from short term sources which are for a
period of less than one year and the same helps the company in generating cash for working
of the business and for operating expenses which is usually for a smaller amount and it
involves generating cash by online loans, lines of credit, invoice financing.
It is also referred to as working capital financing and is used for inventory, receivables, etc.
In most cases, this type of financing is required in the business process because of their
uneven cash flow into the business or due to their seasonal business cycle.
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TYPES OF SHORT TERM FINANCING
Below are the types of Short Term Financing
Trade Credit
This is the floating time allowed the business to pay for the goods or services which they
have purchased or received. The general floating time allowed to pay is 28 days. This helps
the businesses in managing their cash flows more efficiently and help in dealing with their
finances. Trade credit is a good way of financing the inventories which means how many
numbers of days the vendor will be allowed before its payment is due. The trade-credit is
offered by the vendor as an inducement in continuing business and that is why it costs
nothing.
Working Capital Loans

Banks or other financial institutions extend loans for a shorter period after studying the
business nature, its working capital cycle, past records, etc. Once the loan is sanctioned and
disbursed by the bank or other financial institutions it can be repaid in small installments or
can be paid in full at the end of loan tenure depending on the agreed terms of loans between
both the parties. It is often advised to finance the permanent working capital needs through
these loans
Invoice Discounting
It refers to arranging the funds against the submission of invoices whose payments are to be
received in the near future. The receivables invoices are discounted with the banks, financial
institutions or any third party. On submission of bills, they will pay the discounted value of
bills and on the due date, they on the business behalf will collect the payment.
Factoring
It is a similar arrangement of finance like invoice discounting. It is debtor finance in which
business sells their accounts receivable to a third party whom we call factor at a rate which is
lower than the net realizable value. It can be of any type with recourse or without recourse
unlike invoice discounting which can only be with recourse.
Business Line of Credit

It is the best way of financing working capital needs. The business can approach the bank for
approval of a certain amount based on their credit line structure judged through a credit score,
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a model of business, projected inflows. The business can withdraw the amount as and when
needed subject to the maximum approved amount. They can again deposit the amount as and
when it gets available. Moreover, the best thing is that interest is charged on the utilized
amount on daily reducing balance method. In this manner, it becomes a very cost-efficient
mode of financing.
Example of Short Term Finance
Marry took a loan of $10,000 for a period of 6 months at the 5% APR. Since the loan is for
the shorter period i.e. the period of less than one year, it will be treated as the short term
finance. After the 6 months marry has to repay the loan amount along with the interest due.
Advantages of Short Term Loans
Less interest: As these are to be paid off in a very short period within about a year, the total
amount of interest cost under it will be least as compared to long term loans which take many
years to be paid off. The long term loan total interest cost might be more than the principal
amount.
Disbursed Quickly: As the risk involved in defaulting of the loan payment is lesser than that
of the long-term loan as they are having a long maturity date. Because of this, it takes lesser
time to get sanctioned the short term loan as their maturity date will be shorter. Thus one can
get the loan sanctioned and fund disbursed very quickly.
Less Documentation: As it is less risky, the documents required for the same will also be not
too much making it an option for all to approach for short term loans.
Disadvantages of Short Term Loans
The main disadvantage of the short term finance is that one can get a smaller amount of loan
only and that too with shorter maturity date so that the borrower won’t get burdened with
bigger installments. It is fixed that the period of loan will be less than 1 year and if a high
amount of loan is sanctioned, the monthly installment will come very high resulting in an
increase in the chance of default in repayment of loan which will affect the credit score
adversely.
It can leave the borrower with no other option than to come into the trap of the cycle of
borrowing in which one continues borrowing to repay the previous unpaid loan. In this cycle,
the interest rate keeps on increasing and can terribly affect the business and its liquidity.
CAPITAL STRUCTURE
Capital Structure means a combination of all long-term sources of finance. It includes Equity
Share Capital, Reserves and Surplus, Preference Share capital, Loan, Debentures and other
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such long-term sources of finance. A company has to decide the proportion in which it should
have its own finance and outsider’s finance particularly debt finance. Based on the proportion
of finance, WACC and Value of a firm are affected. There are four capital structure theories
for this, viz. net income, net operating income, traditional and M&M approach.
Capital structure is the proportion of all types of capital viz. equity, debt, preference etc. It is
synonymously used as financial leverage or financing mix. Capital structure is also referred
to as the degree of debts in the financing or capital of a business firm.
Financial leverage is the extent to which a business firm employs borrowed money or debts.
In financial management, it is a significant term and it is a very important decision in
business. In the capital structure of a company, broadly, there are mainly two types of capital
i.e. Equity and Debt. Out of the two, debt is a cheaper source of finance because the rate of
interest will be less than the cost of equity and the interest payments are a tax-deductible
expense.
Capital Structure Components
Components of Capital Structure
The capital structure of the company is nothing but taking decision-related to the acquisition
of funds from various sources and composition of debts and equity.
Followings are the multiple sources of funds which the company takes into consideration
while determining its capital structure:
Figure 7.2
Shareholder’s Funds
The owner’s funds refer to generating capital by issuing new shares or utilizing the retained
earnings to meet up the company’s financial requirement. However, it is an expensive means
of acquiring funds. The three sources of capital acquisition through shareholder’s funds are as
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follows:
• Equity Capital: The new shares are issued to the equity shareholders who enjoy the
ownership of the company are liable to get dividends in proportion to the profits earned by
the company. They are also exposed to the risk of loss associated with the company.
• Preference Capital: The preference shareholders enjoy a fixed rate of dividends along
with preferential rights of receiving the return on capital in case of the company’s liquidation,
over the equity shareholders. However, they have limited rights of voting and control over the
company.
• Retained Earnings: The company sometimes utilize the funds available with it as retained
earnings accumulated by keeping aside some part of the profit for business growth and
expansion.
Borrowed Funds
The capital which is acquired in the form of loans from the external sources is known as
borrowed funds. These are external liabilities of the firm, which leads to the payment of
interests at a fixed rate. However, there is a tax deduction on such borrowings; it creates a
burden on the company. Following are the various types of borrowed funds:
• Debentures: It is a debt instrument which the companies and the government issue to the
public. Though the rate of interest is quite high on debentures, they are not by any collateral
or security.
• Term Loans: The fund acquired by the company from the bank at a floating or fixed rate
of interest is known as a term loan. This is an appropriate source of fund for the companies
which have a good and strong financial position.
• Public Deposits: The management invite public through advertisements to create deposits
in the company. It facilitates meeting up the medium- or long-term financial needs of the
company, such as working capital requirements and enjoy a fixed rate of interest on it.
CAPITAL STRUCTURE THEORIES
Capital structure or financial leverage deals with a very important financial management
question. The question is – ‘what should be the ratio of debt and equity?’ Before scratching
our minds to find the answer to this question, we should know the objective of doing all this.
In the financial management context, the objective of any financial decision is to maximize
the shareholder’s wealth or increase the value of the firm. The other question which hits the
mind in the first place is whether a change in the financing mix would have any impact on the
value of the firm or not. The question is a valid question as there are some theories which
believe that financial mix has an impact on the value and others believe it has no connection.
One thing is sure that wherever and whatever way one sources the finance from, it cannot
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change the operating income levels. Financial leverage can, at the max, have an impact on the
net income or the EPS (Earning per Share). The reason we are discussing later. Changing the
financing mix means changing the level of debts. This change in levels of debt can impact the
interest payable by that firm. The decrease in interest would increase the net income and
thereby the EPS and it is a general belief that the increase in EPS leads to an increase in the
value of the firm.
Apparently, under this view, financial leverage is a useful tool to increase value but, at the
same time, nothing comes without a cost. Financial leverage increases the risk of bankruptcy.
It is because higher the level of debt, higher would be the fixed obligation to honor the
interest payments to the debt’s providers.
Discussion of financial leverage has an obvious objective of finding an optimum capital
structure leading to maximization of the value of the firm. If the cost of capital is high
important theories or approaches to financial leverage or capital structure or financing mix
are as follows:
Discussion of financial leverage has an obvious objective of finding an optimum capital
structure leading to maximization of the value of the firm. If the cost of capital is high
important theories or approaches to financial leverage or capital structure or financing mix
are as follows:
Net Income Approach
This approach was suggested by Durand and he was in favor of financial leverage decision.
According to him, a change in financial leverage would lead to a change in the cost of capital.
In short, if the ratio of debt in the capital structure increases, the weighted average cost of
capital decreases and hence the value of the firm increases.
According to NI approach a firm may increase the total value of the firm by lowering its cost
of capital.
When cost of capital is lowest and the value of the firm is greatest, we call it the optimum
capital structure for the firm and, at this point, the market price per share is maximized.
The same is possible continuously by lowering its cost of capital by the use of debt capital. In
other words, using more debt capital with a corresponding reduction in cost of capital, the
value of the firm will increase.
The same is possible only when:
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(i) Cost of Debt (Kd) is less than Cost of Equity (Ke);
(ii) There are no taxes; and
(iii) The use of debt does not change the risk perception of the investors since the degree of
leverage is increased to that extent.
Since the amount of debt in the capital structure increases, weighted average cost of capital
decreases which leads to increase the total value of the firm. So, the increased amount of debt
with constant amount of cost of equity and cost of debt will highlight the earnings of the
shareholders.
Illustration 1:
X Ltd. presents the following particulars:

EBIT (i.e., Net Operating income) is Rs. 30,000;
The equity capitalization ratio (i.e., cost of equity) is 15% (Ke);
Cost of debt is 10% (Kd);
Total Capital amounted to Rs. 2,00,000. Calculate the cost of capital and the value of the firm
for each of the following alternative leverage after applying the NI approach.
Leverage (Debt to total Capital) 0%, 20%, 50%, 70% and 100%.
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From the above table it is quite clear that the value of the firm (V) will be increased if there is
a proportionate increase in debt capital but there will be a reduction in overall cost of capital.
So, Cost of Capital is increased and the value of the firm is maximum if a firm uses 100%
debt capital.
It is interesting to note the NI approach can also be graphically presented as under (with the
help of the above illustration):
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Figure 7.3
Behavior of Ke, Kw and Kd as per Net Income Approach
The degree of leverage is plotted along the X-axis whereas Ke, Kw and Kd are on the Y-axis.
It reveals that when the cheaper debt capital in the capital structure is proportionately
increased, the weighted average cost of capital, Kw, decreases and consequently the cost of
debt is Kd.
Thus, it is needless to say that the optimal capital structure is the minimum cost of capital if
financial leverage is one; in other words, the maximum application of debt capital.
The value of the firm (V) will also be the maximum at this point.
Net Operating Income Approach
This approach is also provided by Durand. It is opposite of the Net Income Approach if there
are no taxes. This approach says that the weighted average cost of capital remains constant. It
believes in the fact that the market analyses a firm as a whole and discounts at a particular
rate which has no relation to debt-equity ratio. If tax information is given, it recommends that
with an increase in debt financing WACC reduces and value of the firm will start increasing.
For more – Net Operating Income Approach.
Now we want to highlight the Net Operating Income (NOI) Approach which was advocated
by David Durand based on certain assumptions.
They are:
(i) The overall capitalization rate of the firm Kw is constant for all degree of leverages;
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(ii) Net operating income is capitalized at an overall capitalization rate in order to have the
total market value of the firm.
Thus, the value of the firm, V, is ascertained at overall cost of capital (Kw):
V = EBIT/Kw (since both are constant and independent of leverage)
(iii) The market value of the debt is then subtracted from the total market value in order to get
the market value of equity.
S–V–T
(iv) As the Cost of Debt is constant, the cost of equity will be
Ke = EBIT – I/S
The NOI Approach can be illustrated with the help of the following diagram:
Behavior of Ke, Kw and Kd Net Operating Income Approach
Under this approach, the most significant assumption is that the Kw is constant irrespective
of the degree of leverage. The segregation of debt and equity is not important here and the
market capitalizes the value of the firm as a whole.
Thus, an increase in the use of apparently cheaper debt funds is offset exactly by the
corresponding increase in the equity- capitalization rate. So, the weighted average Cost of
Capital Kw and Kd remain unchanged for all degrees of leverage. Needless to mention here
that, as the firm increases its degree of leverage, it becomes more risky proposition and
investors are to make some sacrifice by having a low P/E ratio.
Illustration 2:
Assume:
Net Operating Income or EBIT Rs. 30,000
Total Value of Capital Structure Rs. 2,00,000.
Cost of Debt Capital Kd 10%
Average Cost of Capital Kw 12%
Calculate Cost of Equity, Ke: value of the firm V applying NOI approach under each of the
following alternative leverages:
Leverage (debt to total capital) 0%, 20%, 50%, 70%, and 100%
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Although the value of the firm, Rs. 2,50,000 is constant at all levels, the cost of equity is
increased with the corresponding increase in leverage. Thus, if the cheaper debt capital is
used, that will be offset by the increase in the total cost of equity Ke, and, as such, both Ke
and Kd remain unchanged for all degrees of leverage, i.e. if cheaper debt capital is
propor•tionately increased and used, the same will offset the increase of cost of equity.
This approach does not define hard and fast facts. It says that the cost of capital is a function
of the capital structure. The special thing about this approach is that it believes an optimal
capital structure. Optimal capital structure implies that at a particular ratio of debt and equity,
the cost of capital is minimum and value of the firm is maximum. For more – Traditional
Approach.
It is accepted by all that the judicious use of debt will increase the value of the firm and
reduce the cost of capital. So, the optimum capital structure is the point at which the value of
the firm is highest and the cost of capital is at its lowest point. Practically, this approach
encompasses all the ground between the Net Income Approach and the Net Operating Income
Approach, i.e., it may be called Intermediate Approach.
The traditional approach explains that up to a certain point, debt-equity mix will cause the
market value of the firm to rise and the cost of capital to decline. But after attaining the
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optimum level, any additional debt will cause to decrease the market value and to increase the
cost of capital.
In other words, after attaining the optimum level, any additional debt taken will offset the use
of cheaper debt capital since the average cost of capital will increase along with a
corresponding increase in the average cost of debt capital.
Thus, the basic proposition of this approach is:

(a) The cost of debt capital, Kd, remains constant more or less up to a certain level and
thereafter rises.
(b) The cost of equity capital Ke, remains constant more or less or rises gradually up to a
certain level and thereafter increases rapidly.
(c) The average cost of capital, Kw, decreases up to a certain level remains unchanged more
or less and thereafter rises after attaining a certain level.
The traditional approach can graphically be represented under taking the data from the
previous illustration:
It is found from the above that the average cost curve is U-shaped. That is, at this stage the
cost of capital would be minimum which is expressed by the letter ‘A’ in the graph. If we
draw a perpendicular to the X-axis, the same will indicate the optimum capital structure for
the firm.
Thus, the traditional position implies that the cost of capital is not independent of the capital
structure of the firm and that there is an optimal capital structure. At that optimal structure,
the marginal real cost of debt (explicit and implicit) is the same as the marginal real cost of
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equity in equilibrium.
For degree of leverage before that point, the marginal real cost of debt is less than that of
equity beyond that point the marginal real cost of debt exceeds that of equity.
Illustration 3:
Calculate the cost of capital and the value of the firm under each of the following alternative
degrees of leverage and comment on them:
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Thus, from the above table, it becomes quite clear the cost of capital is lowest (at 25%) and
the value of the firm is the highest (at Rs. 2,33,333) when debt-equity mix is (1,00,000:
1,00,000 or 1: 1). Hence, optimum capital structure in this case is considered as Equity
Capital (Rs. 1,00,000) and Debt Capital (Rs. 1,00,000) which bring the lowest overall cost of
capital followed by the highest value of the firm.
Variations on the Traditional Theory:

This theory underlines between the Net Income Approach and the Net Operating Income
Approach. Thus, there are some distinct variations in this theory. Some followers of the
traditional school of thought suggest that Ke does not practically rise till some critical
conditions arise. Only after attaining that level the investors apprehend the increasing
financial risk and penalize the market price of the shares. This variation expresses that a firm
can have lower cost of capital with the initial use of leverage significantly.
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This variation in Traditional Approach is depicted as:
Figure 7.4
Other followers e.g., Solomon, are of opinion the Ke is being saucer-shaped along with a
horizontal middle range. It explains that optimum capital structure has a range where the cost
of capital is rather minimized and where the total value of the firm is maximized. Under the
circumstances a change in leverage has, practically, no effect on the total firm’s value. So,
this approach grants some sort of variation in the optimal capital structure for various firms
under debt-equity mix.
Such variation can be depicted in the form of graphical representation:
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Modigliani and Miller Approach (Mm Approach)
It is a capital structure theory named after Franco Modigliani and Merton Miller. MM theory
proposed two propositions.
Proposition I: It says that the capital structure is irrelevant to the value of a firm. The value of
two identical firms would remain the same and value would not affect by the choice of
finance adopted to finance the assets. The value of a firm is dependent on the expected future
earnings. It is when there are no taxes.
Proposition II: It says that the financial leverage boosts the value of a firm and reduces
WACC. It is when tax information is available.
Modigliani-Miller’ (MM) advocated that the relationship between the cost of capital, capital
structure and the valuation of the firm should be explained by NOI (Net Operating Income
Approach) by making an attack on the Traditional Approach.
The Net Operating Income Approach, supplies proper justification for the irrelevance of the
capital structure. In Income Approach, supplies proper justification for the irrelevance of the
capital structure.
In this context, MM support the NOI approach on the principle that the cost of capital is not
dependent on the degree of leverage irrespective of the debt-equity mix. In the words,
according to their thesis, the total market value of the firm and the cost of capital are
independent of the capital structure.
They advocated that the weighted average cost of capital does not make any change with a
proportionate change in debt-equity mix in the total capital structure of the firm.
The same can be shown with the help of the following diagram:
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Figure 7.6
Proposition:
The following propositions outline the MM argument about the relationship between cost of
capital, capital structure and the total value of the firm:
(i) The cost of capital and the total market value of the firm are independent of its capital
structure. The cost of capital is equal to the capitalization rate of equity stream of operating
earnings for its class, and the market is determined by capitalizing its expected return at an
appropriate rate of discount for its risk class.
(ii) The second proposition includes that the expected yield on a share is equal to the
appropriate capitalization rate of a pure equity stream for that class, together with a premium
for financial risk equal to the difference between the pure-equity capitalization rate (Ke) and
yield on debt (Kd). In short, increased Ke is offset exactly by the use of cheaper debt.
(iii) The cut-off point for investment is always the capitalization rate which is completely
independent and unaffected by the securities that are invested.
Assumptions:
The MM proposition is based on the following assumptions:
(a) Existence of Perfect Capital Market It includes:
(i) There is no transaction cost;
(ii) Flotation costs are neglected;

(iii) No investor can affect the market price of shares;
(iv) Information is available to all without cost;
(v) Investors are free to purchase and sale securities.
(b) Homogeneous Risk Class/Equivalent Risk Class:
It means that the expected yield/return have the identical risk factor i.e., business risk is equal
among all firms having equivalent operational condition.
(c) Homogeneous Expectation:
All the investors should have identical estimate about the future rate of earnings of each firm.
(d) The Dividend pay-out Ratio is 100%:
It means that the firm must distribute all its earnings in the form of dividend among the
shareholders/investors, and
(e) Taxes do not exist:
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That is, there will be no corporate tax effect (although this was removed at a subsequent
date).
Interpretation of MM Hypothesis:
The MM Hypothesis reveals that if more debt is included in the capital structure of a firm, the
same will not increase its value as the benefits of cheaper debt capital are exactly set-off by
the corresponding increase in the cost of equity, although debt capital is less expensive than
the equity capital. So, according to MM, the total value of a firm is absolutely unaffected by
the capital structure (debt-equity mix) when corporate tax is ignored.
Proof of MM Hypothesis—The Arbitrage Mechanism:
MM have suggested an arbitrage mechanism in order to prove their argument. They argued
that if two firms differ only in two points viz. (i) the process of financing, and (ii) their total
market value, the shareholders/investors will dispose-off share of the over-valued firm and
will purchase the share of under-valued firms.
Naturally, this process will be going on till both attain the same market value. As such, as
soon as the firms will reach the identical position, the average cost of capital and the value of
the firm will be equal. So, total value of the firm (V) and Average Cost of Capital, (Kw) are
independent.
It can be explained with the help of the following illustration:
Let there be two firms, Firm ‘A’ and Firm ‘B’. They are similar in all respects except in the
composition of capital structure. Assume that Firm ‘A’ is financed only by equity whereas
Firm ‘B’ is financed by a debt-equity mix.
The following particulars are presented:
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From the table presented above, it is learnt that value of the levered firm ‘B’ is higher than
the unlevered firm ‘A’. According to MM, such situation cannot persist long as the investors
will dispose-off their holding of firm ‘B’ and purchase the equity from the firm ‘A’ with
personal leverage. This process will be continued till both the firms have same market value.
Suppose Ram, an equity shareholder, has 1% equity of firm ‘B’. He will do the following:
(i) At first, he will dispose-off his equity of firm ‘B’ for Rs. 3,333.
(ii) He will take a loan of Rs. 2,000 at 5% interest from personal account.
(iii) He will purchase by having Rs. 5,333 (i.e. Rs. 3,333 + Rs. 2,000) 1.007% of equity from
the firm ‘A’.
By this, his net income will be increased as:
Obviously, this net income of Rs. 433 is higher than that of the firm ‘B’ by disposing-off 1%
holding.
It is needless to say that when the investors will sell the shares of the firm ‘B’ and will
purchase the shares from the firm ‘A’ with personal leverage, this market value of the share
of firm ‘A’ will decline and, consequently, the market value of the share of firm ‘B’ will rise
and this will be continued till both of them attain the same market value.
We know that the value of the levered firm cannot be higher than that of the unlevered firm
(other things being equal) due to that arbitrage process. We will now highlight the reverse
direction of the arbitrage process.
Consider the following illustration:
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In the above circumstances, equity shareholder of the firm ‘A’ will sell his holdings and by
the proceeds he will purchase some equity from the firm ‘B’ and invest a part of the proceeds
in debt of the firm ‘B’.
For instance, an equity shareholder holding 1% equity in the firm ‘A’ will do the following:
(i) He will dispose-off his 1% equity of firm ‘A’ for Rs. 6,250.
(ii) He will buy 1 % of equity and debt of the firm ‘B’ for the like amount.
(iii) As a result, he will have an additional income of Rs. 86.
Thus, if the investors prefer such a change, the market value of the equity of the firm ‘A’ will
decline and, consequently, the market value of the shares of the firm ‘B’ will tend to rise and
this process will be continued till both the firms attain the same market value, i.e., the
arbitrage process can be said to operate in the opposite direction.
Criticisms of the MM Hypothesis:

We have seen (while discussing MM Hypothesis) that MM Hypothesis is based on some
assumptions. There are some authorities who do not recognize such assumptions as they are
quite unrealistic, viz. the assumption of perfect capital market.
We also know that most significant element in this approach is the arbitrage process forming
the behavioral foundation of the MM Hypothesis. As the imperfect market exists, the
arbitrage process will be of no use and as such, the discrepancy will arise between the market
value of the unlevered and levered firms.
The shortcomings for which arbitrage process fails to bring the equilibrium condition are:
(i) Existence of Transaction Cost:

The arbitrage process is affected by the transaction cost. While buying securities, this cost is
involved in the form of brokerage or commission etc. for which extra amount is to be paid
which increases the cost price of the shares and requires a greater amount although the return
is same. As such, the levered firm will enjoy a higher market value than the unlevered firm.
(ii) Assumption of borrowing and lending by the firms and the individual at the same rate of
interest:
The above proposition that the firms and the individuals can borrow or lend at the same rate
of interest, does not hold good in reality. Since a firm holds more assets and credit reputation
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in the open market in comparison with an individual, the former will always enjoy a better
position than the latter.
As such, cost of borrowing will be higher in case of an individual than a firm. As a result, the
market value of both the firms will not be equal.
(iii) Institutional Restriction:
The arbitrage process is retarded by the institutional investors e.g., Life Insurance
Corporation of India, Commercial Banks; Unit Trust of India etc., i.e., they do not encourage
personal leverage. At present these institutional investors dominate the capital market.
(iv) “Personal or home-made leverage” is not the prefect substitute for “corporate leverage.”:
MM hypothesis assumes that “personal leverage” is a perfect substitute for “corporate
leverage” which is not true as we know that a firm may have a limited liability whereas there
is unlimited liability in case of individuals. For this purpose, both of them have different
footing in the capital market.
(v) Incorporation of Corporate Taxes:
If corporate taxes are considered (which should be taken into consideration) the MM
approach will be unable to discuss the relationship between the value of the firm and the
financing decision. For example, we know that interest charges are deducted from profit
available for dividend, i.e., it is tax deductible.
In other words, the cost of borrowing funds is comparatively less than the contractual rate of
interest which allows the firm regarding tax advantage. Ultimately, the benefit is being
enjoyed by the equity-holders and debt-holders.
According to some critics the arguments which were advocated by MM, are not valued in the
practical world. We know that cost of capital and the value of the firm are practically the
product of financial leverage.
MM Hypothesis with Corporate Taxes and Capital Structure:

The MM Hypothesis is valid if there is perfect market condition. But, in the real world capital
market, imperfection arises in the capital structure of a firm which affects the valuation.
Because, presence of taxes invites imperfection.
We are, now, going to examine the effect of corporate taxes in the capital structure of a firm
along with the MM Hypothesis. We also know that when taxes are levied on income, debt
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financing is more advantageous as interest paid on debt is a tax-deductible item whereas
retained earnings or dividend so paid in equity shares are not tax-deductible.
Thus, if debt capital is used in the total capital structure, the total income available for equity
shareholders and/or debt holders will be more. In other words, the levered firm will have a
higher value than the unlevered firm for this purpose, or, it can alternatively be stated that the
value of the levered firm will exceed the unlevered firm by an amount equal to debt
multiplied by the rate of tax.
The same can be explained in the form of the following equation:
Illustration 4:
Assume:
Two firms—Firm ‘A’ and Firm ‘B’ (identical in all respects except capital structure)
Firm ‘A’ has financed a 6% debt of Rs. 1,50,000
Firm ‘B’ Levered
EBIT (for both the firm) Rs. 60,000
Cost of Capital is @ 10%
Corporate rate of tax is @ 60%
Compute market value of the two firms.
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Thus, a firm can lower its cost of capital continuously due to the tax deductibility of interest
charges. So, a firm must use the maximum amount of leverage in order to attain the optimum
capital structure although the experience that we realize is contrary to the opinion.
In real-world situation, however, firms do not take a larger amount of debt and
creditors/lenders also are not interested to supply loan to highly levered firms due to the risk
involved in it.
Thus, due to the market imperfection, after tax cost of capital function will be U-shaped. In
answer to this criticism, MM suggested that the firm would adopt a target debt ratio so as not
to violate the limits of level of debt imposed by creditors. This is an indirect way of stating
that the cost of capital will increase sharply with leverage beyond some safe limit of debt.
MM Hypothesis with corporate taxes can better be presented with the help of the following
diagram:
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Figure 7.7
SUMMARY
Short term finance refers to financing needs for a small period normally less than a year. In
businesses, it is also known as working capital financing. This type of financing is normally
needed because of uneven flow of cash into the business, the seasonal pattern of business, etc.
In most cases, it is used to finance all types of inventory, accounts receivables etc. At times,
only specific one time orders of business are financed.
Long-term finance can be defined as any financial instrument with maturity exceeding one
year (such as bank loans, bonds, leasing and other forms of debt finance), and public and
private equity instruments. Maturity refers to the length of time between origination of a
financial claim (loan, bond, or other financial instrument) and the final payment date, at
which point the remaining principal and interest are due to be paid. Equity, which has no final
repayment date of a principal, can be seen as an instrument with nonfinite maturity. The one
year cut-off maturity corresponds to the definition of fixed investment in national accounts.
The Group of 20, by comparison, uses a maturity of five years more adapted to investment
horizons in financial markets (G-20 2013). Depending on data availability and the focus, the
report uses one of these two definitions to characterize the extent of long-term finance.
Moreover, because there is no consensus on the precise definition of long-term finance,
wherever possible, rather than use a specific definition of long-term finance, the report
provides granular data showing as many maturity buckets and comparisons as possible.
Everything you need to know about the theories of capital structure. Capital structure theories
seek to explain the relationship between capital structure decision and the market value of the
firm.
There are conflicting opinions regarding whether or not capital structure decision (or leverage
or proportion of debt and equity) affects the value of the firm (or shareholder’s wealth).
There is a viewpoint that strongly supports the close relationship between capital structure
decision and value of a firm. There is an equally strong body of opinion which believes that
capital structure decision has no impact on the value of the firm. Different theories are. Net
Income (NI) Approach Net Operating Income Approach, Traditional Approach, Modigliani
and Miller Approach with illustrations, formulas, calculations and graphs.
KEYWORDS
• Capital growth fund: An investment fund which invests principally in assets most likely
to increase in value, such as shares and property.
• Capital guaranteed fund: A Fund in which the original capital and the declared
investment returns are guaranteed.
214
• Capital Structure: The debt and equity portfolio of a company balance sheet. Privately
held companies can contain several levels (or tranches) of debt and equity in their capital
structures.
• Equity Ownership Structure: A schedule of who owns what type of equity of a specific
investment. There are a variety of equity instruments available to owners of a company.
These include preferred stock, common equity, equity options, equity warrants and
convertible debt (that can be converted into equity).
• Financial Leverage: Use of debt to increase the expected return on equity. Financial
leverage is measured by the ratio of debt to debt plus equity.
LEARNING ACTIVITY
1. Mehta Company Limited is expecting an annual EBIT of Rs. 2,00,000. The company has
Rs. 5,00,000 in 10% debentures. The cost of equity capital or capitalization rate is 12.5%.
Compute the value of the firm.
2. An organization expects a net income of Rs. 1,00,000. It has Rs. 1,50,000, 10 %

debentures. The equity capitalization rate of the company is 12%. Calculate the value of the
firm and overall capitalization rate according to the Net Income Approach (ignoring income-
tax).If the debenture debt increased to Rs. 2,00,000, what shall be the value of the firm and
the overall capitalization rate?
UNIT END QUESTIONS
1. Explain the NET OPERATING INCOME (NOI) approach.
2. Provide a critical review of the Modigliani Miller theorem, and the dominating literature
that is pro and against this theory.
3. Explain, when determining financing needs what factor should businesses consider that
would help decide whether they can repay the debt?
4. Discuss, what are the sources of finance?
5. Discuss long term financial costs. Describe and provide examples, if possible.
Long Questions
215
6. Blueline Publishers is considering a recapitalization plan. It is currently 100% equity
financed but under the plan it would issue long-term debt with a yield of 9% and use the
proceeds to repurchase common stock. The recapitalization would not change the company s
total assets, nor would it affect the firm's basic earning power, which is currently 15%. The
CFO believes that this recapitalization would reduce the WACC and increase stock price.
What would also be likely to occur if the company goes ahead with the recapitalization plan?
7. Mehta Company Limited is expecting an annual EBIT of Rs. 2,00,000. The company has
Rs. 5,00,000 in 10% debentures. The cost of equity capital or capitalization rate is 12.5%.
Compute the value of the firm.
8. An organization expects a net income of Rs. 1,00,000. It has Rs. 1,50,000, 10 %
debentures. The equity capitalization rate of the company is 12%. Calculate the value of the
firm and overall capitalization rate according to the Net Income Approach (ignoring income-
tax). If the debenture debt increased to Rs. 2,00,000, what shall be the value of the firm and
the overall capitalization rate?
9. A manufacturing company is expecting the Net Operating Income of is Rs. 200,000. The
company has debenture lending of Rs 6,00,000 at 10% interest payable. The overall
capitalization rate is 20%. Calculate the value of the firm and the equity capitalization rate as
per the NOI approach. What will be the impact on value of the firm and equity capitalization
firm if the debenture amount is increased to Rs. 7,50,000?
10. Company A and B are two similar businesses with similar business risks. Company A is
unlevered whereas Company B is levered with Rs. 2,00,000 debenture @ 5% interest rates.
Both the companies earn Rs. 50,000 before tax income. The after-tax capitalization rate is
10% and the corporate tax-rate is 40%. Calculate the market value of two firms.

1. Ordinary shares in limited companies:
a. has a limited life, with no voting rights but receive dividends
b. has an unlimited life, and voting rights and receive dividends
c. has an unlimited life, and voting rights but receive no dividends

d. has a limited life, and voting rights and receive dividends
2. Loans to limited companies:
a. does not have a fixed term but receive interest which is allowable for corporation tax,
and have voting rights
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b. does not have a fixed term and receive interest which is allowable for corporation tax,
but have no voting rights
c. does have a fixed term and receive interest which is not allowable for corporation tax,
but have no voting rights
d. has a fixed term and receive interest which is allowable for corporation tax, but have no
voting rights
3. External sources of finance do not include:

a. debentures
b. leasing
c. retained earnings
d. overdrafts
4. Which of the following is a characteristic of debentures?

a. debentures are issued to raise debt funding.
b. debentures are secured by a fixed or floating charge over the issuing entity's assets.
c. debentures may be issued to the public via a prospectus.
d. all of the options are characteristics of debentures.
5. Which factor does not impact financial contributions to voluntary organizations?

a. Number of disaster events in a specific timeframe
b. Perceived need of the affected populations
c. Ability of the community to quickly organize
d. Personal desire to donate
6. Which of the following working capital strategies is the most aggressive?

a. Making greater use of short term finance and maximizing net short term asset.
b. Making greater use of long term finance and minimizing net short term asset.
c. Making greater use of short term finance and minimizing net short term asset.
d. Making greater use of long term finance and maximizing net short term asset.
217
7. Which of the following would NOT improve the current ratio?
a. Borrow short term to finance additional fixed assets.
b. Issue long-term debt to buy inventory.
c. Sell common stock to reduce current liabilities.
d. Sell fixed assets to reduce accounts payable.
8. Proprietary ratio is calculated by

a. Total assets/Total outside liability
b. Total outside liability/Total tangible assets
c. Fixed assets/Long term source of fund
d. Proprietors’’ Funds/Total
9. In approach, the capital structure decision is relevant to the valuation

of the firm.
a. Net income
b. Net operating income
c. Traditional
d. Miller and Modigliani
10. of a firm refers to the composition of its long-term funds and its
capital structure.
a. Capitalization
b. Over-capitalization
c. Under-capitalization
d. Market capitalization
Answers
1. b 2. b 3. c 4. d 5. C 6.c 7.a 8.d 9.a 10.a
218
SUGGESTED READING
 "Personal Finance - Definition, Overview, Guide to Financial Planning". Corporate
Finance Institute. Retrieved 2019-10-23.
 Publishing, Speedy (2015-05-25). Finance (Speedy Study Guides). Speedy Publishing

LLC. ISBN 978-1-68185-667-4.
 "Personal Finance - Definition, Overview, Guide to Financial Planning". Corporate

Finance Institute. Retrieved 2020-05-18.

Pvt. Ltd.

219
UNIT 8 DIVIDEND DECISION
Structure
Learning objectives
Introduction
Dividend Decisions
Type of Dividend Decisions
Long-Term Financing Decision:
Wealth Maximization Decisions:

Factors affecting Dividend Decisions of Firms:
Limitation on Dividend Payments:
Dividend policy
Theories of Dividend
Walter’s model:
Gordon’s Model:
Modigliani and Miller’s hypothesis:
Determinants of Dividend Policy
Summary
Keywords
Learning activity
Unit end questions
References
LEARNING OBJECTIVES

• Explain Dividend decision,
• To study the factors affecting various dividend decisions
• List the dividend policy concept
• State about theories of dividend
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INTRODUCTION
Dividend refers to a reward, cash or otherwise, that a company gives to its shareholders.
Dividends can be issued in various forms, such as cash payment, stocks or any other form. A
company’s dividend is decided by its board of directors and it requires the shareholders’
approval. However, it is not obligatory for a company to pay dividend. Dividend is usually a
part of the profit that the company shares with its shareholders.
After paying its creditors, a company can use part or whole of the residual profits to reward
its shareholders as dividends. However, when firms face cash shortage or when it needs cash
for reinvestments, it can also skip paying dividends. When a company announces dividend, it
also fixes a record date and all shareholders who are registered as of that date become eligible
to get dividend payout in proportion to their shareholding. The company usually mails the
cheques to shareholders within in a week or so. Stocks are normally bought or sold with
dividend until two business days ahead of the record date and then they turn ex-dividend. A
recent study found that dividend-paying firms in India fell from 24 per cent in 2001 to almost
16 per cent in 2009 before rising to 19 per cent in 2010.
In the US, some of the companies like Sun Microsystems, Cisco and Oracle do not pay
dividends and reinvest their total profit in the business itself. Dividend payment usually does
not affect the fundamental value of a company’s share price. Companies with high growth
rate and at an early stage of their ventures rarely pay dividends as they prefer to reinvest most
of their profit to help sustain the higher growth and expansion. On the other hand, established
companies try to offer regular dividends to reward loyal investors.
DIVIDEND DECISIONS
The Dividend Decision is one of the crucial decisions made by the finance manager relating
to the pay-outs to the shareholders. The pay-out is the proportion of Earning Per Share given
to the shareholders in the form of dividends.
The companies can pay either dividend to the shareholders or retain the earnings within the
firm. The amount to be disbursed depends on the preference of the shareholders and the
investment opportunities prevailing within the firm.
The optimal dividend decision is when the wealth of shareholders increases with the increase
in the value of shares of the company. Therefore, the finance department must consider all
the decisions viz. Investment, Financing and Dividend while computing the payouts.
If attractive investment opportunities exist within the firm, then the shareholders must be
convinced to forego their share of dividend and reinvest in the firm for better future returns.
At the same time, the management must ensure that the value of the stock does not get
adversely affected due to less or no dividends paid out to the shareholders.
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The objective of the financial management is the Maximization of Shareholder’s Wealth.
Therefore, the finance manager must ensure a win-win situation for both the shareholders and
the company.
TYPES OF DIVIDEND DECISIONS
Long-Term Financing Decision:
As long-term financing decision the significance of the profits of the firm after tax is to be
considered in paying dividends. Investor should know that cash dividends have the nature of
reducing the funds of the firm and firm is restricted to grow or to find other financing
sources. If the firm desires to fund dividend as a long-term decision, then it should be guided
by the following points.
Projects available with the firm:

When a firm has many large projects to put its investments then instead of distributing a large
amount of profit it may retain earnings of the firm and advance these projects.
Requirement of equity funds:

A company may be able to finance itself either through long-term loans or through raising of
capital such as equity and preference shares. To raise capital also, the firm has to incur a large
cost. The company may thus take a decision of retaining some part of the earnings of the firm
and may be guided by this view at the time of paying dividends to shareholders.
Wealth Maximization Decisions:
While the firm regards the needs of investment and expansion programmes and is guided by
the decision of paying dividends as a long-term financing requirement, the other decisions
that the firm may be guided by, is the project of paying to the shareholders a high amount of
dividend to satisfy them and also to raise the price of its equity stock in the capital market.
This project takes into consideration the expectation of both the investors and the
shareholders. The management may adopt any one of these methods after taking into
consideration the factors which affect the dividend decisions.
Factors affecting Dividend Decisions of Firms:
There are many factors affecting the decisions relating to dividends to be declared to
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shareholders.
These are discussed below:
i. Expectation of Investors:
People who invest in the firms have basically done so, with the view of long-term investment
in a particular firm to avoid the necessity of shifting from one firm to another. The
expectation of the investor has been two fold. They expect to receive income annually and
have a stable investment.
Capital Gains:
All investors who are less interested in speculation and more interested in long-term
investment do so with a view to making some capital appreciation on their investment.
Capital gain is the profit, which results from the sale of any capital investment. If the investor
invests in equity stock, the capital gain would be out of the sale of equity stock after holding
it for a reasonable period of time.
Current Income:
The investor would like to have some current earnings which are also continuous in nature
and it is the price of abstinence from current consumption to more profitable avenues.
The expectation of the shareholder should be considered before taking any appropriate
decision regarding dividends. In this sense, the company has to think of both maximization of
wealth of the investor as well as its own internal requirements for long-term financing.
Reducing of Uncertainty:
Dividends should be declared in a manner that the investor is confident about the future of his
earnings. If he receives dividends annually and the amount is such that it satisfies him then
the company is able to gain his confidence because it reduces his uncertainty about future
capital gains or appreciation of the company’s equity stock.
A current dividend is the present value cash in-flow to the investors. This also helps him to
assess the kind of future that his investments will carry for him. The decisions for paying
dividend should also considered this point.
Financial Strength:
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The payment of dividend which is regular, stable and continuous with a promise of capital
appreciation, helps the company in judging its own financial strength and also it receives
financial commitments from creditors and financial institutions because they are in a position
to gauge the kind of working of the firm through the information they receive regarding the
amount of dividend and the market value of their shares.
While all investors would like to maximize their wealth, the company must also see its
requirement for expansion programs. The company also has certain limitations or
environmental constraints which enable it to pay dividend in a limited form.
Limitation on Dividend Payments:
The firm has the following limitations in paying dividends.

The management of the firm while making decision in paying out dividends to its
shareholders should also analyze these problems:
i. Cash Requirements:
Many firms are unable to pay dividends regularly. A company which is going through its
gestation period or is small in nature and is trying to expand its business has the problem of
paying high dividends.
If it does, it will be surrounded by inefficiency because of the insufficiency of cash.
Sometimes, a firm has the problem of tying up all resources in inventories or in the
commitment of purchasing long-term investments. This acts as a restraint of the firm to pay
out dividends.
ii. Limitations Placed by Creditors:

Sometimes, a firm requires funds for long-term purpose and to fulfil this obligation it makes,
the use of funds on long-term loans. While taking these loans the firm makes an arrangement
with the creditors that it will not pay dividends to its shareholders till its debt equity ratio
depicts 2:1.
Sometimes, the firm also makes contractual obligations with its creditors to maintain a certain
pay-out ratio till the time that it is using the loan facilities. Under these contractual
obligations, the firm cannot pay more than the dividends it can, or is allowed to pay, under
the agreement.
iii. Legal Constraints:

In India, there are many legal constraints in payment of dividends. The payment of dividends
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is subject to government policy and tax laws. This restraint also covers bonds, debentures and
equity shares.
There are regulatory authorities such as Reserve Bank of India, Securities Exchange Board of
India, Insurance Regulatory Authority of India. Income Tax Act of India and Companies Act
followed in India. These legal constraints should be carefully analyzed before paying
dividends to the shareholders.
DIVIDEND POLICY
The Dividend Policy is a financial decision that refers to the proportion of the firm’s earnings
to be paid out to the shareholders. Here, a firm decides on the portion of revenue that is to be
distributed to the shareholders as dividends or to be ploughed back into the firm.
The amount of earnings to be retained back within the firm depends upon the availability of
investment opportunities. To evaluate the efficiency of an opportunity, the firm assesses a
relationship between the rate of return on investments “r” and the cost of capital “K.”
As per the dividend models, some practitioners believe that the shareholders are not
concerned with the firm’s dividend policy and can realize cash by selling their shares if
required. While the others believed that, dividends are relevant and have a bearing on the
share prices of the firm. This gave rise to the following models:
1. Miller and Modigliani Hypothesis- Dividend Irrelevance Theory
2. Walter’s Model – Dividend Relevance Theory
3. Gordon’s Model- Dividend Relevance Theory
As long as returns are more than the cost, a firm will retain the earnings to finance the
projects, and the shareholders will be paid the residual dividends i.e. the earnings left after
financing all the potential investments. Thus, the dividend payout fluctuates from year to
year, depending on the availability of investment opportunities.
THEORIES OF DIVIDEND
Some of the major different theories of dividend in financial management are as follows: 1.
Walter’s model 2. Gordon’s model 3. Modigliani and Miller’s hypothesis.
On the relationship between dividend and the value of the firm different theories have been
advanced.
They are as follows:
1. Walter’s model
2. Gordon’s model
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3. Modigliani and Miller’s hypothesis
Walter’s model:
Professor James E. Walter argues that the choice of dividend policies almost always affects
the value of the enterprise. His model shows clearly the importance of the relationship
between the firm’s internal rate of return (r) and its cost of capital (k) in determining the
dividend policy that will maximize the wealth of shareholders.
Walter’s model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is debt or new equity is not
issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. Beginning earnings and dividends never change. The values of the earnings per share (E),
and the divided per share (D) may be changed in the model to determine results, but any
given values of E and D are assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
The above equation clearly reveals that the market price per share is the sum of the present
value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
ii) The present value of the infinite stream of stream gains.
[r (E-D)/K/K]
Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm
under different assumptions about the rate of return. However, the simplified nature of the
model can lead to conclusions which are net true in general, though true for Walter’s model.
The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with investment policy of the
firm. The model assumes that the investment opportunities of the firm are financed by
retained earnings only and no external financing debt or equity is used for the purpose when
such a situation exists either the firm’s investment or its dividend policy or both will be sub-
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optimum. The wealth of the owners will maximize only when this optimum investment in
made.
2. Walter’s model is based on the assumption that r is constant. In fact decreases as more
investment occurs. This reflects the assumption that the most profitable investments are made
first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to
optimize the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly
with the firm’s risk. Thus, the present value of the firm’s income moves inversely with the
cost of capital. By assuming that the discount rate, K is constant, Walter’s model abstracts
from the effect of risk on the value of the firm.
Gordon’s Model:
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
According to Gordon’s dividend capitalization model, the market value of a share (Pq) is
equal to the present value of an infinite stream of dividends to be received by the share. Thus:
The above equation explicitly shows the relationship of current earnings (E,), dividend
policy, (b), internal profitability (r) and the all-equity firm’s cost of capital (k), in the
determination of the value of the share (P0).
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Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does
not affect the wealth of the shareholders. They argue that the value of the firm depends on the
firm’s earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm. M – M’s hypothesis of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As
a result, the price of each share must adjust so that the rate of return, which is composed of
the rate of dividends and capital gains, on every share will be equal to the discount rate and
be identical for all shares.
Thus, the rate of return for a share held for one year may be calculated as follows:
Where P^ is the market or purchase price per share at time 0, P, is the market price per share
at time 1 and D is dividend per share at time 1. As hypothesized by M – M, r should be equal
for all shares. If it is not so, the low-return yielding shares will be sold by investors who will
purchase the high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to increase the prices
of the high-return shares. This switching will continue until the differentials in rates of return
are eliminated. This discount rate will also be equal for all firms under the M-M assumption
since there are no risk differences.
From the above M-M fundamental principle we can derive their valuation model as follows:
Multiplying both sides of equation by the number of shares outstanding (n), we obtain the
value of the firm if no new financing exists.
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If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at
time 0 will be
The above equation of M – M valuation allows for the issuance of new shares, unlike
Walter’s and Gordon’s models. Consequently, a firm can pay dividends and raise funds to
undertake the optimum investment policy. Thus, dividend and investment policies are not
confounded in M – M model, like waiter’s and Gordon’s models.
Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical
relevance in the real world situation. Thus, it is being criticized on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This cannot be true if
the costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm
pays dividends or not. But, because of the transactions costs and inconvenience associated
with the sale of shares to realize capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k)
should be same whether firm uses the external or internal financing. If investors have desire
to diversify their port folios, the discount rate for external and internal financing will be
different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.
DETERMINANTS OF DIVIDEND POLICY
Some of the most important determinants of dividend policy are: (i) Type of Industry (ii) Age
of Corporation (iii) Extent of share distribution (iv) Need for additional Capital (v) Business
Cycles (vi) Changes in Government Policies (vii) Trends of profits (vii) Trends of profits
(viii) Taxation policy (ix) Future Requirements and (x) Cash Balance.
The declaration of dividends involves some legal as well as financial considerations. From
the point of legal considerations, the basic rule is that dividend can only be paid out profits
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without the impairment of capital in any way. But the various financial considerations present
a difficult situation to the management for coming to a decision regarding dividend
distribution.
These considerations are discussed below:
(i) Type of Industry:
Industries that are characterized by stability of earnings may formulate a more consistent
policy as to dividends than those having an uneven flow of income. For example, public
utilities concerns are in a much better position to adopt a relatively fixed dividend rate than
the industrial concerns.
(ii) Age of Corporation:
Newly established enterprises require most of their earning for plant improvement and
expansion, while old companies which have attained a longer earning experience, can
formulate clear cut dividend policies and may even be liberal in the distribution of dividends.
(iii) Extent of share distribution:
A closely held company is likely to get consent of the shareholders for the suspension of
dividends or for following a conservative dividend policy. But a company with a large
number of shareholders widely scattered would face a great difficulty in securing such assent.
Reduction in dividends can be affected but not without the co-operation of shareholders.
(iv) Need for additional Capital:
The extent to which the profits are ploughed back into the business has got a considerable
influence on the dividend policy. The income may be conserved for meeting the increased
requirements of working capital or future expansion.
(v) Business Cycles:

During the boom, prudent corporate management creates good reserves for facing the crisis
which follows the inflationary period. Higher rates of dividend are used as a tool for
marketing the securities in an otherwise depressed market.
(vi) Changes in Government Policies:

Sometimes government limits the rate of dividend declared by companies in a particular
industry or in all spheres of business activity. The Government put temporary restrictions on
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payment of dividends by companies in July 1974 by making amendment in the Indian
Companies Act, 1956. The restrictions were removed in 1975.
(vii) Trends of profits:
The past trend of the company’s profit should be thoroughly examined to find out the average
earning position of the company. The average earnings should be subjected to the trends of
general economic conditions. If depression is approaching, only a conservative dividend
policy can be regarded as prudent.
(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce
the residual profits after tax available for shareholders and indirectly, as the distribution of
dividends beyond a certain limit is itself subject to tax. At present, the amount of dividend
declared is tax free in the hands of shareholders.
(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against contingencies (or hazards) of
the business, to finance future- expansion of the business and to modernize or replace
equipment’s of the enterprise. The conflicting claims of dividends and accumulations should
be equitably settled by the management.
(x) Cash Balance:
If the working capital of the company is small liberal policy of cash dividend cannot be
adopted. Dividend has to take the form of bonus shares issued to the members in lieu of cash
payment.
The regularity of dividend payment and the stability of its rate are the two main objectives
aimed at by the corporate management. They are accepted as desirable for the corporation’s
credit standing and for the welfare of shareholders.
High earnings may be used to pay extra dividends but such dividend distributions should be
designed as “Extra” and care should be taken to avoid the impression that the regular
dividend is being increased.
A stable dividend policy should not be taken to mean an inflexible or rigid policy. On the
other hand, it entails the payment of a fair rate of return, taking into account the normal
growth of business and the gradual impact of external events.
A stable dividend record makes future financing easier. It not only enhances the credit-
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standing of the company but also stabilizes market values of the securities outstanding. The
confidence of shareholders in the corporate management is also strengthened.
Legal rules governing payment of dividends:

It is illegal to pay a dividend, if after its payment; the capital would be impaired (reduced).
This requirement might be met if only capital surplus existed. An upward revaluation of
assets, however, would create a capital surplus, but at the same time might operate as a fraud
on creditors and for that reason is illegal.
Basically the dividend laws were intended to protect creditors and therefore prohibit payment
of a dividend if a corporation is insolvent or if the dividend payment will cause insolvency.
The corporate laws must be taken into consideration by the directors before they declare a
dividend. The company can postpone the distribution of dividend in cash, which may be
conserved for strengthening the financial condition of the company by declaring stock
dividend or bonus shares.
To sum up, the decision with regard to dividend policy rests on the judgement of the
management, since it is not a contractual obligation like interest. The formulation of dividend
policy requires a balanced financial judgement by judiciously weighting the different factors
affecting the policy.
Stock dividend or bonus shares:

A stock dividend is a distribution of additional shares of stock to existing shareholders on a
pro-rata basis i.e. so much stock for each share of stock held. Thus, a 10% stock dividend
would give a holder of ICQ shares, as additional 10 shares, whereas a 250% stock dividend
would give him 250 additional shares. A stock dividend has no immediate effect upon assets.
It results in a transfer of an amount from the accumulated earnings or surplus account to the
share capital account. In other words, the reserves are capitalized and their ownership is
formally transferred to the shareholders.
The equity of the shareholders in the corporation increases. Stock dividends do not alter the
cash position of the company. They serve to commit the retained earnings to the business as a
part of its fixed capitalization.
Reasons for declaring a stock dividend:

Two principal reasons which usually actuate the directors to declare a stock dividend are:
(1) They consider it advisable to reduce the market value of the stock and thereby facilitate a
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broader distribution of ownership.
(2) The corporation may have earnings but may find it inadvisable to pay cash dividends. The
declaration of a stock dividend will give the stock holders evidence of the increase in their
investment without interfering with the company’s cash position. If the stock holders prefer
cash to additional stock in the company, they can sell the stock received as dividend.
Sometimes, a stock dividend is declared to protect the interests of old stock holders when a
company is about to sell a new issue of stock (so that new shareholders should not share the
accumulated surplus).
Limitations of stock dividends:
The bonus shares entail an increase in the capitalization of the corporation and this can only
be justified by a proportionate increase in the earning capacity of the corporation. Young
companies with uncertain earnings or companies with fluctuating income are likely to take
great risk by distribution stock dividends.
Every stock dividend carries an implied promise that future cash dividends will be
maintained at a steady level because of the permanent capitalization of reserves. Unless the
corporate management has reasonable grounds of entertaining this hope, the wisdom of large
stock dividend is always subject to grave suspicion.
The existence of legal sanction for distributing the accumulated earnings or reserves does not
warrant the issue of stock dividends from the point of view of sound financial practice. There
should be other conditioning factors also for the issue of stock dividend.
(a) Bonus shares bring about a capitalization of undistributed profits in the companies where
the profits originate and this led to a linear development of corporate enterprise and greater
concentration of economic power.
(b) By issuing stock dividends-the corporations deprive the capital market of ‘secondary’
funds which would otherwise have flowed into more widely dispersed investments.
(c) Bonus shares enable companies to appropriate to their own use undistributed profits
which, otherwise, would have led either to an increase in the share of labor or a reduction in
prices for the consumer.
SUMMARY
A dividend policy is the policy a company uses to structure its dividend payout to
shareholders. Some researchers suggest the dividend policy is irrelevant, in theory, because
investors can sell a portion of their shares or portfolio if they need funds. This is the dividend
irrelevance theory, which infers that dividend payouts minimally affect a stock's price.
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KEYWORDS
• Dividends: Dividends are payments made by a corporation to its shareholder members. It
is the portion of corporate profits paid out to stockholders.
• Capital loss: The loss in the value of an investment, calculated by the difference between
the purchase price and the net sales price.
• Capital preservation: An investment goal or objective to keep the original investment
amount (the principal) from decreasing in value.
• Diversification: The practice of investing in multiple asset classes and securities with
different risk characteristics.
• Dividend: Money an investment fund or company pays to its stockholders, typically from
profits. The amount is usually expressed on a per-share basis.
LEARNING ACTIVITY
1. The stock price of Alps Co. is $53.90. Investors require a return of 13 percent on similar
stocks.
If the company plans to pay a dividend of $3.60 next year, what growth rate is expected for
the company's stock price? (Do not round intermediate calculations and enter the answer as a
percent rounded to 2 decimal places)
2. Knudsen Corporation was organized on January 1, 2016. During its first year, the
corporation issued 1,950 shares of $50 par value preferred stock and 110,000 shares of $10
par value common stock. At December 31, the company declared the following cash
dividends: 2016, $6,325; 2017, $13,900; and 2018, $28,500.
a. Show the allocation of dividends to each class of stock, assuming the preferred stock
dividend is 7% and noncumulative.
b. Show the allocation of dividends to each class of stock, assuming the preferred stock
dividend is 9% and cumulative.
c. Journalize the declaration of the cash dividend at December 31, 2018, under part (b).
UNIT END QUESTIONS
234
1. Define dividend decisions.
2. Explain wealth maximization decisions.
3. Stuart sold 200 shares of stock he owned. He purchased the stock three years ago for $28
per share. Following is a table that shows the market value of the stock at the end of each
year and the amount of the dividend that Stuart received during the year:
Year Market Value per share Dividend per share
1 $26 $0.60
2 $28 $0.60
3 $32 $0.60
What return did Stuart earn for each year he held the stock?
4. Discuss, why would an organization issue dividends? When might it decide not to do so?
5. The following events occurred during 2016 for Titus Corporation and have not been
recorded:
a. 1/10/2016 - Issued 200,000 shares of stock at $16 per share.
b. 1/25/2016 - The law firm that helped the company incorporate and file all forms for the
stock issue accepts 1,000 shares of newly issued stock in lieu of cash for its legal bill
rendered. The amount of the legal bill was $20,000.
c. 6/10/2016 - Titus Corporation declares a 50 cent per share dividend payable July 15 to
shareholders of record as of June 30, 2016.
d. 6/30/2016 - The record date for the dividend declared on June 10.
e. 7/15/2016 - The dividend declared on June 10 is paid.
f. 9/15/2016 - Titus Corporation declares a 10% stock dividend payable on September 30
to shareholders of record as of September 20. The market value of the stock was $15
immediately prior to the declaration of the stock dividend.
g. 9/30/2016 - The stock dividend declared on September 15 is paid.
h. 10/15/2016 - Titus Corporation buys 5,000 shares of its own stock on the open market
for $18 per share.
i. 12/18/2016 - Titus Corporation resells 2,000 shares of the treasury stock for $20 per
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share.
Prepare journal entries in good form for the transactions listed above.
6. Cape Corp. will pay a dividend of $3.30 next year. The company has stated that it will
maintain a constant growth rate of 5.25 percent a year forever.
a. If you want a return of 18 percent, how much will you pay for the stock?
b. If you want a return of 12 percent, how much will you pay for the stock?
7. Explain theories of determinants.

1. Which of the following examples best represents a passive dividend policy?
a. The firm sets a policy such that the proportion of dividends paid from net income
remains constant.
b. The firm pays dividends with what remains of net income after taking acceptable
investment projects.
c. The firm sets a policy such that the quantity (dollar amount per share) of dividends paid
from net income remains constant.
d. All of the above are examples of various types of passive dividend policies.
2. Modigliani and Miller argue that the dividend decision .

a. is irrelevant as the value of the firm is based on the earning power of its assets
b. is relevant as the value of the firm is not based just on the earning power of its assets
c. is irrelevant as dividends represent cash leaving the firm to shareholders, who own the
firm anyway
d. is relevant as cash outflow always influences other firm decisions
3. Financial signaling has been raised as an argument in the battle over the relevancy of
dividends. Which of the following statements concerning dividends is most likely to be
voiced by someone using the financial signaling argument?
a. A dividend decrease should be viewed by investors as "good news." The dividend
decrease acts to add conviction to the statement that the firm has better uses for the earnings
of the company than the stockholders.
b. Reported accounting earnings of a company, not dividends, are a proper reflection or
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signal of the company's economic earnings.
c. The price of a firm's stock should react unfavorably to an increase in dividends.
d. Cash dividends speak louder than words when it comes to conveying information about
management's expectations of the future.
4. A number of legal rules help to establish the legal boundaries within which a firm's
finalized dividend policy can operate. These legal rules have to do with capital impairment,
insolvency, and undue retention of earnings. Some states have a (an) rule, while
the Internal Revenue Service has a (an) rule.
a. capital impairment; insolvency
b. undue retention of earnings; insolvency
c. insolvency rule; capital impairment
d. capital impairment (or insolvency); undue retention of earnings
5. Firm Pickemon, Inc. has had earnings of $3.20, $3.00, and $5.50 per share for the past
three years. The firm anticipates maintaining the same dividend policy this year as the past
three years. That dividend policy has resulted in dividends per share of $1.28, $1.20, and
$2.20 for the past three years. It is anticipated that the next year will result in a large increase
in earnings to $9.80 per share. What dividend do you expect the firm to pay in the next year?
a. $3.92
b. $1.56
c. $3.12
d. $4.68
6. Investors may be willing to pay a premium for stable dividends because of the
informational content of , the desire of investors for , and certain
.
a. institutional considerations; dividends; current income.
b. dividends; current income; institutional considerations.
c. current income; dividends; institutional considerations.
d. institutional considerations; current income; dividends.
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7. The dividend-payout ratio is equal to
a. the dividend yield plus the capital gains yield.
b. dividends per share divided by earnings per share.
c. dividends per share divided by par value per share.
d. dividends per share divided by current price per share.
8. An offer by a firm to repurchase some of its own shares is known as

a. a DRIP.
b. a self-tender offer.
c. a reverse split.
9. If Ian O'Connor Enterprises, Inc., repurchased 50 percent of its outstanding common

stock from the open (secondary) market, the result would be
a. a decline in EPS.
b. an increase in cash.
c. a decrease in total assets.
d. an increase in the number of stockholders.
10. Which of the following is an argument for the relevance of dividends?

a. Informational content.
b. Reduction of uncertainty.
c. Some investors' preference for current income.
d. All of these
Answers
1. b 2. a 3. d 4. d 5. a 6. B 7.b 8.b 9.c 10.a
REFERENCES
 Huston, Jeffrey L.: The Declaration of Dependence: Dividends in the Twenty-First

Century. (Archway Publishing, 2015, ISBN 1480825042)
 Freedman, Roy S.: Introduction to Financial Technology. (Academic Press, 2006,

ISBN 0123704782)
238
 DK Publishing (Dorling Kindersley): The Business Book (Big Ideas Simply
Explained). (DK Publishing, 2014, ISBN 1465415858)
 Chambers, Clem (July 14, 2006). "Who needs stock exchanges?".

MondoVisione.com. Retrieved May 14, 2017.

Pvt. Ltd.

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UNIT 9 RISK MANAGEMENT
Structure
Learning objectives
Introduction
Concept of Risk Management
Corporate risk management
Protecting Shareholders
Economic Value
Book Value
Strategic risk management
Project risk management
Project risk management tools
Business Risk Management (BRM)
Summary
Keywords
Learning activity
Unit end questions
References
LEARNING OBJECTIVES
• State the risk management

• Explain the concept of corporate, strategic and project risk management
INTRODUCTION
Risk management is the identification, evaluation, and prioritization of risks (defined in ISO
31000 as the effect of uncertainty on objectives) followed by coordinated and economical
application of resources to minimize, monitor, and control the probability or impact of
unfortunate events or to maximize the realization of opportunities.
Risks can come from various sources including uncertainty in financial markets, threats from
project failures (at any phase in design, development, production, or sustaining of life-
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cycles), legal liabilities, credit risk, accidents, natural causes and disasters, deliberate attack
from an adversary, or events of uncertain or unpredictable root-cause. There are two types of
events i.e. negative events can be classified as risks while positive events are classified as
opportunities. Risk management standards have been developed by various institutions,
including the Project Management Institute, the National Institute of Standards and
Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary
widely according to whether the risk management method is in the context of project
management, security, engineering, industrial processes, financial portfolios, actuarial
assessments, or public health and safety.
Strategies to manage threats (uncertainties with negative consequences) typically include
avoiding the threat, reducing the negative effect or probability of the threat, transferring all or
part of the threat to another party, and even retaining some or all of the potential or actual
consequences of a particular threat. The opposite of these strategies can be used to respond to
opportunities (uncertain future states with benefits).
Certain risk management standards have been criticized for having no measurable
improvement on risk, whereas the confidence in estimates and decisions seems to increase.
For example, one study found that one in six IT projects were "black swans" with gigantic
overruns (cost overruns averaged 200%, and schedule overruns 70%).
CONCEPT OF RISK MANAGEMENT
Concept # 1. Risk Exposure Analysis:

The most basic way of protecting against risk is to deal only with creditworthy
counterparties. This is easier said than done! It is the responsibility of the lender to
understand and evaluate the risk. Gaining this understanding can be achieved through
identifying categories of risk and then addressing the issues associated with each of these
categories. One of the measures that could be adopted is risk exposure analysis.
For this purpose, banks have to establish an appropriate and adequate system for monitoring
and reporting risk exposures. A periodic overview by the Board and senior management
would be necessary.
Reporting system developed for this purpose would involve:

(a) Evaluating the level and trends of the bank’s aggregated rate risk exposure, particularly
interest rate,
(b) Evaluating the sensitivity and reasonableness of key assumptions—such as those dealing
with changes in the shape of the yield curve or in the pace of anticipated loan prepayments or
deposit withdrawals,
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(c) Verifying compliance with the established risk tolerance levels and limits and identifying
any policy exceptions, and
(d) Determining whether the bank holds sufficient capital for the risk being taken.
The reports provided to the board and senior management should be clear, concise, and
timely and provide the information needed for making decisions.
The measures would include:

Limiting Risks:
A sound system of integrated institution-wide limits and risk-taking guidelines is an essential
component of the risk management process. Global limits should be set for each major type
of risk involved. These limits should be consistent with the bank’s overall risk measurement
approach and should be integrated to the fullest extent possible with institution-wide limits on
those risks as they arise in all other activities of the firm.
The limit system should provide the capability to allocate limits down to individual business
units. At times, especially when markets are volatile, traders may exceed their limits. When
such exceptions occur, the facts should be made known to the senior management and
approved only by authorized personnel.
Reporting:
An accurate, informative, and timely management information system is essential to the
prudent operation of security trading or derivatives activity. More frequent reports should be
made as market conditions dictate.
Reports to other levels of senior management and the board may occur less frequently, but
examiners should determine whether the frequency of reporting provides these individuals
with adequate information to judge the changing nature of the institution’s risk profile.
Management Evaluation and Review:

Management should ensure that the various components of a bank’s risk management process
are regularly reviewed and evaluated. This review should take into account changes in the
activities of the institution and in the market environment, since the changes may have
created exposures that require additional management and further examination.
Any material changes to the risk management system should also be reviewed. Assumptions
should be evaluated on a continual basis. Banks should also have an effective process to
evaluate and review the risks involved in products that are either new to the firm or new to
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the marketplace and of potential interest to the firm.
Managing Specific Risks:

Various risks are to be addressed differently when it comes to the issue of risk exposure
analysis.
Credit Risk:
Master netting agreements and various credit enhancements, such as collateral or third party
guarantees, can be used by banks to reduce their counterparty credit risk. In such cases, a
bank’s credit exposures should reflect these risk reducing features only to the extent that the
agreements and recourse provisions are legally enforceable in all relevant jurisdictions.
This legal enforceability should extend to any insolvency proceedings of the counterparty.
Banks should be able to demonstrate that they have exercised due diligence in evaluating the
enforceability of these contracts and that individual transactions have been executed in a
manner that provides adequate protection to the bank.
Credit limits that consider both settlement and pre-settlement exposures should be established
for all counterparties with whom the bank trades. Trading activities that involve cash
instruments often involve short-term exposures that are eliminated at settlement.
However, in the case of derivative products traded in over-the- counter markets, the exposure
can often exist for a period similar to that commonly associated with a bank loan.
Market Risk:
Banks should establish limits for market risk that relate to their risk measures and that are
consistent with maximum exposures authorized by their senior management and board of
directors. These limits should be allocated to business units and individual traders and be
clearly understood by all relevant parties.
Liquidity Risk:
Banks face two types of liquidity risks in their trading activities:
(a) those related to specific products or markets, and
(b) those related to the general funding of the bank’s trading activities.
The former is the risk that a banking institution cannot easily unwind or offset a particular
position at or near the previous market price because of inadequate market depth or because
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of disruptions in the marketplace.
In the Funding liquidity risk the bank will be unable to meet its payment obligations on
settlement dates. Since neither type of liquidity risk is unique, the management should
evaluate these risks in the broader context of the institution’s overall liquidity. When
establishing limits, banks should be aware of the size, depth and liquidity of the particular
market and establish trading guidelines accordingly.
In developing guidelines for controlling the liquidity risks exposures in trading activities,
banks should consider the possibility that they could lose access to one or more markets,
either because of concerns about the bank’s own creditworthiness, the creditworthiness of a
major counterparty, or because of generally stressful market conditions.
At such times, the bank may have less flexibility in managing its market, credit, and liquidity
risk exposures. The bank’s liquidity plan should reflect the ability to turn to alternative
markets, such as futures or cash markets, or to provide sufficient collateral or other credit
enhancements in order to continue trading under a broad range of scenarios.
Operational and Legal Risk:

Operating risk is caused due to deficiencies in information systems or internal controls,
resulting in unexpected loss. Legal risk arises when contracts are not legally enforceable or
documented correctly.
Although operating and legal risks are difficult to quantify, they can often be monitored by
examining a series of plausible “worst-case” or “what if” scenarios, such as a power loss, a
doubling of transaction volume, a mistake found in the pricing software for collateral
management, or an unenforceable contract.
They can also be assessed through periodic reviews of procedures, documentation
requirements, data processing systems, contingency plans, and other operating practices.
Such reviews may help reduce the likelihood of errors and breakdowns in controls, improve
the control of risk and the effectiveness of the limit system, and prevent unsound marketing
practices and the premature adoption of new products or lines of business.
Banks should also ensure that trades that are consummated orally are confirmed in writing as
soon as possible. Transactions conducted via telephone should be recorded on tape and
subsequently supported by written documents.
Legal risks should be limited and managed through policies developed by the institution’s
legal counsel (typically in consultation with officers in the risk management process) that
have been approved by the bank’s senior management and board of directors. Banks should
also ensure that the counterparty has sufficient authority to enter into the transaction and that
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the terms of the agreement are legally sound.
Banks should also ascertain whether their netting agreements are adequately documented,
that they have been executed properly, and that they are enforceable in all relevant
jurisdictions. Banks should have knowledge of relevant tax laws and interpretations
governing the use of these instruments.
To address this issue, risk managers have developed “stress testing,” which is a risk-
management tool used to evaluate the potential impact on portfolio values of unlikely,
although plausible, events or movements in a set of financial variables.
While such unlikely outcomes do not mesh easily with VaR analysis, analysis of these
outcomes can provide further information on expected portfolio losses over a given time
horizon. Accordingly, stress testing is used increasingly as a complement to the more
standard statistical models used for VaR analysis.
Stress testing is mostly used in managing market risk, which deals primarily with traded
market portfolios. These portfolios include interest rate, equity, foreign exchange, and
commodity instruments and are amenable to stress testing because their market prices are
updated on a regular basis.
In addition to providing a “reality check” on VaR models, stress testing has been found to be
an effective communication tool between a firm’s senior management and its business lines.
The communication advantage that stress tests have over VaR analysis is their explicit
linking of potential losses to a specific and concrete set of events.
That is, stress tests can be thought of as exercises based on a unique set of outcomes for the
relevant risk factors—interest rates change by a certain number of basis points, the US $
dollar depreciates by a certain percent, and so on.
In contrast, in the VaR framework, there is no unique configuration of the underlying risk
factors that is identified with the value of, say, a portfolio falling below a given level. Again,
however, stress tests and VaR analysis provide different information and are considered to be
complementary.
Stress Testing:
Stress-testing techniques fall into two general categories: sensitivity tests and scenario tests.
Sensitivity tests assess the impact of large movements in financial variables on portfolio
values without specifying the reasons for such movements.
A typical example might be a 100 basis point increase across the yield curve or a 10% decline
in stock market indexes. These tests can be run relatively quickly and are commonly used as
a first approximation of the portfolio impact of a financial market move.
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However, the analysis lacks historical and economic content, which can limit its usefulness
for longer-term risk-management decisions. Scenario tests are constructed either within the
context of a specific portfolio or in the light of historical events common across portfolios.
In a stylized version of the specific portfolio approach, risk managers identify a portfolio’s
key financial drivers and then formulate scenarios in which these drivers are stressed beyond
standard VaR (Value-at-Risk) levels. For the event-driven approach, stress scenarios are
based on plausible but unlikely events, and the analysis addresses how these events might
affect the risk factors relevant to a portfolio.
Commonly used events for historical scenarios are the large US $ stock market declines of
October 1987, the Asian financial crisis of 1997, the financial market fluctuations
surrounding the Russian default of 1998, and financial market developments following the
September 11,2001, terrorist attacks in the United States.
The choice of portfolio-based or event-based scenarios depends on several factors, including
the relevance of historical events to the portfolio and the firm resources available for
conducting the exercise. Historical scenarios are developed more fully since they reflect an
actual stressed market environment that can be studied in great detail, thereby requiring fewer
judgments by risk managers.
Since such events may not be relevant to a specific portfolio, hypothetical scenarios that are
directly relevant can be crafted, but only at the cost of a more labor-intensive and judgmental
process. Hybrid scenarios are commonly used, where risk managers construct scenarios that
are informed by historical market movements that may not be linked to a specific event.
Historical events also can provide information for calibrating movements in other market
factors, such as firm credit quality and market liquidity. More generally, risk managers
always face a trade-off between scenario realism and comprehensibility; that is, more fully
developed scenarios generate results that are more difficult to interpret.
Stress testing is an appealing risk-management tool because it provides risk managers with
additional information on possible portfolio losses arising from extreme, although plausible,
scenarios. In addition, stress scenarios can often be an effective communication tool within
the banks and to outside parties, such as supervisors and investors.
The Exposure Document:

For a better risk exposure analysis, banks can develop an exposure document. It may contain
information on the banking corporation’s existing exposure to the various market risks, credit
risks and liquidity risks in a condensed form in a comprehensive manner.
This document shall include (a) A description of all the risks, to which the bank is exposed,
giving information on changes in exposures, the parties authorized to deal with each
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exposure, and their authority, (b) Details of the steps taken to minimize the operational risks
and the legal risks, etc.
An updated exposure document shall be submitted to the board and the management to
include all discussions in which decisions are made and changes determined in the bank’s
preferred risk- exposure mix. It can also include the regular periodic discussions of the
updated exposures document.
Role of the Board:
1. The board of directors of a bank shall discuss and approve a policy of exposure to the
various risks, and set the permitted ceiling exposures in the various activity segments. It shall
also discuss and approve the organizational format for managing and controlling the bank’s
overall exposure to the various risks.
2. The board shall hold the discussion, grade the risks, and set limits after considering the
quality of the bank’s existing tools for managing and controlling every type of risk and in
every type of activity.
3. It would ensure that approvals are given to all new activities of the bank, (e.g. a new
derivative financial instrument significantly different from those currently existing in the
bank, the creation of a new type of exposure, market making, etc.)
4. Consideration shall be given to all the risks involved in the new activity, after checking the
mechanisms the bank will use to manage, measure, and control the risks.
It would set quantitative limits required as a result of the risks inherent in the new activity,
and ascertain the availability of necessary manpower, sources of finance, and computer and
technological infrastructure. This would facilitate proper absorption and management of the
activity and its consistency with the existing activities.
Role of the Risk Manager:

In the light of the policy and decisions of the board of directors, the risk manager will deal
with:
1. On-going management of exposures, directing the various units involved in managing the
bank’s financial instruments and creating exposures in the various activity segments.
2. Making recommendations to the board of directors and management about the authority
and the type of financial instruments, which are permitted in the formation and hedging of
risks.
3. Making recommendations to the board of directors and management on all matters related
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to exposure management.
4. Regulating monitoring, reporting, and control procedures for matters related to exposures
management incorporating the rules for reporting deviations from the set limits.
Role of Internal Audit:

Internal audit shall incorporate in its annual work program an assessment of the overall
procedure that the banking corporation follows regarding risk management in its financial
activities.
The internal auditor shall examine, review, and assess the extent to which:
1. The policy of the board of directors is carried out;
2. Its decisions and instructions regarding management, estimation and control of risks are
implemented;
3. The units comply with the limits imposed and the reliability and availability of
management information and financial and operational reports to the board of directors and
the management of the banking corporation.
The risk-management unit and risk-control function (if such exists) shall be among those
examined by the auditor.
Concept # 2. Open Position:

Open position is a term generally used in foreign exchange transactions. It exists when any
instrument either short or long is not hedged against price or interest-rate risk by using
derivatives or opposite transactions.
It is an obligation to take or make delivery of an asset or currency in the future without cover,
that is, without a matching obligation in the other direction that protects them from effects of
change in the price of the asset or currency. Open position is a long or short trading position
that is not yet closed.
In either case the dealer remains vulnerable to fluctuations until the position is closed. It
denotes the difference between assets and liabilities in a particular currency. This may be
measured on a per currency basis or the position of all currencies when calculated in base
currency.
There are many activities of banks, which involve risk-taking, but there are a few in which a
bank may quickly incur large losses as in foreign exchange transactions. The risks inherent in
foreign exchange business, particularly in running open foreign exchange positions, have
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been heightened in recent years. Consequently, the monitoring of these risks has become a
matter of increased interest to banks and regulators.
Currency Pairs:
In discussing on open positions, the trading terminology while dealing in a variety of
currencies must be known.
Figure 9.1
The Players:
There are four primary groups that trade in foreign exchange market:
1. Novice or Retail Traders:
These are part-time, nonprofessional traders who are speculating on market direction and not
hedging, that is, not using these markets as part of other international business dealings.
2. Dealers:
These are the market makers, setting prices and putting together trades.
3. Institutional Traders, Banks or Government Agencies:
They trade huge amounts of money and the size of their trading moves the markets. These
traders are often trading to settle accounts for import/export and other actual international
business dealings.
4. Advanced. Traders:
This group comprises of professional full-time traders, people from all across the world,
sitting in smaller investment firms, offices, or even their homes. Again, these traders are
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generally speculating on market direction – not hedging.
Trading Transactions:
A Bid is what someone is willing to pay for an asset. The Ask, or offer, is what someone is
willing to accept to sell an asset. As a Forex trader, you can Buy at the Ask and Sell at the
Bid.
A price quote of EURUSD at 1.3085 means that one euro is equal to 1.3085 US $ dollars.
When that number increases, it means the Euro is appreciating while the US $ dollar is
depreciating and vice versa.
USDJPY is trading at 124.00. It means 1 US $ dollar is equal to 124 Japanese yen. An
increase in the number means that the US $ dollar is appreciating while the Japanese yen is
depreciating, and vice versa.
Again, if a currency quote goes higher, that increases the value of the base currency. A lower
quote means the base currency is weakening.
Cross currency pairs do not involve US $ dollar. EURJPY at a price of 126.34, means that 1
euro is equal to 126.34 Japanese yen.
There are transactional costs incurred each time a bank makes a trade. There are two
exchange rates for each currency pair: The Bid, which is the rate at which the bank can Sell;
and the Ask, is the rate at which it can Buy. The difference is known as the spread, and
determines the transactional cost of the trade. Each currency pair has its own fixed Bid-Ask
spread.
Based on a 100,000-unit contract trade of EURUSD, the total transactional cost of 3 pips
would be $30.00.
Spread = Ask – Bid (1.2960 – 1.2957 = .0003)
Cost = .0003 * 100,000 = $30.00
(A pip is the minimum movement for a currency pair.)
Types of Prudential Risks:

While banks are exposed to a number of different types of risk in the conduct of their foreign
exchange business, most of these risks also feature in domestic banking business. The
accounting department should receive without delay all the information from the dealers that
is necessary to ensure that no deal goes unrecorded.
All foreign exchange contracts whether spot or forward, should be promptly confirmed in
writing. Dealers should never write their own outgoing confirmations; this should be the
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responsibility of the accounting department alone, which should also be the first to receive
the corresponding incoming confirmations. If confirmations are not forthcoming, the
counterparties should be contacted promptly.
In addition, foreign exchange accounting should be organized in such a way that the bank’s
management is continuously in possession of a full and up-to-date picture of the bank’s
position in individual currencies and with individual counterparties.
This information should not only include the head office but also the positions of affiliates at
home or abroad. Moreover, periodic and frequent revaluations at current market rates should
permit the monitoring of the development of the bank’s profits or losses on its outstanding
foreign exchange book.
It will be the responsibility of the internal audit function to make sure that all dealers observe
their instructions and the code of behavior required from them, and that accounting
procedures meet the necessary standards of accuracy, promptness and completeness.
For this purpose, it will be advisable that not only the internal audits and inspections should
take place at regular intervals, but that occasional spot checks are to be made. As a further
safeguard against malpractices, the auditors, in co-operation with the management may seek
an exchange of information on outstanding foreign exchange contracts with the
counterparties to these contracts.
In order to facilitate internal supervision and monitoring of open exchange of position,
branches should daily report their dealing positions to head office. While the extent to which
individual branches are permitted to run open positions is a matter for a bank’s management,
the decision may be on the basis of geographical factors and the dealing expertise of the
branch concerned, etc.
However, the head office should strictly enforce the limits it sets in order to keep control of
its worldwide exposure.
Closing out a Position:

An open position is one that is live and on-going. As long as the position is open, its value
will fluctuate in accordance with the exchange rate in the market. Any profits or losses will
exist on paper only and will be reflected in the margin account. To close out open position,
what is needed is to conduct an equal and opposite trade in the same currency pair.
For example, if a bank has bought (“gone long”) one lot of EURUSD (at the prevailing offer
price), it can close out that position by subsequently selling one EURUSD lot (at the
prevailing bid price). Some examples are given below.
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Stop-loss Limit:
The Concept:
The Forex (Foreign Exchange) Market behaves differently from other markets. The Forex
market’s speed, volatility, and enormous size are unlike anything else in the financial world.
Forex market is uncontrollable. No single event, individual, or factor impacts on it.
It is a perfect market. Just like any other speculative business, increased risk entails chances
for a higher profit/loss. Any transaction involving currencies involves risks including, but not
limited to, the potential for changing political and/or economic conditions that may
substantially affect the price or liquidity of a currency.
The market is highly speculative and volatile in nature. Any currency can become very
expensive or very cheap in relation to any or all other currencies in a matter of days, hours or
sometimes, in minutes. This unpredictable nature of the currencies is what attracts an investor
to trade and invest in the currency market.
Following are the foreign exchange risk management issues that may come up in day-to-day
foreign exchange transactions:
1. Unexpected corrections in currency exchange rates,
2. Wild variations in foreign exchange rates,

3. Volatile markets offering profit opportunities,
4. Lost payments,
5. Delayed confirmation of payments and receivables, and
6. Divergence between bank drafts received and the contract price.
Stop-loss limit allows traders to set an exit point for a losing trade. A stop-loss limit indicates
an amount of money that a portfolio’s single-period market loss should not exceed. Various
periods may be used, and sometimes multiple stop-loss limits are specified for different
periods.
A trader might be given the following stop-loss limits:
A limit violation occurs whenever a portfolio’s single-period market loss exceeds a stop-loss
limit. In such an event, a trader is usually required to unwind or otherwise hedge material
exposures—hence the name stop-loss limit.
Stop-loss as a risk management tool is useful in equity market as well. No one can pick
winning stocks 100% of the time. Let’s say a bank buys a stock at Rs.200 with the view that
it will go up to Rs.240. Now it has to decide what to do if the stock does not go up, but
suddenly starts to fall.
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A decision is made that if the stock moves below Rs. 190, the bank will accept that it was
wrong about the direction of the stock, sell the position immediately, and take a small loss.
By taking small losses, it preserves trading capital, which allows the bank to trade again on
the next day.
Before the bank even gets into a position, it has to measure the risk-reward ratio. In the above
example, if the bank were to correct the stock pick, it would have made 20 points. If it were
wrong in the stock pick, it would take a loss of 10 points. That is a risk-reward of 4:1.
Assuming that the bank was correct only about stock picks 50% of the time and it makes four
trades. Two were winners (2×4 points) equaling 8 points. Two trades were losers (2 x 1)
totaling 2 points. There is a gain of 6 points by only selecting winning stocks 50% of the
time. Assuming the bank was the worst stock picker in the world and was only correct 25%
of the time, it would still have a gain of 1 point.
It is important to keep risk-reward ratio 4:1. If the bank can only find a risk-reward ratio of
2:1, it is better to leave it alone. If the market is behaving in a way that the bank only finds
risk-reward ratios of 2:1, it has probably no idea as to which way the market is going to
move. The market spends most of its time moving sideways.
The bank must have the discipline to stay on the side-lines when it does not feel comfortable.
Getting into low risk- reward positions because the bank wants to be in the game is wrong. It
shows a lack of discipline and the punishment is losing capital. Discipline includes hitting the
stops and not following the temptation to stay with a losing position that has gone through the
stop-loss level.
Setting Stop-Loss limits:

Setting of a stop-loss limit entails many considerations. First and foremost is the purpose of
the stop-loss limit. For example, if the bank depends entirely on stop-loss limits for limiting
market risk, those limits are likely to play a different role than if merely using them to
supplement value-at-risk limits or exposure limits.
In the latter case, the stop-loss limits represent somewhat of a belt-and- suspenders approach
to limits. The bank may make the stop-loss limits fairly high so that value-at-risk or exposure
limits would typically apply before the stop-loss limits did. In such case, the stop-loss limits
would merely be a safeguard against some sort of situation that the value-at-risk or exposure
limits clearly were failing to adequately address.
Another dimension is the sanction that a violation triggers. The bank may have “green” limits
that simply require that management be informed that there is a loss situation. Higher
“yellow” limits might require that the trader report on how and why the situation arose and
indicate a constructive plan for dealing with the situation moving forward.
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Even higher “red” limits might require the immediate hedging of the position. In practice, the
bank sets the limits based upon an assessment of what is a reasonable loss given the horizon
and the trader’s mandate In this respect, the liquidation period is not particularly relevant.
The process may not be entirely scientific. It will entail subjective opinion. At the end of the
day, a large part of the question is how management wants the system to work … and how
often do they want to have to deal with stop-loss limit violations? Do they want to deal with
them infrequently … but take strong steps when violations do occur, or do they want to have
frequent violations that require a more modest response?
Limitations:
Stop-loss limits have shortcomings. Single-period market loss is a retrospective risk metric. It
only indicates risk after the financial consequences of that risk have been realized. Also, it
provides an inconsistent indication of risk. If a portfolio suffers a large loss over a given
period, this is a clear indication of risk.
If the portfolio does not suffer a large loss, this does not indicate an absence of risk. Another
problem is that traders cannot control the specific losses they incur, so it is difficult to hold
traders accountable for isolated stop-loss limit violations. However, the existence of stop-
loss limits does motivate traders to manage portfolios in such a manner as to avoid limit
violations.
Despite their shortcomings, stop-loss limits are simple and convenient to use. Non-specialists
easily understand stop-loss limits. A single risk metric can be applied consistently across an
entire hierarchy of limits.
As the portfolio loss encompasses all sources of market risk, just one or a handful of limits
are required for each portfolio or sub-portfolio. For these reasons, stop-loss limits are widely
implemented by trading organizations.
Concept # 3. Duration:
Duration is a measure of the average (cash-weighted) term-to- maturity of a bond. Duration is

measured in years. There are two types of durations, Macaulay duration and modified
duration. It is named after its creator, Frederick Macaulay. Macaulay duration is useful in
immunization, where a portfolio of bonds is constructed to fund a known liability.
Immunization is a strategy that matches the duration of assets and liabilities, thereby
minimizing the impact of interest rates on the net worth. Duration is a weighted average of
the times that interest payments and the final return of principal are received. The weights are
the amounts of the payments discounted by the yield-to-maturity of the bond.
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For all bonds, duration is shorter than maturity except zero coupon bonds, whose duration is
equal to maturity. The weight of each cash flow is determined by dividing the present value
of the cash flow by the price
It is an important measure for investors to consider, as bonds with higher durations are more
risky and have higher price volatility than bonds with lower durations.
It is important to note, however, that duration changes as the coupons are paid to the
bondholder. As the bondholder receives a coupon payment, the amount of the cash flow is no
longer on the timeline, which means it is no longer counted as a future cash flow that goes
towards repaying the bondholder.
Duration increases immediately on the day a coupon is paid, but throughout the life of the
bond, the duration is continually decreasing as time to the bond’s maturity decreases.
Duration will decrease as time moves closer to maturity, but duration will increase
momentarily on the day a coupon is paid and removed from the series of future cash flows—
all this occurs until duration, as it does for a zero-coupon bond, eventually converges with the
bond’s maturity.
Besides the movement of time and the payment of coupons, there are other factors that affect
a bond’s duration: the coupon rate and its yield. Bonds with high coupon rates and in turn
high yields will tend to have lower durations than bonds that pay low coupon rates, or offer a
low yield. When a bond pays a higher coupon rate, or has a high yield, the holder of the
security receives repayment for the security at a faster rate.
The computation of duration is done as under:
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Concept # 4. Modified Duration:
Modified duration is an extension of Macaulay duration and is a useful measure of the
sensitivity of a bond’s prices (the present value of the cash flows) to interest rate movements.
Modified duration is a measure of the price sensitivity of a bond to interest rate movements.
It accounts for changing interest rates. Because the interest rates affect yield, fluctuating
interest rates will affect duration. Modified formula shows how much the duration changes
for each percentage change in yield.
For bonds without any embedded features, bond price and interest rate move in opposite
directions. There is an inverse relationship between modified duration and an approximate
one-percentage change in yield. As the modified duration shows how a bond’s duration
changes in relation to interest rate movements, the formula is appropriate for investors
wishing to measure the volatility of a particular bond.
Modified duration follows the concept that interest rates and bond prices move in opposite
directions. This formula is used to determine the effect a 100 basis point (1%) change in
interest rates will have on the price of a bond Modified duration t is calculated as shown
below:
Where y = yield to maturity and

n = number of discounting periods in year (2 for semi – annually paid bonds)
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The Dmod (modified duration) from the earlier example would be worked out as under:
Dmod = 1 * 4.26/ (1 + .075/2) = 4.106 years
Modified duration indicates the percentage change in the price of a bond for a given change
in yield. The percentage change applies to the price of the bond including accrued interest. In
the section showing a bond’s price as the present value of its cash flows, the bond shown was
priced initially at par (100), when the YTM was 7.5%, with Macaulay duration of 4.26 years.
Assume that the bond was re-priced for an increase and decrease in rates of 2.5% (i.e. =+/-
2.50%) A change in the yield of +/- 2.5% should result in a % change in the price of the
bond.
The computation of the same is as under:
% Price Change = -1 * Modified Duration * Yield Change
= -/+1 * (4.106)*0.025
= -/+4.106 * .025
= +/-0.10265
= (+/- 10.265 %).
Since the bond was initially priced at par, the estimated prices are $110.27 at 5.00% and
$89.74 at 10.00%. In reality, there may be certain variation in the estimated change in the
bond price due to the convexity of the bond, which must be included in the price change
calculation when the yield change is large. However, modified duration is still a good
indication of the potential price volatility of a bond.
Concept # 5. Convexity:
The previous percentage price change calculation was not fully accurate because it did not
recognize the convexity of the bond. Convexity is a measure of the amount of “whip” in the
bond’s price yield curve and is so named because of the convex shape of the curve.
Because of the shape of the price yield curve, for a given change in yield down or up, the
gain in price for a drop in yield will be greater than the fall in price due to an equal rise in
yields.
This slight “upside capture, downside protection” is what convexity accounts for.
Mathematically Dmod is the first derivative of price with respect to yield and convexity is the
second (or convexity is the first derivative of modified duration) derivative of price with
respect to yield.
An easier way to think of it is that convexity is the rate of change of duration with yield, and
accounts for the fact that as the yield decreases, the slope of the price— yield curve and
duration, will increase. Similarly, as the yield increases, the slope of the curve will decrease,
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as will the duration. By using convexity in the yield change calculation, a much closer
approximation is achieved.
Using Convexity (C) and Dmod,
% Price Chg. =.
Using the previous example, convexity can be calculated and it results in the expected price
change being:
Concept # 6. RAROC (Risk Adjusted Return on Capital):

A basic premise of finance is that capital should only be invested if the probable future return
on that capital will exceed its cost. The potential investment that requires the apportionment
of existing capital or the generation of incremental capital, should meet such a test.
Risk-adjusted return on capital (RAROC) is a relatively new tool for applying this test in the
lending and credit risk management context. It is known as return on risk-adjusted capital
(RORAC) or risk-adjusted return on risk-adjusted capital (RARORAC)
In financial analysis, riskier projects and investments must be evaluated differently from their
risk less counterparts. By discounting risky cash flows against less risky cash flows RAROC
accounts for changes in the profile of the investment Thus, when companies need to compare
and contrast two different projects or investments, it is important to take into account these
possibilities.
During the 1980s, Bankers Trust developed a firm wide RAPM that they called risk-adjusted
return on capital (RAROC). Bankers Trust was a commercial bank that had adopted a
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business model much like that of an investment bank. It had divested its retail deposit and
lending businesses.
It actively dealt in exempt securities and had an emerging derivatives business. Such
wholesale activities are easier to model than the retail businesses Bankers Trust had divested,
and this certainly facilitated the development of the system. RAROC was well publicized,
and during the 1990s, a number of other banks developed their own firm wide systems.
Today, many banks have built such models, and some use them as decision-making tools at
the heart of their lending processes.
RAROC systems allocate capital for two basic reasons:
(1) risk management, and
(2) Performance evaluation.
For risk-management purposes, the overriding goal of allocating capital to individual
business units is to determine the bank’s optimal capital structure.
This process involves estimating how much the risk (volatility) of each business unit
contributes to the total risk of the bank and, hence, to the bank’s overall capital requirements.
For performance-evaluation purposes, RAROC systems assign capital to business units as
part of a process for determining the risk- adjusted rate of return and, ultimately, the
economic value added to each business unit.
The objective in this case is to measure a business unit’s contribution to shareholder value
and, thus, to provide a basis for effective capital budgeting and incentive compensation at the
business-unit level.
Risk is looked upon as any phenomenon that creates potential volatility in the economic cash
flows of the bank. The purpose of risk capital is to provide comprehensive coverage of losses
for the organization as a whole. By “comprehensive,” they mean coverage of all sources of
risk with a very high degree of confidence.
Computation of RAROC:
RAROC measures performance on a risk-adjusted basis. It is calculated as the economic
return divided by economic capital. RAROC helps determine if a company has the right
balance between capital, returns and risk. The central concept in RAROC is economic
capital: the amount of capital a company should put aside need be based on the risk it runs.
The calculation of RAROC is relatively simple once all the risk calculations have been
completed. RAROC is computed by dividing risk-adjusted net income by the total amount of
economic capital assigned based on the risk calculation. Risk adjusted net income is
determined by taking the financial data allocation to the businesses and adjusting the income
statement for expected loss.
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RAROC = Revenues – Cost – Expected Loss/Economic Capital
Economic Profit = Revenues – Cost – Expected Loss – RoEC X Economic Capital
RAROC = Risk Adjusted Return on Capital
RoEC = required return on Economic Capital
RAROC and EP are equivalent measures, as
RAROC > RoEC if and only if EP > 0
Where expected loss is the mean of the loss distribution associated with some activity, most
typically it represents expected loss from defaulting loans or from operational risk. The
original Bankers Trust RAROC system provided results on an after-tax basis. Today, systems
typically perform calculations before tax.
Advantages of RAROC:
The primary advantage that can be provided by a RAROC model lies in the discipline it can
bring to lending decisions. The model itself is not the objective because it will only be as
good as its builders. RAROC is not an end in itself. Its advantages are more in the way that it
ensures that risk and reward remain linked and in the consistency of decision thinking that it
forces.
Having a calculated RAROC for a transaction does not obviate the need for a careful review
of all new credits and a senior screening (whether by committee or some other means) of
deals that bring a lot of incremental risk.
However, a RAROC model provides a number of advantages to a discriminating user,
including the following:
1. It provides a platform to calculate both risk and return and thereby remove the bias from
one objective or the other. A RAROC calculation can bring an added dimension by showing
the use and return on capital.
2. If provided to all commercial/corporate lenders and used appropriately, a RAROC model
can almost ensure that decisions made in different locations, at different times, with different
relationship managers will be made using the same principles and calculation methodology.
Banks have many decision-makers in the lending business, and their negotiation skills can
vary substantially. A RAROC model tends to level the playing field and give all staff the
chance for a common comparison of their transactions.
3. A RAROC model emphasizes that risk must be compensated for, while ensuring that the
risk is both measured and appropriately considered through the enforced completion of the
calculation.
4. A RAROC model can provide a “what if” capability to the user. In most cases, the
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relationship manager or the credit officer can solve for the price or the risk and rebalance by
adjusting one or the other.
Although these benefits can provide some improvement to the traditional credit process, it
must be repeated that the RAROC calculation is not an end in itself. One of the realities of
RAROC is that the calculation is certain to change because risk changes as time passes. As
such, it is not a solution in itself, nor is it more than a measure at a point in time (albeit a
critical point in time).
The critical question is whether its introduction will improve the existing lending process, the
decision-making ability, and the performance of corporate lending. The answer is specific to
each institution.
RAROC is not an off-the-shelf technology one can apply, but a complicated set of rules that
needs to be calibrated for each bank’s unique set of products, incentive compensation plans,
pricing models, and, most importantly, information systems.
Those who build the RAROC models, however, tend to learn a great deal about their
management of loan assets. They tend to improve on their rating system, they put more
consistency into structuring and pricing, and they are often forced to upgrade their
management information systems. This is why the production of a RAROC model can be a
rewarding journey.
Concept # 7. Auditing Risk Management:

Risk management is one of the means to attain a better trade-off between risk and return. It is
not a panacea for an assured and sustained success. Risk management, as a function in a bank
is fraught with risks. Unless appropriate measures are taken in implementing the process, the
managing of risk itself can give rise to problems.
The risks involved in risk management (RM) are:
1. Inadequate resources for RM,
2. Exclusion of RM cost from business cost and business case for project,
3. Unaffordable risk treatment,
4. Wrong mix of RM team,
5. Risk team not being integrated with other business groups,
6. Late discovery of risk,
7. Risk of abandoning formal process of risk management,
8. Optimization bias,
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9. Planned treatment becoming ineffective, and
10. Inappropriate risk management methods.
To address these issues, it is necessary that like any other banking function, risk management
is also subjected to internal/external audit. The audit may be different from the usual audit of
credit or resources functions.
The basic approach may involve:
Figure 9.2
The Process:
The audit process has to focus on checking the capability profile of concerned people,
leadership, policies/procedures, partners/ resources, and processes as also outcome of the risk
management followed. The purpose is to assess the capability from the perspective of risk
management within the bank.
The intention is not a personnel appraisal of people involved as it would come out as a by-
product of the examination process. The focus is on examining the preparedness of all
concerned to manage the bank’s risk areas.
The capability is judged by many factors. Awareness and understanding about the risk issues
is the first factor to be considered. In case the people are not conscious of the risks
undertaken and the business that involves risk, the situation is considered critical.
As the risk management functionaries would put in place the plan of action, the level of
implementation and progress made in putting the plan to performance is another factor that is
examined.
There may be certain basic measures like segregation of duties, deal confirmations, follow-up
of pending response, etc. Further, there would be critical areas like adherence to risk limits,
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generation and reporting of exceptions, following up of laid down approval procedures, and
the like. Audit has to look into all these aspects.
While the risk management policy would state about the alternate sources of funds through
unconfirmed lines of credit, the operators may not be in know of such arrangements.
Checking on such issues is important.
The best way to assess the adequacy of risk management mechanism is not based on the
amount of income generated. As the future is not likely to behave like the past always, the
possible risk situations in the future may be different.
Actual audit is the only alternative to keep the appetite for risk management alive. The
auditor can take an overall view and come with rating such as unsatisfactory, satisfactory,
good, very good or excellent.
An illustrative check list of the following kind could be a useful starting point for conduct of
an audit of risk management function:
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CORPORATE RISK MANAGEMENT
Corporate risk management refers to all of the methods that a company uses to minimize
financial losses. Risk managers, executives, line managers and middle managers, as well as
all employees, perform practices to prevent loss exposure through internal controls of people
and technologies. Risk management also relates to external threats to a corporation, such as
the fluctuations in the financial market that affect its financial assets.
Protecting Shareholders
A corporation has at least one shareholder. A large corporation, such as a publicly-traded or

employee-owned firm, has thousands, or even millions, of shareholders. Corporate risk
management protects the investment of shareholders through specific measures to control
risk. For example, a company needs to ensure that its funds for capital projects, such as
construction or technology development, are protected until they are ready to use.
Economic Value
Techniques of the first form focus on a concept called economic value. If a market value
exists for an asset, then that market value is the asset’s economic value. If a market value
doesn’t exist, then economic value is the “intrinsic value” of the asset—what the market
value of the asset would be, if it had a market value. Economic values can be assigned in two
ways. One is to start with accounting metrics of value and make suitable adjustments, so they
are more reflective of some intrinsic value. This is the approach employed with economic
value added (EVA) analyses. The other approach is to construct some model to predict what
value the asset might command, if a liquid market existed for it. In this respect, an
unflattering name for economic value is mark-to-model value.
Once some means has been established for assigning economic values, these are treated like
market values. Standard techniques of financial risk management—such as value-at-risk
(VaR) or economic capital allocation—are then applied.
This economic approach to managing business risk is applicable if most of a firm’s balance
sheet can be marked to market. Economic values then only need to be assigned to a few items
in order for techniques of financial risk management to be applied firm wide. An example
would be a commodity wholesaler. Most of its balance sheet comprises physical and forward
positions in commodities, which can be mostly marked to market.
More controversial has been the use of economic valuations in power and natural gas
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markets. The actual energies trade and, for the most part, can be marked to market. However,
producers also hold significant investments in plants and equipment—and these cannot be
marked to market. Suppose some energy trades spot and forward out three years. An asset
that produces the energy has an expected life of 50 years, which means that an economic
value for the asset must reflect a hypothetical 50-year forward curve. The forward curve
doesn’t exist, so a model must construct one. Consequently, assigned economic values are
highly dependent on assumptions. Often, they are arbitrary.
In this context, it isn’t enough to assign economic values. Value-at-risk analyses require
standard deviations and correlations as well. Assigning these to 50-year forward prices that
are themselves hypothetical is essentially meaningless—yet, those standard deviations and
correlations determine the reported value-at-risk.
Such practices got out of hand in the US energy markets during the late 1990s and early
2000s. The most publicized case was Enron Corp., which went beyond using economic
values for internal reporting and incorporated them into its financial reporting to investors.
The 2001 bankruptcy of Enron and subsequent revelations of fraud tainted mark-to-model
techniques.
Book Value
The second approach to addressing business risk starts by defining risks that are meaningful
in the context of book value accounting. Most typical of these are:
• earnings risk, which is risk due to uncertainty in future reported earnings, and
• cash flow risk, which is risk due to uncertainty in future reported cash flows.
Of the two, earnings risk is more akin to market risk. Yet, it avoids the sometimes arbitrary
assumptions of economic valuations. A firm’s accounting earnings are a well-defined notion.
A problem with looking at earnings risk is that earnings are, well, non-economic. Earnings
may be suggestive of economic value, but they can be misleading and are often easy to
manipulate. A firm can report high earnings while its long term franchise is eroded by lack of
investment or the emergence of competing technologies. Financial transactions can boost
short-term earnings at the expense of long-term earnings.
Cash flow risk is less akin to market risk. It relates more to liquidity than the value of a firm,
but this is only partly true. As anyone who has ever worked with distressed firms can attest,
“cash is king.” When a firm gets into difficulty, earnings and market values don’t pay the
bills. Cash flow is the life blood of a firm. However, as with earnings risk, cash flow risk
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offers only an imperfect picture of a firm’s business risk. Cash flows can also be
manipulated, and steady cash flows may hide corporate decline.
Techniques for managing earnings risk and cash flow risk draw heavily on techniques of
asset-liability management—especially scenario analysis and simulation analysis. They also
adapt techniques of financial risk management. In this context, value-at-risk (VaR) becomes
earnings-at-risk (EaR) or cash-flow-at-risk (CFaR). For example, EaR might be reported as
the 10% quantile of this quarter’s earnings.
The actual calculations of EaR or CFaR differ from those for VaR. These are long-term risk
metrics, with horizons of three months or a year. VaR is routinely calculated over a one-day
horizon. Also, EaR and CFaR are driven by rules of accounting while VaR is driven by
financial engineering principles. Typically, EaR or CFaR are calculated by first performing a
simulation analysis. That generates a probability distribution for the period’s earnings or cash
flow, which is then used to value the desired metric of EaR or CFaR.
One decision that needs to be made with EaR or CFaR is whether to use a constant or
contracting horizon. If management wants an EaR analysis for quarterly earnings, should the
analysis actually assess risk to the current quarter’s earnings? If that is the case, the horizon
will start at three months on the first day of the quarter and gradually shrink to zero by the
end of the quarter. The alternative is to use a constant three-month horizon. After the first day
of the quarter, results will no longer apply to that quarter’s actual earnings, but to some
hypothetical earnings over a shifting three-month horizon. Both approaches are used. The
advantage of a contracting horizon is that it addresses an actual concern of management—
will we hit our earnings target this quarter? A disadvantage is that the risk metric keeps
changing—if reported EaR declines over a week, does this mean that actual risk has declined,
or does it simply reflect a shortened horizon?
STRATEGIC RISK MANAGEMENT
Risk has traditionally been seen as something to be avoided – with the belief that if behavior
is risky, it’s not something a business should pursue. But the very nature of business is to take
risks to attain growth. Risk can be a creator of value and can play a unique role in driving
business performance, and so strategies for corporate risk management must be developed to
help guide the business as it decides which risks to take.
Risk management, then, is the identification, assessment and prioritization of risks or
uncertainties in business. Any strategies for corporate risk management must be backed up by
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a risk management analysis and a plan for controlling or mitigating those risks.
But what are risks in corporate life? While the obvious come immediately to mind – the
financial risk of running out of money or inheriting bad debt, or the risk of being unable to
continue operations, for example due to workers going on strike or a force of nature closing a
plant – it’s important to remember corporate risk doesn’t just encompass operational and
financial risks, but also risks to the wider corporate strategy.
In fact, studies indicate that financial risks only generate about 10% of major declines in
market capitalization, while operational risks account for around 30%; the other 60% of
declines are a result of strategic risks, and yet the strategy comes in a poor third in risk-
prioritization exercises.
Strategic corporate risks could include:

Shifts in consumer demand and preferences
Legal and regulatory changes
Competitive pressures
Merger integrations
Technological changes
Senior management turnover
Stakeholder pressure
You’ll note that a lot of strategic risk closely aligns with the compliance and governance
function of an entity, and so these teams must be involved and informed as strategies for
corporate risk management are devised.
Building strategies for corporate risk management

Strategies for corporate risk management usually consist of two processes: setting the
framework for the company’s risk management and setting the communication channels in
the organization. Risk management is, though, useless unless you measure and know your
risks first. You must also have a robust procedure for ongoing monitoring and a cycle of
continual assessment.
Risk management planning encompasses three elements:

Operational risk management, such as damage to property or other risks that can’t be planned
for.
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Financial risk management, which emerges from the effects of markets on an entity’s assets;
this includes risks to credit, price and liquidity.
Strategic risk management, or thinking about the bigger picture and the future of the
company.
Consider what happened to Kodak once digital cameras came along, and ask if that was a
failure of operational risk management or strategic risk management.
One of the best available metrics of risk measurement is economic capital, which is the
amount of equity required to cover any unexpected losses. The economic capital required to
support an individual risk can be calculated and results aggregated across all risks. Dividing
the anticipated after-tax return on each strategic initiative by the economic capital gives you a
RAROC, or risk adjusted return on capital, figure – if the RAROC is less than the cost of
capital, it will destroy value and is, therefore, a huge risk to the company.
Outside of economics, there are five steps to take when first assessing the risk and deciding
on the best solutions for mitigation:
Identify the risk: Risks can be internal or external, so include any events that could cause
problems or benefits for the company.
Analyze the risk: Thoroughly analyze the potential effects each risk will have on consumer
behavior, the company or any endeavors underway.
Evaluate the risk: Rank risks according to the likelihood of each outcome to see how severely
a set risk could impact the company or its strategy.
Treat the risk: Look at ways to reduce the probability of a negative risk and increase the
probability of positive risks, preparing preventative and contingency plans as needed.
Monitor the risk: Track variables and proposed possible threats, and calmly treat any
problems that arise as your tracking system identifies changes.
Once the risk assessment is complete, assign a strategy to treat the identified risks. Generally,
there are four ways to handle a risk:
Avoid the risk, or forfeit all activity that carries the risk – though this also means forfeiting all
associated potential returns and opportunities.
Reduce the risk, or make small changes to reduce the weight of both risk and reward.
Transfer or share the risk, or redistribute the burden of loss or gain by entering partnerships
or bringing on new entities.
Accept the risk, or assume any loss or gain entirely; this is usually put into play for small
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risks where any loss can be easily absorbed by the entity.
The role of the Board in strategies for corporate risk management

One of the central tenets of any Board is to oversee risk, but that job has become highly
complex as market forces become more volatile and modern corporates grow into
multinational behemoths. A strong enterprise risk management (ERM) process doubles as
both an internal safeguard and a shareholder engagement tool. We’ve previously reported that
an ERM framework is a great starting point for board discussion, but also acts as proof that
the company is systematically analyzing and rigorously managing risk in case of investor and
shareholder nerves – all things the Board cares about and is responsible for.
The COSO framework says the role of the board in risk oversight includes: reviewing,
challenging and concurring with management on the proposed strategy and risk appetite;
aligning strategy and business objectives with mission, vision and values; participating in
significant business decisions; formulating responses to significant performance or portfolio
fluctuations; and formulating responses to any deviation from core values; plus approving
management incentives and remuneration, and participating in investor and stakeholder
relations.
Remember, there must be a robust, unshakeable relationship between risk management and
corporate governance in any entity. Falling out of compliance with local regulations is a big
risk that must be managed effectively, and strategies for corporate risk management must
include a focus on compliance.
How technology can help manage corporate risk
All of this leads up to one resounding conclusion: To keep on top of risks, and to manage
them effectively, it pays to incorporate technology into your risk management practices. The
right software platforms can automate regular tasks, act as central repositories for key
information, and make roles, responsibilities and deadlines clear through process
management.
It’s important to assess all three risk areas – financial, operational and strategic – to safeguard
your company’s future growth and reputation, but it’s just as important to regularly check in
with your risk assessments and to ensure progress toward mitigation is going according to
plan. This is where technology can help streamline tasks, and where Diligent’s entity and
board management software can help ease the burden on company secretaries, general
counsels and legal operations teams.
Acting as that all-important central repository for all entity management information, Diligent
software provides secure file sharing and communications, virtual data rooms, assessment
tools and board management tools. Compliance workflows and calendars help keep risk
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management on track through notifications and RAG status, while entity relationship
diagramming can reveal compliance risks that may not be obvious at first sight. All of this
can help drive risk assessments and enhance risk management strategies.
PROJECT RISK MANAGEMENT
Risk management activities are applied to project management. Project risk is defined by
PMI as, "an uncertain event or condition that, if it occurs, has a positive or negative effect on
a project’s objectives."
Project risk management remains a relatively undeveloped discipline, distinct from the risk
management used by Operational, Financial and Underwriters' risk management. This gulf is
due to several factors: Risk Aversion, especially public understanding and risk in social
activities, confusion in the application of risk management to projects, and the additional
sophistication of probability mechanics above those of accounting, finance and engineering.
With the above disciplines of Operational, Financial and Underwriting risk management, the
concepts of risk, risk management and individual risks are nearly interchangeable; being
either personnel or monetary impacts respectively. Impacts in project risk management are
more diverse, overlapping monetary, schedule, capability, quality and engineering
disciplines. For this reason, in project risk management, it is necessary to specify the
differences (paraphrased from the "Department of Defense Risk, Issue, and Opportunity
Management Guide for Defense Acquisition Programs"):
Risk Management: Organizational policy for optimizing investments and (individual) risks to
minimize the possibility of failure.
Risk: The likelihood that a project will fail to meet its objectives.
A risk: A single action, event or hardware component that contributes to an effort's "Risk."
An improvement on the PMBOK definition of risk management is to add a future date to the
definition of a risk. Mathematically, this is expressed as a probability multiplied by an
impact, with the inclusion of a future impact date and critical dates. This addition of future
dates allows predictive approaches.
Good Project Risk Management depends on supporting organizational factors, having clear
roles and responsibilities, and technical analysis.
Chronologically, Project Risk Management may begin in recognizing a threat, or by
examining an opportunity. For example, these may be competitor developments or novel
products. Due to lack of definition, this is frequently performed qualitatively, or semi-
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quantitatively, using product or averaging models. This approach is used to prioritize possible
solutions, where necessary.
In some instances it is possible to begin an analysis of alternatives, generating cost and
development estimates for potential solutions.
Once an approach is selected, more familiar risk management tools and a general project risk
management process may be used for the new projects:
1. A Planning risk management

2. Risk identification and monetary identification
3. Performing qualitative risk analysis
4. Communicating the risk to stakeholders and the funders of the project
5. Refining or iterating the risk based on research and new information
6. Monitoring and controlling risks
Finally, risks must be integrated to provide a complete picture, so projects should be

integrated into enterprise wide risk management, to seize opportunities related to the
achievement of their objectives.
Project risk management tools
In order to make project management effective, the manager’s use risk management tools. It
is necessary to assume the measures referring to the same risk of the project and
accomplishing its objectives.
The project risk management (PRM) system should be based on the competences of the
employees willing to use them to achieve the project’s goal. The system should track down
all the processes and their exposure which occur in the project, as well as the circumstances
that generate risk and determine their effects. Nowadays, the Big Data (BD) analysis appears
an emerging method to create knowledge from the data being generated by different sources
in production processes. According to Górecki, the BD seems to be the adequate tool for
PRM.
BUSINESS RISK MANAGEMENT (BRM)
Business Risk management is a subset of risk management used to evaluate the business risks
involved if any changes occur in the business operations, systems and process. It identifies,
prioritizes and addresses the risk to minimize penalties from unexpected incidents, by
keeping them on track. It also enables an integrated response to multiple risks, and facilitates
a more informed risk-based decision making capability.
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Businesses today are unpredictable, volatile and seem to become more complex every day.
By its very nature, it is filled with risk. Businesses have viewed risk as an evil that should be
minimized or mitigated, whenever possible. However, risk assessment provides a mechanism
for identifying which risks represent opportunities and which represent potential pitfalls.
Risks can have negative impact, positive impact, or both. Risks with a negative impact can
prevent value creation or erode existing value. Risks with positive impact may offset negative
impacts or represent opportunities.
The risk management process involves:

1. Identifying risks – Spotting the evolving risks by studying internal and external factors
that impact the business objectives
2. Analyzing risks – It includes the calibration and, if possible, creation of probability

distributions of outcomes for each material risk.
3. Responding to risk – After identifying and analyzing the potential risk, appropriate
strategy needs to be incorporated. Either by establishing new processes or eliminating,
depending on kind and severity of the risk.
4. Monitoring risk and opportunities – Continually measuring the risks and opportunities of
the business environment. Also keep a check on performance of management strategies.
Types of risks
• Hazard risk: A hazard is anything in the workplace that has the potential to harm people.
Hazard risk includes factors which are not under the control of business environment, such as
fallout of machinery or dangerous chemical, natural calamities.
• Financial risk: A large number of businesses take risk with their financial assets, quite
regularly. Sometimes choosing a wrong supplier or distributor can backfire. Financial risk
also includes risk in pricing, currency exchange and during liquidation of any asset. Business
risk management should say how much risk is too much in financial relationship.
• Operational risk: Evaluation of risk loss resulting from internal process, system, people
or due to any external factor through which a company operates.
• Strategic risks: Might arise from making poor or wrong business plans and losing the
competition in the market. Failure to respond to changes in the business environment or
inadequate capital allocation also represents strategic risk.
SUMMARY
In a corporate setting, the familiar division of risks into market, credit and operational risks
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breaks down.
Of these, credit risk poses the least challenges. To the extent that corporations take credit risk
(some take a lot; others take little), new and traditional techniques of credit risk management
are well established and transferable from one context to another.
Operational risk has little applicability to most corporations. It includes such factors as model
risk or settlement errors. Some aspects do affect corporations—such as fraud or natural
disasters—but corporations have been addressing these with internal audit, facilities
management and legal departments for decades. Corporations may face risks that are akin to
the operational risk of financial institutions but are unique to their own business lines. An
airline is exposed to risks due to weather, equipment failure and terrorism. A power generator
faces the risk that a generating plant may go down for unscheduled maintenance. In corporate
risk management, these risks—those that overlap with the operational risks of financial firms
and those that are akin to such operational risks but are unique to non-financial firms—are
called operations risks.
The biggest challenge of corporate risk management is those risks that are akin to market risk
but aren’t market risk. An oil company holds oil reserves. Their “value” fluctuates with the
market price of oil, but what does this mean? Oil reserves don’t have a market value. As
another example, suppose a chain of restaurants is thriving. Its restaurants are “valuable,” but
it is impossible to assign them market values. Something that doesn’t have a market value
doesn’t pose market risk. This is almost a tautology. Such risks are business risks as opposed
to market risks.
KEYWORDS
• Key Performance Indicator (KPI): A measurement with a defined set of goals and
tolerances that gauges the performance of an important business activity
• Key Risk Indicator (KRI): A proactive measurement for future and emerging risks that
indicates the possibility of an event that adversely affects business activities
• Likelihood: The probability of a risk occurring
• Mitigation Actions: The necessary steps, or action items, to reduce the likelihood and/or
impact of a potential risk
• Operation Risk Profile: The risk arising from the execution of an organization’s business
processes; The risk of loss resulting from failed or inadequate internal processes, systems,
people, or other entities
LEARNING ACTIVITY
1. Identify the factors which are important while framing the systematic framework for risk
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management in Banks.
2. What are the different types of risks that banks are exposed to in the present day context?
UNIT END QUESTIONS
1. Explain what do you understand by the concept of risk management
2. Explain strategic risk management.
3. Explain project risk management
4. Explain business risk management and assumptions.
Long questions
5. Discuss the concept of Business Risk Management
6. Gwendolyn and Jack Francis are typical investors. As they approach retirement, which
approach will they likely take? Explain Why
7. The bidders when ranked from the highest price bid to the lowest are: H, C, F, A, B, D,
E, and G. Bidders H, C, and F have bid for 140,000 shares. A has bid for 20,000. Theprice
that nears the market is the price that was bid by A, or $100. H, C, Fand get their orders filled
at this price. Half of A’s order is filled at this price

1. A tornado swept through a city making it difficult for a small business to earn money for
some time. What kind of insurance would help to minimize the loss of income?
a. Errors and Omissions Insurance
b. General Liability Insurance
c. Directors and Officers Insurance
d. Business Interruption Insurance
2. The proposition that a prediction based upon a sample of 10,000 occurrences is more
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accurate than a prediction based upon 100 occurrences is an illustration of the .
a. first law of prediction
b. first law of probability
c. law of large numbers
d. law of risk management
3. Assessing risks in terms of probability and magnitude of impact is called:

a. risk management
b. risk assessment
c. risk assumption
d. risk avoidance
e. risk identification
4. What is the process for determining the types of risks to which the company is exposed:
a. risk assessment
b. risk identification
c. risk mitigation
d. risk assumption
5. Project Risk Management includes all of the following processes except:

a. Risk Monitoring and Control
b. Risk Identification
c. Risk Avoidance
d. Risk Response Planning
e. Risk Management Planning
6. Risk, as distinct from uncertainty considers:

a. a qualitative approach
b. a Maximaxapproaches
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c. a quantitative approach
d. a maximin approach
7. Which of the following is not a source of financial risk?

a. credit terms
b. exchange rates
c. interest rates
d. marketing mix
8. The exchange rate equivalency model excludes which of the following?

a. Interest Rate Parity Theory
b. International Fisher Effect
c. Expectations Theory
d. International Fletcher Effect
9. Interest rate risk is not faced by:

a. lenders
b. borrowers
c. ordinary shareholders
d. debenture holders
10. Exchange rate risk does not include:
a. transaction risk
b. transposition risk
c. translation risk
d. economic risk
Answers
1. d 2.d 3. b 4. b 5. A 6.c 7.c 8.d 9.d 10.c
REFERENCES
 Dorfman, Mark S. (2007). Introduction to Risk Management and Insurance (9 ed.).
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Englewood Cliffs, N.J: Prentice Hall. ISBN 0-13-224227-3.
 McGivern, Gerry; Fischer, Michael D. (1 February 2012). "Reactivity and reactions to

regulatory transparency in medicine, psychotherapy and counseling" (PDF). Social
Science & Medicine. 74 (3): 289–296. doi:10.1016/j.socscimed.2011.09.035. PMID
22104085.
 IADC HSE Case Guidelines for Mobile Offshore Drilling Units 3.2, section 4.7
 Roehrig, P (2006). "Bet On Governance To Manage Outsourcing Risk". Business

Trends Quarterly.

Pvt. Ltd.

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UNIT 10 FINANCIAL RISK MANAGEMENT
Structure
Learning objectives
Introduction
Financial Risk Management
Market Risk
Credit Risk
Liquidity Risk
Operational Risk
How Do You Implement Financial Risk Control?
Who Manages Financial Risk?
Economic Value
Book Value
Cash flow risk
Effective Cash Flow Risk Management Matters
Improving Your Cash Flow Risk Management
Summary
Keywords
Learning activity
Unit end questions
References
LEARNING OBJECTIVES
After studying this lesson, you will be able:

• Explain financial risk management
• Study about market risks, credit risks, liquidity risk and operational risks
• State about Cash flow risks
INTRODUCTION
Financial risk management is the practice of protecting economic value in a firm by using
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financial instruments to manage exposure to risk: operational risk, credit risk and market risk,
foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk,
legal risk, reputational risk, sector risk etc. Similar to general risk management, financial risk
management requires identifying its sources, measuring it, and plans to address them.
FINANCIAL RISK MANAGEMENT
Financial risk management can be qualitative and quantitative. As a specialization of risk

management, financial risk management focuses on when and how to hedge using financial
instruments to manage costly exposures to risk.
In the banking sector worldwide, the Basel Accords are generally adopted by internationally
active banks for tracking, reporting and exposing operational, credit and market risks.
Finance theory (i.e., financial economics) prescribes that a firm should take on a project if it
increases shareholder value. Finance theory also shows that firm managers cannot create
value for shareholders, also called its investors, by taking on projects that shareholders could
do for themselves at the same cost.
When applied to financial risk management, this implies that firm managers should not hedge
risks that investors can hedge for themselves at the same cost. This notion was captured by
the so-called "hedging irrelevance proposition": In a perfect market, the firm cannot create
value by hedging a risk when the price of bearing that risk within the firm is the same as the
price of bearing it outside of the firm. In practice, financial markets are not likely to be
perfect markets.
This suggests that firm managers likely have many opportunities to create value for
shareholders using financial risk management, wherein they have to determine which risks
are cheaper for the firm to manage than the shareholders. Market risks that result in unique
risks for the firm are commonly the best candidates for financial risk management.
The concepts of financial risk management change dramatically in the international realm.
Multinational Corporations are faced with many different obstacles in overcoming these
challenges. There has been some research on the risks firms must consider when operating in
many countries, such as the three kinds of foreign exchange exposure for various future time
horizons: transactions exposure, accounting exposure, and economic exposure
Anything that relates to money flowing in and out of the business is a financial risk. Since the
list of potential risks is so long, most analysts place them into one of four categories as
follows:
MARKET RISK
As the name implies, a market risk is any risk that comes out of the marketplace in which
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your business operates. For example, if you are a bricks-and-mortar clothing store, the
increasing tendency of customers to shop online would be a market risk. Businesses that
adapt to serve the online crowd have a better chance of surviving than businesses who stick to
the offline business model.
More generally and whatever sector you're in, every business runs the risk of being outpaced
by competitors. If you don't keep up with consumer trends and pricing demands, then you're
likely to lose market share.
CREDIT RISK
Credit risk is the possibility that you'll lose money because someone fails to perform
according to the terms of a contract. For example, if you deliver goods to customers on 30-
day payment terms and the customer does not pay the invoice on time (or at all), then you
have suffered a credit risk. Businesses must retain sufficient cash reserves to cover their
accounts payable or they are going to experience serious cash flow problems.
LIQUIDITY RISK
Also known as funding risk, this category covers all the risks you encounter when trying to
sell assets or raise funds. If something is standing in your way of raising cash fast, then it's
classified as a liquidity risk. A seasonal business, for example, might experience significant
cash flow shortages in the off-season. Do you have enough cash put aside to meet the
potential liquidity risk? How quickly can you dispose of old inventory or assets to get the
cash you need to keep the lights on?
Liquidity risk also includes currency risk and interest rate risk. What would happen to your
cash flows if the exchange rate or interest rates were to suddenly change?
OPERATIONAL RISK
Operational risk is a catch-all term that covers all the other risks a business might encounter
in its daily operations. Staff turnover, theft, fraud, lawsuits, unrealistic financial projections,
poor budgeting and inaccurate marketing plans can all pose a risk to your bottom line if they
are not anticipated and handled correctly.
Financial risk management is the process of understanding and managing the financial risks
that your business might be facing either now or in the future. It's not about eliminating risks,
since few businesses can wrap themselves in cotton wool. Rather, it's about drawing a line in
the sand. The idea is to understand what risks you're willing to take, what risks you'd rather
avoid, and how you're going to develop a strategy based on your risk appetite.
The key to any financial risk management strategy is the plan of action. These are the
practices, procedures and policies your business will use to ensure it doesn't take on more risk
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than it is prepared for. In other words, the plan will make it clear to staff what they can and
cannot do, what decisions need escalating, and who has overall responsibility for any risk that
might arise.
BUSINESS RISK
Business risk is the exposure a company or organization has to factor(s) that will lower its
profits or lead it to fail. Anything that threatens a company's ability to achieve its financial
goals is considered a business risk. There are many factors that can converge to create
business risk. Sometimes it is a company's top leadership or management that creates
situations where a business may be exposed to a greater degree of risk.
However, sometimes the cause of risk is external to a company. Because of this, it is
impossible for a company to completely shelter itself from risk. However, there are ways to
mitigate the overall risks associated with operating a business; most companies accomplish
this through adopting a risk management strategy.
Understanding Business Risk

When a company experiences a high degree of business risk, it may impair its ability to
provide investors and stakeholders with adequate returns. For example, the CEO of a
company may make certain decisions that affect its profits, or the CEO may not accurately
anticipate certain events in the future, causing the business to incur losses or fail.
Business risk is influenced by a number of different factors including:
Consumer preferences, demand, and sales volumes

Per-unit price and input costs
Competition
The overall economic climate
Government regulations
A company with a higher amount of business risk may decide to adopt a capital structure with
a lower debt ratio to ensure that it can meet its financial obligations at all times. With a low
debt ratio, when revenues drop the company may not be able to service its debt (and this may
lead to bankruptcy). On the other hand, when revenues increase, a company with a low debt
ratio experiences larger profits and is able to keep up with its obligations.
HOW DO YOU IMPLEMENT FINANCIAL RISK CONTROL?
Organizations manage their financial risk in different ways. This process depends on what the
business does, what market it operates in and the level of risk it is prepared to accept. In this
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sense, it's up to the business owner and directors of the company to identify and assess the
risk and decide how the company is going to manage them.
Some of the stages in the financial risk management process are:
Identifying the risk exposures

Risk management starts by identifying the financial risks, and their sources or causes. A good
place to start is with the company's balance sheet. This provides a snapshot of the debt,
liquidity, foreign exchange exposure, interest rate risk and commodity price vulnerability the
company is facing. You should also examine the income statement and the cash flow
statement to see how income and cash flows fluctuate over time, and the impact this has on
the organization's risk profile.
Questions to ask here include:

What are the main sources of revenue of the business?
Which customers does the company extend credit to?
What are the credit terms for those customers?
What type of debt does the company have? Short-term or long-term?

What would happen if interests’ rates were to rise?
Quantifying the exposure

The second step is to quantify or put a numerical value on the risks you've identified. Of
course, risk is uncertain, and putting a number on risk exposure will never be exact. Analysts
tend to use statistical models such as the standard deviation and regression method to
measure a company's exposure to various risk factors. These tools measure the amount by
which your data points differ from the average or mean.
For small businesses, computer software like Excel can help you to run some straightforward
analysis in an efficient and accurate way. The general rule is the greater the standard
deviation, the greater the risk associated with the data point or cash flow you're quantifying.
Making a "hedging" decision

After you've analyzed the sources of risk, you must decide how you will act on this
information. Can you live with the risk exposure? Do you need to mitigate it or hedge against
it in some way? This decision is based on multiple factors such as the goals of the company,
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its business environment, its appetite for risk and whether the cost of mitigation justifies the
reduction in risk.
Generally, you might consider the following action steps:
Reducing cash-flow volatility.

Fixing interest rates on loans so you have more certainty in your financing costs.
Managing operating costs.
Managing your payment terms.
Putting rigorous billing and credit control procedures in place.
Saying farewell to customers who regularly abuse your credit terms.
Understanding your commodity price exposure, that is, your susceptibility to variations in the
price of raw materials. If you work in the haulage industry, for example, a rise in oil prices
can increase costs and reduce profits.
Making sure the right people are given the right jobs with the right degree of supervision, to
reduce the risk of fraud.
Performing due diligence on projects, for example, considering the uncertainties associated
with a partnership or joint venture.
WHO MANAGES FINANCIAL RISK?
In a small business, the business owner and senior managers are responsible for risk
management. It's only when the business grows to include multiple departments and activities
that you may wish to bring in a dedicated Financial Risk Manager to manage risk — and
make recommendations for action — on behalf of the company.
The Global Association of Risk Professionals is recognized globally as the premier
accreditation for Financial Risk Management professionals. To receive the FRM certification,
candidates must have two years' work experience and pass a rigorous exam risk on the
subjects of market risk, credit risk, operational risk and investment management. Details are
available on the GARP website.
ECONOMIC VALUE
Techniques of the first form focus on a concept called economic value. If a market value
exists for an asset, then that market value is the asset’s economic value. If a market value
doesn’t exist, then economic value is the “intrinsic value” of the asset—what the market
value of the asset would be, if it had a market value. Economic values can be assigned in two
284
ways. One is to start with accounting metrics of value and make suitable adjustments, so they
are more reflective of some intrinsic value. This is the approach employed with economic
value added (EVA) analyses. The other approach is to construct some model to predict what
value the asset might command, if a liquid market existed for it. In this respect, an
unflattering name for economic value is mark-to-model value.
Once some means has been established for assigning economic values, these are treated like
market values. Standard techniques of financial risk management—such as value-at-risk
(VaR) or economic capital allocation—are then applied.
This economic approach to managing business risk is applicable if most of a firm’s balance
sheet can be marked to market. Economic values then only need to be assigned to a few items
in order for techniques of financial risk management to be applied firm wide. An example
would be a commodity wholesaler. Most of its balance sheet comprises physical and forward
positions in commodities, which can be mostly marked to market.
More controversial has been the use of economic valuations in power and natural gas
markets. The actual energies trade and, for the most part, can be marked to market. However,
producers also hold significant investments in plants and equipment—and these cannot be
marked to market. Suppose some energy trades spot and forward out three years. An asset
that produces the energy has an expected life of 50 years, which means that an economic
value for the asset must reflect a hypothetical 50-year forward curve. The forward curve
doesn’t exist, so a model must construct one. Consequently, assigned economic values are
highly dependent on assumptions. Often, they are arbitrary.
In this context, it isn’t enough to assign economic values. Value-at-risk analyses require
standard deviations and correlations as well. Assigning these to 50-year forward prices that
are themselves hypothetical is essentially meaningless—yet, those standard deviations and
correlations determine the reported value-at-risk.
Such practices got out of hand in the US energy markets during the late 1990s and early
2000s. The most publicized case was Enron Corp., which went beyond using economic
values for internal reporting and incorporated them into its financial reporting to investors.
The 2001 bankruptcy of Enron and subsequent revelations of fraud tainted mark-to-model
techniques.
BOOK VALUE
The second approach to addressing business risk starts by defining risks that are meaningful
in the context of book value accounting. Most typical of these are:
• Earnings risk, which is risk due to uncertainty in future reported earnings, and
• Cash flow risk, which is risk due to uncertainty in future reported cash flows.
285
Of the two, earnings risk is more akin to market risk. Yet, it avoids the sometimes arbitrary
assumptions of economic valuations. A firm’s accounting earnings are a well-defined notion.
A problem with looking at earnings risk is that earnings are, well, non-economic. Earnings
may be suggestive of economic value, but they can be misleading and are often easy to
manipulate. A firm can report high earnings while its long term franchise is eroded by lack of
investment or the emergence of competing technologies. Financial transactions can boost
short-term earnings at the expense of long-term earnings.
Cash flow risk is less akin to market risk. It relates more to liquidity than the value of a firm,
but this is only partly true. As anyone who has ever worked with distressed firms can attest,
“cash is king.” When a firm gets into difficulty, earnings and market values don’t pay the
bills. Cash flow is the life blood of a firm. However, as with earnings risk, cash flow risk
offers only an imperfect picture of a firm’s business risk. Cash flows can also be
manipulated, and steady cash flows may hide corporate decline.
Techniques for managing earnings risk and cash flow risk draw heavily on techniques of
asset-liability management—especially scenario analysis and simulation analysis. They also
adapt techniques of financial risk management. In this context, value-at-risk (VaR) becomes
earnings-at-risk (EaR) or cash-flow-at-risk (CFaR). For example, EaR might be reported as
the 10% quantile of this quarter’s earnings.
The actual calculations of EaR or CFaR differ from those for VaR. These are long-term risk
metrics, with horizons of three months or a year. VaRis routinely calculated over a one-day
horizon. Also, EaR and CFaR are driven by rules of accounting while VaR is driven by
financial engineering principles. Typically, EaR or CFaRare calculated by first performing a
simulation analysis. That generates a probability distribution for the period’s earnings or cash
flow, which is then used to value the desired metric of EaR or CFaR.
One decision that needs to be made with EaR or CFaR is whether to use a constant or
contracting horizon. If management wants an EaR analysis for quarterly earnings, should the
analysis actually assess risk to the current quarter’s earnings? If that is the case, the horizon
will start at three months on the first day of the quarter and gradually shrink to zero by the
end of the quarter. The alternative is to use a constant three-month horizon. After the first day
of the quarter, results will no longer apply to that quarter’s actual earnings, but to some
hypothetical earnings over a shifting three-month horizon. Both approaches are used. The
advantage of a contracting horizon is that it addresses an actual concern of management—
will we hit our earnings target this quarter? A disadvantage is that the risk metric keeps
changing—if reported EaR declines over a week, does this mean that actual risk has declined,
or does it simply reflect a shortened horizon?
286
CASH FLOW RISK
A river of money flows in and out of your business every day, and if you’re not managing it
effectively, you might find your coffers running dry when it’s time to pay bills, cover surprise
expenses, or direct capital into innovation and growth. Cash flow risk is the term used to
describe the potential danger of falling short created by your cash flow management practices—
the lower your cash flow risk, the better equipped your company will be to use its working
capital effectively.
Taking control of your cash flow risk can seem daunting. But by implementing the right best
practices, you can optimize your cash flow risk management and rest easy knowing you have
the funds you need, when you need them most.
While it may be confused or conflated with profits by some, cash flow is actually a process,
not just a figure on the balance sheet. Cash flow can be positive (more cash is flowing in than
out) or negative (more cash is flowing out than in). Negative cash flow presents a much
higher financial risk for businesses of all sizes and types, especially since it’s possible for a
company to have a negative cash flow while still generating a profit.
That’s why cash flow has its own financial documentation (the cash flow statement) to record
all cash flowing in and out of an organization through its financing activities, operations, and
investments. The profit and loss statement (also called the income statement), on the other
hand, records expenses, total sales, and profits. The two are indeed connected, but profits are
not the same as cash; rather, a net loss on the income statement increases cash flow risk, since
capital will be diverted to cover the gap between sales and operating costs.
Investors and lenders regard long-term positive cash flow as an indicator of value generation,
creditworthiness, and stability. Consequently, managing cost flow risk is crucial to both the
immediate financial health and long-term growth of your company.
Effective Cash Flow Risk Management Matters
A lack of readily available capital can make or break a business—particularly during tough
times, such as a recession or a pandemic like the COVID-19 crisis. Cash is used to cover not
just short-term debts like vendor invoices and operating costs, but interest payments on long-
term financing. Without careful, consistent, and complete cash flow risk management, a
company could find itself teetering on the brink of disaster due to a lack of readily available
funds.
To understand cash flow risk, it’s important to know a few key terms:
• Cash Flow at Risk (CFaR) is a measure of how changes in market variables can cause
future cash flows to fall short of expectations, as well as the extent of those changes by risk
factor.
287
• Value at Risk (VaR): Similar to CFAR. A metric used to measure an investment’s
potential loss over a specific time period, generally expressed as the probability of loss
exceeding a specific threshold (e.g., $3 million over a given year).
• Liquidity Risk: A measure of how well an organization can cover its short-term financial
obligations. Liquidity risk increases when a company lacks the working capital to cover these
costs, or has sufficient assets, but cannot readily access them in a timely fashion or without
significant financial loss.
A comprehensive cash flow risk management strategy accounts for the many different
scenarios in business-critical areas that can affect, and are affected by, cash flow, including:
• Operational Strategy: The standards and practices set for accounts receivable,
procurement, and accounts payable will have a pronounced impact on how cash enters and
exits a business, and a direct impact on a company’s liquidity risk.
• Market Conditions: The availability of corporate finance options (and the relative ease of
corporate financial management) is directly tied to market risk. Small businesses, already
hobbled by fewer capital market investment and lending options than their larger brethren,
may find themselves struggling to find investments they can readily liquidate to improve cash
flow, or long-term investments that provide equity for debt management. This is especially
true during a crisis or market downturn/recession. Market conditions have a strong impact on
both CFAR and VAR for both your business and your evaluation of other organizations in
which you may choose to invest.
• Industry-Specific Risks: A sharp downturn in any industry, whether due to economic
disruption, abrupt changes to commodity prices, a loss of customers, etc., can raise expenses
and reduce sales, slashing operational cash flows.
• Investment Strategy: While major investments are generally long-term, rather than short-
term, expenses, they can absolutely affect cash flow. Interest payments (and their associated
interest rates) can consume a sizable chunk of available cash during a given period,
depending on your company’s investment strategy. In addition, pouring large amounts of
capital into expensive equipment or real estate can raise cash flow at risk by reducing
liquidity for the immediate and near future.
• Balancing Short- and Long-Term Debt: Striking the right balance between debt and
equity is crucial to keeping cash flow risk to a minimum. Too many short-term debts can
create a crisis if they’re called in when cash is low, while long term investments may not be
as readily available for small businesses.
Improving Your Cash Flow Risk Management
In tackling a complex process like cash flow management to improve performance, reduce
overall risk as well as cash flow at risk and value at risk, and effectively track (and manage)
288
debt capacity, you need a clear plan and the right tools.
Consider making these best practices part of your cash flow risk management strategy:
1. Invest in Automation and AI
Reducing all your financial risks, including cash flow risk, begins with total transparency
into, and control over, your company’s financial activity. A comprehensive solution like
Purchase Control gives you access to tools you can use to:
• Perform smart and strategic risk assessment.
• Monitor and optimize your entire procure-to-pay (P2P) process
• Leverage on-demand visibility of all your company’s cash flows (both in and out)
• Integrate your P2P workflows with other accounting software to ensure you have
accurate and complete information you need to manage cash flow and reduce risk.
In addition, by centralizing your data management, strengthening your reporting and
forecasting capabilities, and incorporating process optimization (including key performance
enhancers such as automatic three-way matching of vendor invoices), you’ll be able to
implement all the other best practices for cash flow risk management more effectively.
2. Optimize Your Cash Inflow
In good times and bad (but especially in bad), making the most of every incoming dollar is
crucial to business continuity and growth. You can gain better visibility into, and control
over, incoming cash flows by:
• Offering your customers a variety of payment options. More options increase the
likelihood of faster payment.
• Promptly issuing and following up on invoices.
• Providing clear incentives for early payment (including the occasional early payment
discount where prudent) and firm consequences (including fees) for late payments.
• Increase your customer base by:
• Developing new goods or services.
• Getting creative with your marketing to reach new markets.
• Developing and implementing a referral program to grow business and reward loyal
customers.
• Performing additional cost and market research to determine whether you can, and
should, be charging higher prices for goods and services.
• Selling your unpaid invoices in order to generate cash immediately (i.e., invoice
factoring). The purchaser takes a small fee off the top and then collects the payment from the
289
original customer.
• Strategically leveraging small business loans to fund expansions, purchase new
equipment, cover unexpected costs (or mitigate seasonal shortages), and invest in research
and development.
3. Optimize Your Outgoing Cash Flows
Chances are, your management team wants the biggest possible return on investment (ROI)
for every dollar you spend, along with healthy levels of liquidity, VAR and CFAR. You can
make it happen by:
• Reviewing and eliminating any unnecessary expenses.
• Making strategic upgrades to equipment and technology. The immediate costs will be
readily offset by long-term value in the form of greater production capacity and efficiency, as
well as lower maintenance and labour costs that free up more cash.
• Optimizing your workflows to reduce cycle times for both purchase orders and invoices.
• Using a comprehensive P2P solution can make this much easier, and provide a
foundation for a larger digital transformation and business process optimization
• Automation and data management create a closed buying environment that lowers costs
and increases value by eliminating rogue spend and invoice fraud.
• Capturing more discounts from vendors through early payments.
• Taking strategic advantage of extended payment terms when you need more cash.
• Negotiating the best possible payment terms with vendors through contract negotiation
and supplier relationship management (strategic partnerships, e.g.).
• Transferring some short-term debt to long-term debt through financing or the use of
corporate credit cards.
Keep Your Cash Flowing and Your Business Thriving
Is your company’s cash flow a healthy torrent you can tap on demand, or an unpredictable
deluge that suddenly becomes a trickle when you need it most? Invest in the tools and
techniques you need for effective cash risk management, and you’ll have a firm grasp on your
company’s working capital, visibility into and control over cash payments, and stronger
resistance to cash flow volatility that can hurt not only your operational agility, but your
credit rating and perceived value generation for investors and lenders.
SUMMARY
Financial risk management is the process of understanding and managing the financial risks
that your business might be facing either now or in the future. It's not about eliminating risks,
290
since few businesses can wrap themselves in cotton wool. Rather, it's about drawing a line in
the sand. The idea is to understand what risks you're willing to take, what risks you'd rather
avoid, and how you're going to develop a strategy based on your risk appetite.
The key to any financial risk management strategy is the plan of action. These are the
practices, procedures and policies your business will use to ensure it doesn't take on more risk
than it is prepared for. In other words, the plan will make it clear to staff what they can and
cannot do, what decisions need escalating, and who has overall responsibility for any risk that
might arise.
KEYWORDS
• Expected value: The weighted average of a probability distribution

• Option: A contract that gives the holder the right, but not the obligation, to buy or sell a
specified quantity of a security at a specified price within a specified period of time.
• Risk: The degree of uncertainty of return on an asset. Exposure to potential loss or
damage.
• Standard deviation: A measure of dispersion of a set of data from its mean.
• Variance: A measure of the volatility or risk on an investment. Dispersion of a set of data
points around their mean value. In mathematical terms, the square root of the variance is the
standard deviation.
LEARNING ACTIVITY
1. Discuss the role of Book Value in accounting.
2. As a CFO what kind of risk management policies you will implement in the organization
UNIT END QUESTIONS
1. Explain, what do you understand by FRM?
2. Explain the market risk & Credit risk.
3. Explain economic value.
4. Explain cash flow and cash flow risk?
291
5. Discuss the difference of economic value and market value?
Long Questions
1. A firm is planning a $25 million expansion project. The project will be financed with $10
million in debt and $15 million in equity stock (equal to the company's current capital
structure). The before-tax required return on debt is 10% and 15% for equity. If the company
is in the 35% tax bracket, what cost of capital should the firm use to determine the project's
net present value (NPV)?

1. Traditionally, corporate risk management considered all of the following risks EXCEPT
a. Liability risks.
b. Financial risks.
c. Property risks.
d. Personnel risks.
2. Which of the following is most likely to occur in a hard• insurance market?

a. high insurance premiums and loose underwriting standards
b. low insurance premiums and loose underwriting standards
c. low insurance premiums and tight underwriting standards
d. high insurance premiums and tight underwriting standards
3. A computerized database that permits the risk manager to store and analyze risk
management data is called a.
a. Risk map.
b. Risk management intranet.
c. Risk management software program.
d. Risk management information system.
4. A comprehensive risk management program that addresses an organizations pure risks,

speculative risks, strategic risks, and operational risks is called a(n)
a. Financial risk management program.
292
b. Enterprise risk management program.
c. Integrated risk management program.
d. Double-trigger option program.
5. The risk management departments of some companies have developed interactive

networks incorporating search capabilities. These networks are designed for limited, internal
use. Such networks are called
a. Enterprise risk management plans.
b. Risk management intranets.
c. Risk maps.
d. Risk management information systems.
6. Listed companies can be valued at

a. Book Value
b. Market value
c. Salvage value
d. Liquidation value
7. Unlisted company can be valued at

a. Net asset Method
b. Market value method
c. Both a & b
d. None of these
8. Book value is .
a. the same as market value
b. a more accurate valuation technique than the dividend models
c. the accounting value of the firm as reflected in the financial statements

d. the same as liquidation value
293
9. What is the value of the firm usually based on?
a. The value of debt and equity.
b. The value of equity.
c. The value of debt.
d. The value of assets plus liabilities.
10. This type of risk is avoidable through proper diversification.

a. portfolio risk
b. systematic risk
c. unsystematic risk
d. total risk
Answers
1.b 2. d 3. d 4. b 5. b 6.b 7. A 8.c 9.b 10. c
REFERENCES
 Peter F. Christofferson (22 November 2011). Elements of Financial Risk

Management. Academic Press. ISBN 978-0-12-374448-7.
 Allan M. Malz (13 September 2011). Financial Risk Management: Models, History,
and Institutions. John Wiley & Sons. ISBN 978-1-118-02291-7.
 Van Deventer, Donald R., and Kenji Imai. Credit risk models and the Basel Accords.
Singapore: John Wiley & Sons (Asia), 2003.
 Drumond, Ines. "Bank capital requirements, business cycle fluctuations and the Basel
Accords: a synthesis." Journal of Economic Surveys 23.5 (2009): 798-830.

Pvt. Ltd.

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MASTER OF BUSINESS

Academic and Administrative Management

SLM SPECIALLY PREPARED FOR

Printed and Published by:

SCHOOLGURU EDUSERVE PVT LTD

For: CHANDIGARH UNIVERSITY

Institute of Distance and Online Learning

Unit -1 Corporate Finance Basic-I

Nature of Corporate Finance

After studying this unit, you will be able to:

 Explain about meaning, nature and scope of Corporate finance,

 Discuss the concept of time value money

MEANING OF CORPORATE FINANCE

Separation of Ownership and Management

Liaison between Firms and Capital Markets

1.2.1 Definition by Malcolm Evans

NATURE AND SCOPE OF CORPORATE FINANCE

Corporate finance as managing financial activities involved in running a corporation. It

Nature of Corporate Finance

Corporate finance is plays a crucial and important role in business management.

A dynamic in nature of corporate finance is a distinct feature of finance. That it goes on

Scope of Corporate Finance

1. Estimating Financial Requirements

2. Deciding Capital Structure

Functions of Corporate Finance

1. Acquisition of Resources: Acquisition of resource indicates fund generation at the lowest

 Raising of Capital or Financing

Objective of Corporate Finance

THE ROLE OF FINANCIAL MANAGER

Capital Investment Decisions

Management must allocate limited resources between competing opportunities (projects) in a

Important Skills for Financial Managers

1. Understand and evaluate cash flow scenarios

THE FIRM IN CORPORATE FINANCE

The Firm: Structural Set-Up

The Objective of the Firm

• An assumption in classical economics is that firms seek to maximize profits.

 Therefore, in a monopoly profit maximization involves selling a lower quantity and at

TIME VALUE OF MONEY

Understanding the Time Value of Money

Time Value of Money Formula

Time Value of Money Examples

FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000

PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673

Effect of Compounding Periods on Future Value

• Capital Expenditures – money used to acquire or improve fixed assets.

UNIT END QUESTIONS

A. Short Descriptive Question

B. Multiple Choice Questions (MCQs)

2. The ………in conventional corporate financial theory when making decisions is to

4. Financial management is excellent art considering that it needs individual skills,

 Ivo Welch (2014). Corporate Finance (3rd ed.). ISBN 978-0-9840049-1-1.

 Damodaran, A. (2007). Corporate Finance–Theory & Practice, Hoboken, New

 Pandey, I.M. (2016). Financial Management. New Delhi:

 Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018).

After studying this unit, you will be able to:

• State the factors affecting various financial decisions

Factors Affecting Investment Decisions / Capital Budgeting Decisions:

Factors Affecting Financing Decision:

Factors affecting Dividend Decision:

WORKING CAPITAL MANAGEMENT DECISION

Working capital management is a business strategy designed to ensure that a company

SOME FUNDAMENTAL PROPOSITIONS ABOUT CORPORATE